Will the splurge work?

We have become used to dealing in £billions since the onset of the banking crisis. With the economy facing such a dire economic outlook, there is a sense that many more £billions should be thrown at the problem – but the danger is that, in our desperation for a solution, we rush headlong into potentially more destabilising circumstances.

The UK is in a particularly tricky situation, with the European Commission expecting our deficit to deteriorate to 6.5% in 2010 (the second highest borrowing forecast among the 27 member states), and the Financial Times reporting a probable rise in public borrowing to £120bn. This causes a problem with regard to credibility: will the stimulus be reversed to put the government’s house back in order?

If so – and the Treasury has so far hinted that tax cuts will indeed only be temporary – then the taxpayer is more likely to save the handout, neutralising the expansionary impact. If not, and borrowing is used to finance more borrowing, the Government could face a persistently higher cost of raising capital, as the financial markets demand a higher interest rate to compensate for a higher risk premium.

Aside from the issue of credibility, there is a practical problem with the timing of a Keynesian public spending splurge. Ed Balls, in 2004, highlighted the issue, commenting that “the existence of long decision and implementation lags meant that, too often, what governments thought were counter‐cyclical policy decisions tended to be pro‐cyclical and therefore destabilising”.

There is, of course, the argument that action now means the government will be able to repay its debts and the taxpayer can withstand tax rises, as the total output of the economy will increase in the future. However, a near-term recovery in the UK economy is by no means a consensus view; and with international financial confidence so precarious, UK assets could suffer even before we see the tender green shoots.

Economists have suggested that a more sustainable method for boosting the economy could come from a fiscal consolidation. Our research has focussed on nine studies quoted in an ECB investigation, all of which show that as long as the consolidation centres on unproductive spending and not tax rises, the credibility effects outweighed the traditional ‘Keynesian multiplier’ effects. Taxpayers may spend more today in expectation of future income growth. It will also reduce the chances of higher long-term interest rates, as the market anticipates reduced government borrowing. Finally, there may be a boost to the supply side: making the public sector more efficient and increasing international competitiveness.

There are hard choices ahead for the UK government, but with every crisis comes opportunity. Will the splurge deliver a more robust, balanced, and sustainable economy, or will it destabilise an already precarious situation?

Helen Thomas is the Economics Research Fellow at Policy Exchange