Research published by the Institute of Economic Affairs today highlights how stimulus measures pursued by Western governments in response to the economic crisis have not worked, and why, without drastic fiscal and tax reform, Western countries will not resolve their sovereign debt crises.

Taken from a lecture delivered for the Institute earlier this year by Prof. Robert Barro, the report provides a stark warning to the coalition government to hold the course on deficit reduction and resist temptation to embark on any ‘Plan B’.

Key findings:

• Fiscal stimulus packages might increase output in the short-run, but the long-term effect is negative
  
  
  
  • Growth might be boosted in the first year; but the effect drops in the second
  
  
  • By the third year, the public debt has been inflated substantially and it has to be repaid – not through
    further borrowing, but through tax rises
  
  
  • This has a further negative effect and can dampen economic growth, or even risk another recession
  
  
  • Indeed we may currently be feeling the negative effects of the stimulus packages embarked upon in 2009. If they had not happened, we might well be having faster growth now
  
  
  
  


• If fiscal stimulus packages are to be used, they should be based around tax cuts, so the reductions stimulate work, investment and enterprise


• Increasing spending is simply wasteful, and in certain circumstances can be very damaging
  
  
  
  • e.g. In the US, an increase in unemployment entitlements has seen long-term unemployment increase by between 1 and 2 per cent
  
  
  
  


• The next financial crisis will be one of government debt – not just in the Eurozone but more widely
  
  
  
  • The problem is as acute in the USA as it is for EU Member States.
  
  
  
  


• The government debt crisis involves both explicit borrowing and implicit liabilities (public sector pensions, etc.)
  
  
  
  • Public spending cuts, coupled with robust tax reform, are needed
    Solutions:
  
  
  
  


• Cutting marginal tax rates has a positive effect on economic activity


• Low interest rates brought in since the recession have had a positive effect and it is reasonable for them to stay in place for the foreseeable future


• Current efforts at deficit reduction are focused on cutting current expenditure; more must be done to reform and limit long-term liabilities


• In an EU context, monetary and fiscal policy must be decoupled (precisely the opposite of what is happening now) so that countries do not find themselves liable for each other’s borrowing

Commenting on the report, Mark Littlewood, Director General of the Institute of Economic Affairs, said:

“We must resist the calls of those who say that one last, big spending push could get the economy back to meaningful growth. The opposite is true. Many Western economies might well be tipping back towards recession partly because of these giant fiscal packages that were enacted in 2009, and the coalition government must resist calls for any Plan B that involves more government borrowing and spending.

“The government must be firm on deficit reduction – in fact it should go a lot further – and should look to robust supply-side reform to boost growth.”

Prof Philip Booth, Editorial Director at the Institute of Economic Affairs, said:

“Unfunded promises have been made by Western governments looking to garner votes. This is a problem not just in the Eurozone but in the US too. These long-term liabilities relating to state pension and health obligations must be tackled urgently.

“Recently we have seen the coalition government blink in the face of public sector pensions reform. A more unflinching resolve is needed if the UK’s underlying fiscal issues are to be prevented from turning into a crisis.”

Notes to editors

To arrange an interview with Mark Littlewood (Director General of the Institute of Economic Affairs) or Prof. Philip Booth (Editorial Director at the Institute of Economic affairs) please contact Stephanie Lis, Director of Communications: 020 7799 8909, slis@iea.org.uk

Prof Robert Barro delivered the IEA’s Annual Hayek Memorial Lecture on the subject of Fiscal-Stimulus Packages in July 2011. The report is the transcript of that lecture. A video of his lecture can be viewed here.

The full report Crises of Governments can be downloaded for free by clicking here.

The mission of the Institute of Economic Affairs is to improve understanding of the fundamental institutions of a free society by analysing and expounding the role of markets in solving economic and social problems. The IEA is a registered educational charity and independent of all political parties.