Why getting fiscal won't do any good

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The Independent Online
FISCAL POLICY does not seem to work the way it used to. Take the Budget last week. Budgets are often as interesting for what they leave out as what they put in. With Gordon Brown's, the most obvious omission was any change in fiscal stance. The balance between taxation and spending was left more or less exactly as before: there were lots of detail changes, but the overall balance hardly moved.

Of course, he did not need to do anything. The decision that policy had to be tightened had been taken by Norman Lamont and Kenneth Clarke and was only reinforced by Mr Brown's first Budget last July. The effect has been to tighten policy by the equivalent of about 2 per cent of GDP over a four-year period. This, coupled with growth, has narrowed the public sector deficit from nearly 7 per cent of GDP in 1993-94 to within a whisker of balance in the coming year.

Note three things. First, the principal reason for tightening policy - from all three Chancellors - had nothing to do with slowing the pace of growth, but with the need to be responsible about public borrowing. Second, there seems little evidence that the sharp tightening of policy has had much impact on the economy. And third, despite the surge in the deficit in the last cycle, the recovery began in earnest only when interest rates were cut and sterling left the ERM.

Now look at Japan, running a fiscal deficit of about 7 per cent of GDP. It has had four fiscal packages, supposed to boost the economy, this year. But the economy is heading back into recession. The authorities are being pressed for another fiscal boost, but believe that if a 7 per cent deficit doesn't do the job, there is no reason to expect an 8 or 9 per cent one to do so.

Look at continental Europe. In the last three years fiscal policy has been savagely tightened to meet the Maastricht criteria. Many, myself included, thought this a dreadful time to tighten policy, given that the recovery was so fragile. But we were wrong: the recovery has broadened and deepened despite the tightening.

In short, economies do not seem nearly as responsive as they were (or were thought to be) to changes in fiscal policies. Why, and what are the implications? We are groping for an answer. In 20 years' time economists will have come up with a theory. But I have seen no thorough study of the apparent decline in the effectiveness of fiscal policy as an economic regulator. Indeed people still talk as if it is a powerful weapon.

Here are some suggestions. The first is that the expectations of consumers and business are much more sophisticated. When governments run large deficits, everyone is aware that sooner or later they will have to cut back. They do not, so to speak, "trust" the deficit. Consumers do not regain confidence, businesses keep cutting investment. As deficits start to come down we feel things are under control, relax and spend a bit more.

A second point follows: the bond markets are also fazed by deficits. Until the first oil shock, spending and revenues went up more or less in tandem (see left-hand graph). Then taxation failed to rise sufficiently fast to cover the surge in spending, and governments had to borrow the difference. One result is shown in the other graph, the surge in real interest rates in the 1980s. Governments found that fiscal expansion tended to be offset by an involuntary monetary tightening, with real long-term rates in particular moving in the "wrong" direction.

Third, there has been a shift in the relative importance of the public and private sectors as sources of investment. The overall size of the public sector of most developed countries has not fallen, but spending has. Privatisation has taken a large element of decision-making out of the public sector, and pressure on welfare systems has imposed growing burdens on it. If you want money for investment - for example, for London's Tube - you have to rely mainly on the private sector. Pump-priming through new investment is a private-sector matter.

Finally, globalisation means that the level of investment in a country is determined to a much greater extent by forces outside that country rather than the government and private sector within it. Money flows to what are seen to be the best investment opportunities. Economic activity is therefore profoundly affected by the structural policies of a government - does it encourage a flexible labour market, is it tax-friendly to foreign investors, and so on.

If this argument is right, there are some stunning conclusions. If fiscal policy is less effective, then the only powerful weapon governments have is structural policy. The other candidate - monetary policy - has been largely off-loaded on to (more or less) independent central banks and will be off-loaded entirely under EMU. For EMU members, the pressure on governments to push through business-friendly structural policies will be enormous. They have nothing else: no independent monetary policy, no ability to change exchange rates, and (if I'm right) ineffective fiscal policy. A profound consequence of EMU will therefore be rapid structural reforms; indeed, structural policies will become the main arena where European governments compete. There will be great long-term economic benefits; but there will be equally great tensions in the short term between leaders and laggards.

Finally, remember that structural policy is qualitatively different from both fiscal and monetary policy. It has no cyclical element: you cannot tighten or loosen a structural policy. You can encourage inward investment, which will boost demand - look at Ireland. You can deter inward investment and slow down development. But it is not a regulator.

Does this matter? Well, if you accept that governments have no control over the economy, or you believe they are deeply incompetent when they try, there is no problem. But I'm not sure that governments have quite explained this to the voters. And I'm not sure voters will go a bundle on the idea that governments are powerless in the face of the next global recession.