Fiscal policy limited in the UK and the US

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Clive Crook of the Financial Times rightly takes on the Bush Administration and its squandering of hundreds of billions of dollars of fiscal surplus on war in Iraq and ta cuts for the wealthy. In this time of economic crisis, the U.S. is severely limited in its potential fiscal response by the massive budget deficit left behind by Bush. What Crook fails to mention is the fiscal circumstances in the UK are equally unfortunate given an unprecedented 15-year expansion. One would think, there would be fiscal dividends to reap from such economic times of plenty. Apparently not.

Some fiscal room for manoeuvre would be good right now – but precious little remains. The White House just updated its budget forecasts for next year. These pencil in a deficit of nearly $500bn (£253bn, €321bn). This excludes roughly $80bn of war costs. It also makes incomplete allowance for the fiscal component of the various housing-related bail-outs now in train. If Freddie Mac and Fannie Mae, the housing agencies, are forced to draw on the full support that the Treasury, with the passage of the new housing bill, is empowered to provide, add tens of billions more. A deficit of 5 per cent of gross domestic product next year is within reach.

Looking farther ahead, both presidential candidates are promising to cut taxes by thousands of billions of dollars over the next 10 years (relative to the Bush administration’s bogus baseline). Barack Obama, the Democratic contender, is calling for an additional fiscal stimulus right now.

Budget deficits should indeed rise sharply in recessions. In the US, this requires more forceful intervention than in most European countries. Automatic fiscal stabilisers are less powerful in the US: the government is smaller, and the tax base (lacking a value-added tax or equivalent) is less cyclically sensitive. States have to comply with semi-binding balanced budget rules as well, which perversely tighten fiscal policy during recessions. California, in the midst of the current slowdown, has been forced to sack thousands of workers and put state employees on the minimum wage.

Even so, further aggressive fiscal easing at the federal level would be risky. If the budget outlook starts to scare the markets and interrupt the flow of foreign capital to the US, the dollar might fall abruptly – worsening the inflation risk and forcing the Fed’s hand on interest rates. The point at which fiscal easing becomes self-cancelling may not be far away.

It is worth remembering where the blame for this neutering of fiscal policy lies: squarely with the Bush administration. At the start of this decade, the budget stood in surplus to the tune of 2.4 per cent of GDP. On unchanged policy, this was expected to grow to a surplus of 4.5 per cent of GDP by 2008. This year’s actual deficit of 3 per cent of GDP therefore represents a worsening of more than 7 per cent of GDP, or roughly $1,000bn. Almost all of this deterioration is due to policy: to tax cuts, spending increases, and their associated debt-service costs.

That projected surplus was a priceless gift to the White House. It offered the Bush administration ample scope for outlays on homeland security and other unforeseen priorities, and moderate tax cuts as well, all within a budget balanced over the course of the business cycle. Instead, the administration knowingly opted for outrageous fiscal excess – adding insult to injury with its phoney tax-cut sunset provisions, designed for no other purpose than to disguise the long-term fiscal implications. Eight years on, this startling record of fiscal irresponsibility has all but taken fiscal policy off the table as an available response to the slowdown.

The U.S. economy had better have luck on its side. Luck is about all it has left.

Financial Times, 3 Aug 2008

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