As we are weeks away from the beginning of the bulk of Osborne’s cuts, now is a good time to ask: just how damaging will they be?
First let’s remind ourselves of two facts.
1) Osborne plans to tighten fiscal policy by6.3% of national income (GDP) over the next four years, with most of this coming from cuts rather than tax rises. In other words he is planning discretionary changes in tax and spending that add up to 6.3% of national income: a huge adjustment.
2) According to the OBR the trend growth rate for the UK economy over the next few years is somewhere between 2% and 2.5% per year.
So we have an economy that would normally grow between 2% and 2.5% each year, and Osborne’s planned cuts of around 6.3% over four years.
The IMF, using past experience and economic modelling, last year analysed the impact of spending cuts on GDP growth.
It estimates that spending cuts of 1% of GDP subtract 0.5% from growth.
However it notes that usually when a country makes cuts, its central bank will cut interest rates to support the economy – and its currency will fall making exports more competitive overseas.
But in Britain the Bank of England has no room to cut rates (they are already just 0.5% and higher inflation makes an increase more likely than a cut) – and sterling has already fallen a great deal.
The IMF analysed what happens if the government cuts spending but there is no support for the economy from falling interest rates or a falling currency.
If interest rates don’t fall and the currency doesn’t lose value then the IMF estimates that spending cuts of 1% of GDP subtract 1% from growth.
But what makes the coming period of austerity really different is that it is not limited to just one government. States across the developed world are engaging in the same policies.
Usually when a country makes cuts this supresses domestic demand but companies can still grow by tapping into demand from abroad. That may not be an option this time.
The IMF estimates that if other countries are cutting at the same time, if interest rates cannot fall and if the currency does not depreciate, then spending cuts of 1% of GDP subtract 2% from growth.
“Overall, these results illustrate that changes in both the interest rate and the exchange rate are important to the adjustment process. When countries cannot rely on the exchange rate channel to stimulate net exports, as in the case of the global consolidation, and cannot ease monetary policy to stimulate domestic demand, due to the zero interest rate floor, the output costs of fiscal consolidation are much larger. Thus, in the presence of the zero interest rate floor, there could be large output costs associated with front-loaded fiscal retrenchment implemented across all the large economies at the same time.“
We are about to find out how large the costs of “front-loaded fiscal retrenchment” actually are.
Duncan Weldon is an economist and blogger.