By Morgan Anthony

Picture the scene. Millions of coronavirus vaccinations have been administered. The transmission of the coronavirus has died down. Lockdown restrictions are being lifted. Rishi Sunak is sitting in the U.K. Treasury contemplating which fiscal policies can be administered now that the spread of the coronavirus has been kept under control. Lifting restrictions alone will not be enough to  alleviate the deep double-dip recession the UK finds itself in which included a 20.4% fall in the second quarter of 2020 (the largest quarterly fall in recorded British history). But how effective can fiscal policy be in dragging us from this plight?

Fiscal policy is the spending and taxing powers that a government can administer in order to stabilise an economy. Everything from adjusting income taxes and VAT, to changes in benefits, the employment of teachers and the military, and building infrastructure such as roads or a nationwide 4G network are part of the Treasury’s fiscal toolkit. By increasing government spending through borrowing rather than raising taxes, the government increases output in the economy, which leads to higher disposable incomes for households which spend a proportion of their additional disposable income on consumption thus further growing the economy in the short run. By cutting taxes thus increasing households real disposable income again, households consume more, therefore raising incomes of other households by stimulating more demand for goods and services and further accelerating the growth of the economy. Predicating fiscal policy is this multiplier effect, in which an injection into the economy by the government – either a rise in spending or reduction in taxes – can cause a more than one to one increase in the size of the economy compared to the injection. 

But in the recovery from the Financial Crisis in 2008, economic growth has been sluggish across developed economies in Europe, the Americas and Asia. In research by economist, Valerie Ramey published in the Journal of Economic Perspectives, she finds that fiscal multipliers in the aftermath of the financial crisis were less than unity, regardless of whether the country attempted large fiscal stimulus such as the $831 billion American Recovery or Reinvestment act of 2009 or attempted fiscal consolidation or austerity measures as occurred in Britain and much of Europe. By borrowing from financial markets and reducing the supply of financeable capital, fiscal expansion raises market interest rates and reduces investment. This crowding out of investment counteracts any rise in government spending and subsequent increases in consumer spending. Given that most multipliers after the financial crisis were less than one, with most estimates of the multipliers for Europe or the American Recovery and Relief Act (ARRA) being approximately 0.5, fiscal policy struggled to effectively raise growth across the developed world and promptly return output to pre-crisis levels. 

However, despite the relatively consistent evidence from across the world after the financial crisis, fiscal multipliers haven’t always been this low. Unlike the future recovery of the recession caused by the coronavirus pandemic, fiscal expansion typically has a more noted effect when carried out during a boom with low unemployment. During a recession fiscal expansion signals to households that the economy is in a recession who then carry out cautionary saving but when carried out in a boom, expansionary fiscal policy leads to more confidence and therefore larger fiscal multipliers. Research by Robert Gordon and Robert Krenn find that at the end of the Great Depression just before the United States’ entry to World War 2, fiscal multipliers were as large as 1.8. Furthermore, fiscal multipliers may have risen to as high as 2.5 during the late 1990s and early 2000s in Japan. Due to these much larger multipliers, fiscal policy was successfully able to stabilise these economies.

In the near term, before the threat of coronavirus has subsided, Sunak is likely to extend policies such as the furlough scheme and further grants to struggling businesses in order to keep the economy afloat and wade of financial calamity. Yet, Sunak’s mind will soon turn squarely to fiscal policy to help the economic recovery.

But why were fiscal multipliers larger in certain circumstances and how can Sunak most effectively use fiscal policy? There is an array of economic factors which determine the size of the multiplier. Differences in monetary policy can have a significant impact on the size of the multiplier. When monetary policy is near the effective lower bound (when Central Banks keep their interest rates close to or just below zero and have little ability to reduce interest rates further) or is reduced concurrently with expansionary fiscal policy (as was the case in Japan in the late 90s and early 2000s), fiscal multipliers are larger and often above 1. When monetary policy is at the effective lower bound or is used to accommodate fiscal expansion, expected inflation rises as businesses and households no longer expect the central bank to be as vigorous in controlling inflation. When inflation is expected to rise, real interest rates fall which stimulates more investment and helps magnify the impact of the government’s injection into the economy.  Given that the current Bank of England base rate sits at 0.1%, close to the effective lower bound, once restrictions are lifted fiscal policies may do quite well in raising consumer demand back to the levels it was at before the Coronavirus pandemic. 

Different fiscal policies also effect the size of a multiplier. General transfer payments indiscriminately given out across the population, typically have very low associated fiscal multipliers. As most of the recipients, who weren’t financially constrained, smooth out their spending over long periods of time, any additional stimulation of the economy is negated. Infrastructure bills are also associated with restricted multiplier effects in the short run. As allocating resources and organising infrastructure projects is often incredibly slow, the initial injection into the economy of employing workers and buying raw materials is seldom able to generate a significant multiplier effect or even initial thrust to an economy whereas its longer-term impact on the economy will be much greater. Policies similar to the Eat Out to help Out Scheme, which increase real disposable household income and quickly raise consumption across the entire country, will again be necessary to propel the recovery from the recession we find ourselves in.

Tax cuts can have different effects on a multiplier depending on what type of a cut they are. When interest rates are at the effective lower bound, tax cuts on labour (e.g. income taxes) and taxes on capital will often cause a deflationary effect as monetary policy can’t be loosened to raise inflation. This raises the real interest rate and reduces investment which undermines the expansionary aims of fiscal policy giving the policy a negative or very low multiplier. Policies such as a temporary VAT cut or following through with Sunak’s plan to continue the stamp duty holiday may have a larger multiplier than the alternative of spending increases, as shown in many empirical time-series studies (even if most models suggest tax cuts will have a similarly sized multiplier to government spending at approximately 0.6 to 0.9).

In the longer term, fiscal expansion will somehow have to be funded which will not only impact the growth of the economy when implemented but can also influence the economy in the short term due to households and firms making decisions based on their expectations of future changes to the economy. When fiscal expansion is funded by future rises in taxation (which reduce households’ disposable income), the marginal consumption is suppressed as households and firms engage in cautionary saving to counteract the future rises in taxation. This limits the size of a fiscal multiplier and limits the efficacy of fiscal policy in both the short and long run. Furthermore, if fiscal expansion is expected to be funded by debt in the medium run, the fiscal multiplier is likely to be lower due to rising interest rates on government bonds which accrue due to government debt being harder to finance. This leaves only spending cuts as a feasible method of financing fiscal policy. However, any plan to address the public finances by spending cuts will lack much credibility in a political environment in which governments try to avoid cutting spending and will cause contractions in the economy in the future. Irrespective of whether Rishi Sunak decides to raise taxes or cut spending in the future, both of these policies will dampen any recovery in the medium term. But fixing the roof while the sun shines and repairing the public finances will be a necessary bullet to bite to keep the UK economy on track.

Once the Coronavirus pandemic is in the past, the Chancellor will face the arduous task of deciding the necessary fiscal policies to dovetail with the re-opening of the economy and the relaxation of restrictions in order to stimulate a much needed economic recovery. Even if fiscal multipliers are not that large and fiscal policy is not a panacea, further increasing borrowing alongside the continuation of loose monetary policy will be necessary to spur any economic recovery out of this substantial slump we find ourselves in. But with the UK recording its largest deficit in recorded history, Sunak will eventually face the onerous task of having to return the public finances to order. Whether Sunak raises taxes or cuts spending, these contractionary policies will be a painful end to an unenviable period in the U.K.’s economic history.

The views expressed in this article are the author’s own, and may not reflect the opinions of the St Andrews Economist.

Image source: The Financial Times