finance

Fiscal tightening is upon us


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Yesterday was Budget day in the UK. Read the FT’s excellent coverage here, including Chris Giles’s overview and Martin Wolf’s comment article. The only contribution I want to sneak in among all this fine reporting is to observe how the UK’s budgetary choices compare to the common challenges in the international picture.

As I have warned before, the debate about shortages, inflation and overheating does not give enough attention to the fact that we are entering a period of record-shattering fiscal tightening. Just as the extraordinary deficit spending has supported incomes and thereby economic activity through the pandemic (whatever activity was permitted to go on, that is), so does the withdrawal of that support constitute a drag on demand.

The most detailed calculations of this effect I have seen come from the Brookings Institution’s Hutchins Center, which regularly publishes a “fiscal impact measure” of how the US government’s budgetary decisions affect America’s short-term growth rate. The key to this measure is that, to simplify, it is the change in the budget balance that changes growth. And as the chart below shows, the most recent Hutchins Center estimates are that Washington’s currently enacted budget policy has been reducing the annualised US growth rate by 2 to 3 percentage points since the spring, and will continue to do so for the next two years.

Chart showing the growth impact of US fiscal policy

Those are very big numbers. This “fiscal drag” is the biggest in decades and amounts to more than the US’s total trend growth in normal times. And while these are US numbers, a similar pattern holds for other rich economies, especially the UK.

Below I have charted a crude measure of the fiscal impact of government budgets, with the UK (before this week’s Budget) alongside the average for the G7 group of rich countries and for the eurozone. It is the year-to-year change in the IMF’s October forecasts of the “cyclically adjusted primary deficit” — that is to say the budgetary stance that can be most directly attributed to policy action (or inaction), removing the change automatically affected by the economic cycle or interest payments.

Chart showing the change in cyclically adjusted primary budget balance of the UK, eurozone and G7

It shows that the UK has pencilled in a much stronger fiscal contraction than its peers on average. The same picture emerges when I redo the chart using just the overall primary balance (since there are reasons to be suspicious of any method to separate structural from cyclical budget changes in a pandemic).

Chart showingchange in primary budget balance of the UK, eurozone and G7

Does this week’s UK Budget change this picture? A little, but not all that much. Here is what the independent Office for Budget Responsibility’s report on the budget plans has to say:

“The overall fiscal stance underpinning our forecast is characterised by a sharp tightening between 2021-22 and 2024-25 as pandemic-related fiscal support is withdrawn — the structural deficit falls from 8.3 to 1.8 per cent of GDP over those three years.”

That sharp tightening remains even though the effect of this week’s budget decisions was “to loosen the fiscal stance materially in 2022-23 (by 0.8 per cent of GDP) and then by diminishing amounts thereafter (reaching 0.2 per cent of GDP in 2026-27)”. So the government has lessened the blow a little (through “large rises in departmental spending that are only partly financed by tax increases”) but remains on a course of rapid fiscal contraction.

What should we make, then, of the UK’s decision to top the belt-tightening league? Here are three thoughts.

First, like every other government, the UK’s budget planners are counting on private demand picking up the slack as the public sector slams on the brakes. At a moment of widespread shortages and supply disruptions, that may seem safe enough. But remember that the fiscal contractions have not really started yet, and the hole in aggregate demand that will have to be filled is going to be enormous. Sure enough, the OBR’s projection is that the household savings rate will come down imminently from still record-high levels to somewhere even below its pre-pandemic level. Wherever it does not come down quite that far, fiscal consolidation could sharply slow down growth as private demand fails to compensate fully. That is why I have written that we are entering a moment of maximum danger as economies recover from the pandemic.

Second, the UK government is special in that it has for some time pursued a restructuring of the government’s economic footprint towards a state that both taxes and spends more than it has done in decades. The OBR puts the long-term increase in the tax take at almost 3 per cent and spending at 1.8 per cent of national income. This is a programmed fiscal tightening on top of the withdrawal of pandemic support.

Third, the UK may not have much choice. It has damaged its productive potential by raising trade barriers against its biggest market, and many economists expect it to leave the pandemic with more permanent “scarring” of its economy than other big economies.

Chart showing forecast of output in 2024 compared with the autumn 2019 forecast for the UK and the other G7 countries

A permanently smaller economy ultimately necessitates budgetary retrenchment to close the gap between a smaller tax base and unchanged spending plans. Or so some might think. Others might think that, on the contrary, bigger challenges make it imperative to put resources into whatever may grow the economy. That may mean borrowing more to invest, it may mean reallocating what public budgets are spent on and where they draw their revenues from, and it may justify a higher level of both taxes and government spending overall. One hopes these are the questions being asked inside Her Majesty’s Treasury and finance ministries around the world. They are not easy to answer.

Other readables

  • Ahead of the COP26 climate conference, I interviewed Jeffrey Sachs about what the summit needs to achieve — and many other aspects of what our economic future holds.

  • The incoming German government coalition faces the same dilemma at the domestic and European level: how to boost investment within budget rules that discourage it.

Numbers news

  • My colleague Martin Arnold dissects the perspectives on when the European Central Bank may raise rates, which contrast between market participants and the central bankers themselves.

    Chart showing harmonised index of consumer prices

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