Wednesday, April 08, 2009

Bad debt and the nightmare of the anti-stimulus

This week the Institute for Fiscal Studies published a gloomy report [PDF] on the UK public finances, estimating that the government’s budget deficit will climb to 10.4% of GDP in 2009/10 and 10.5% in 2010/11.

On current policy assumptions, the IFS projects total national debt to peak at over 70% of GDP in a few years – or, if you include what the International Monetary Fund estimates we might lose on bailing out the banks, over 80%.

Against this background, the report blows a gentle raspberry at the thought of further substantial fiscal stimulus.

Not good. The best that can realistically be hoped for in Alistair Darling’s Budget later this month is some targeted assistance for a few particularly needy groups.

But things could be worse.

A real debt crisis is when your public finances have been shredded to the point where not only can you not dare a fiscal stimulus to fight the recession but you actually have to tighten fiscal policy – raising taxes and cutting spending – in a desperate bid to slightly reduce your budget deficit. And you find yourself doing this even though that very policy will make the recession worse.

Welcome to Ireland, where yesterday’s emergency ‘Supplementary Budget’ [PDF] did just that:

Prior to the corrective action taken in this Supplementary Budget, a General Government deficit of -12¾ per cent of GDP was anticipated for 2009.

a General Government Deficit of -10¾ per cent of GDP is now forecast for 2009.

It is estimated that the level of economic activity will be reduced by about 1 percentage point on foot of the Supplementary Budget.

Ouch. Is this a good idea for Ireland? Is trimming two percentage points off a huge deficit really worth cutting the already-plummeting GDP by another point? I’m not sure, but Stephanie Flanders of the Beeb has some thoughts. The aim is to improve market confidence in the government’s finances, but one risk is that this hits consumer confidence to the point where the contractionary effect of the anti-stimulus is bigger than expected, and so the budgetary improvement is smaller than expected. It’s playing with fire.

Any lessons for the UK? Ireland’s recession is much worse than ours, and its borrowing and debt seem due to shoot up by more than ours (albeit from a lower base and so to a comparable level) over the next couple of years. But generally, the smaller your economy, the more public debt the markets will tolerate (which is why the USA can get away with such a huge stimulus).

Given that the Irish government’s credit rating has been downgraded and ours hasn’t, it seems that we’re not in the same dire straits. Calls for more big fiscal stimulus here may be whistling in the wind, but any fiscal tightening mid-recession (Ă  la early 1980s) would be unwarranted and dangerous.

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