Economic Theory

Ignore the IFS, Chancellor. There is no case for a fiscal stimulus

Do not let the title of this blog deceive you, dear reader. I am a big fan of the IFS and its work on the public finances. But sometimes when this interacts with macro it becomes more contentious. So I was intrigued to read in the Telegraph that the think-tank had suggested that the Autumn Statement must focus on “targeted, timely and temporary” spending increases to deal with the economic squeeze of leaving the EU. It seems that some priors die hard.

Let’s take the neo-Keynesian story at face value. The government can smooth business cycles with its forward-looking knowledge of demand shocks. With monetary policy impotent and interest rates at rock bottom, only fiscal policy will do the job. Thus temporary infrastructure spending (with those big old multipliers) can help keep the growth rate on an even keel. In other words, the economy can be fine-tuned.

Problem number 1: there is little evidence, so far at least, that the uncertainty of the Brexit referendum result has resulted in a significant temporary demand shock to the economy. Unemployment is very low at 4.9 per cent and the employment rate at historic highs. Data today shows that British businesses hired permanent staff at the fastest pace in 8 months in October. Retail sales are strong. The economy is currently growing at 2 per cent annualised (exactly the growth rate forecast in the 2016 Budget).

Now, it may well be that next year growth underperforms prior expectations (the current forecasts I’ve seen suggest 1.7 per cent growth vs. 2.2 per cent expected at the last budget). But this is highly uncertain, and the most recent money supply data suggests otherwise. In essence what the IFS are doing then is just assuming that the Brexit referendum result will weigh on demand because that’s what their friends at NIESR and Oxford Economics and every other organisation like that has told them. Yet these were also the institutes which forecast a downturn this year. (Genuine question: is there any evidence from anywhere in the world at any time of a flexible economy experiencing a sharp downturn as a result of uncertainty about future trade arrangements?)

Herein we see the first difficulty of discretionary fiscal policy. Using changes to spending and tax to control the economy and keep it on a steady growth path assumes knowledge of the future that governments just do not have, meaning the use of fiscal policy even theoretically can exacerbate booms and busts.

Problem number 2 (and related to 1): whilst they claim infrastructure spending would be the right theoretical response to a downturn, in reality land use planning laws and long lead times mean that there are very few shovel-ready projects. Thus, the timing effects described above are exacerbated. To the extent that the story above is true, tax cuts are a much more direct and immediate means of affecting economic performance.

In reality I do not subscribe to the assumptions behind the Keynesian story. There seems to me little evidence that monetary policy is impotent just because interest rates are low. There is also academic evidence that fiscal stimulus is particularly ineffective for countries such as the UK: open, highly indebted and with floating exchange rates.

Of course, there is a largely separate debate as to whether infrastructure investment should be increased as a supply-side policy given current low government borrowing rates. Advocates of more spending for this suggest that, because infrastructure spending can enhance growth, we should strip investment spending from any borrowing targets.

But as Diego Zuluaga and I set out in a new note on infrastructure spending, government infrastructure spending should be judged by opportunity costs, not government borrowing rates. The relationship between state investment and growth across countries is also incredibly muddy. This is may be because despite the theoretical appeal, there is a tendency when considering ‘more infrastructure spending to boost growth’ to ignore the dynamics of politics, to set aside the effects of lack of market disciplines in project delivery, to confuse average and marginal (roads help enhance economic mobility so every new road must be good for economic mobility) and to downplay the potential for private-sector delivery.

Head of Public Policy and Director, Paragon Initiative

Ryan Bourne is Head of Public Policy at the IEA and Director of The Paragon Initiative. Ryan was educated at Magdalene College, Cambridge where he achieved a double-first in Economics at undergraduate level and later an MPhil qualification. Prior to joining the IEA, Ryan worked for a year at the economic consultancy firm Frontier Economics on competition and public policy issues. After leaving Frontier in 2010, Ryan joined the Centre for Policy Studies think tank in Westminster, first as an Economics Researcher and subsequently as Head of Economic Research. There, he was responsible for writing, editing and commissioning economic reports across a broad range of areas, as well as organisation of economic-themed events and roundtables. Ryan appears regularly in the national media, including writing for The Times, the Daily Telegraph, ConservativeHome and Spectator Coffee House, and appearing on broadcast, including BBC News, Newsnight, Sky News, Jeff Randall Live, Reuters and LBC radio. He is currently a weekly columnist for CityAM.

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