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Monday, November 10, 2008

A fiscal stimulus will work - won't it?

The conventional wisdom is focusing on tax cuts as providing the fiscal stimulus the economy requires. But is cutting tax the best way forward? And do fiscal measures promote growth in a downturn? Rather worryingly, evidence from the International Monetary Fund suggests that sometimes it could make things worse.

If companies won't invest and the economy is slowing, one response is to cut taxes or increase spending. In last month's World Economic Outlook, the IMF looked at the effect of using fiscal stimulus. It found mixed evidence in practice, with some suggestion that economies with high government debt levels actually saw growth fall after a fiscal stimulus. This was because markets began to worry about mounting levels of government debt, which effectively raised borrowing rates. However, the IMF study defined high debt levels as 75% of GDP (a long way from the UK level). The IMF also found that in the past fiscal stimulus had acted as a counter-cyclical tool, but only in advanced economies.

An IMF simulation indicated that an increase in government investment would be the fastest way of stimulating an economy. However, this appeared to be contrary to the empirical study. More work will be required, both on empirical studies and models used. Perhaps a key lesson is that the easy assumption that a fiscal boost will in turn boost the economy is not necessarily soundly based. We should also not forget that fiscal policy was rejected as an economic policy tool because increasing inflation and lags between policy and implementation meant that it could make things worse.

However, we do live in unusual times. Business confidence is low. Borrowing is difficult because banks are still deleveraging. Cutting interest rates may have some effect, but there is a strong case for government intervention where business will not invest.

In any event, we must not lose sight of a key aim of government policy. It is that people should be productively employed and can lead fulfilling lives.

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