Mervyn King’s speech to the TUC this week reiterated his strong support for the fiscal retrenchment plan announced by the coalition government in the UK. Some people have said that it is not the role of the central bank Governor to comment on fiscal policy, which they argue should be confined to the political arena. However, the Fed Chairman and the President of the ECB frequently comment on government debt and budget deficits, so it is hard to see why Mr King should be criticised for expressing his opinion. A much more important question is what his speech tells us about the likely course of fiscal policy and its relationship with monetary policy.
The main point made by Mr King was that the UK has the highest budget deficit in its history, and that a credible plan for reducing this deficit is essential. He describes the coalition’s plan to eliminate the deficit by the end of the Parliament as “a more gradual fiscal tightening than in some other countries”. This is an interesting choice of words, since the only countries which have embarked on a more rapid tightening than the UK are the peripheral economies in the Eurozone, and they have been forced to take this action by severe financial crises. Clearly, Mr King believes that a similar financial crisis is a very real threat in the UK case.
The Governor has warned of a financial crisis several times before, so this should not come as a surprise. But he then went on to say something which is more interesting. These are his words:
“If the recovery is slower than expected, then the automatic stabilisers – the lower tax receipts and higher spending that result from weaker growth – will act to stimulate demand. And monetary policy can react too, especially when there is a credible plan to reduce the deficit.”
To start with the last part of the statement, the Governor is giving a clear re-assurance that he will support further monetary easing, which means more quantitative easing, if the path for UK GDP is lower than the government expects. Tight fiscal policy, easy monetary policy – that is very clearly the mix which the UK has chosen, and anyone inclined to be bullish about sterling should pay attention to this. Again, no real surprise here, though some members of the MPC may take a more hawkish line than their boss.
That leaves the Governor’s remark about the path for fiscal policy. He seems to be saying that the speed at which the deficit will be reduced should be contingent upon the speed of the recovery in GDP. If the recession persists for longer than expected, then the automatic stabilisers will be allowed to work, and the budget deficit will be higher than the Treasury has targeted.
At first sight, this does not seem to be consistent with the recent statements of the Chancellor. For example, on 17 August, Mr Osborne said:
“Britain now has a credible plan to deal with our record deficit. We must stick by it. To budge from that plan now would risk reigniting markets’ suspicion that Britain does not have the will to pay her way in the world. I will not take that risk.”
However, Mr Osborne did support the use of the automatic stabilisers in 2008, and a careful reading of the 2010 Budget Red Book seems to allow some (limited) leeway for the government to relax its target for budget balance in 2015, if GDP falls below the projected path. Furthermore, the government is only committed to hitting the end point of the target in 2015, which leaves open the possibility that it could deviate from that path in the meantime.
Even so, the Governor has now made a much more explicit statement about fiscal contingency than anything I have been able to find from the Treasury, which of course is focused on the immediate political battle to get its spending cuts through the cabinet. An admission that the path for the budget deficit is not fixed in stone might undermine its case.
If it is correct to conclude that the government’s fiscal plans are actually contingent on the path for GDP, it seems to be a step in the right direction. Martin Wolf has on several occasions asked in the FT “What is the Chancellor’s Plan B?” If the recovery stalls, will fiscal policy really be tightened further in order to stick to the pre-determined target for the budget deficit, which is what Mr Osborne sometimes seems to have implied by his strong emphasis on the deficit reduction plan?
In today’s FT column, Martin goes further and argues that if GDP growth is disappointing, then there should be less rapid cuts in public spending, and reductions in national insurance contributions, in order to cushion the fall in the economy. Martin argues very eloquently that it would be more credible for the government to announce this in advance, and make it part of the explicit medium term fiscal plan, than to wait until targets are missed during a crisis.
Martin’s proposal would go further than simply allowing the automatic stabilisers to work, but actually it is not a million miles away from a plan which could be compatible with the fine print of the 2010 Budget.
Not that you would necessarily jump to that conclusion that from a cursory reading of the Chancellor’s speeches.
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