Pro-growth policies at a time of fiscal austerity

In both the UK and Europe, commentators have become increasingly vocal about the need to combine the necessary fiscal austerity with policies designed to boost economic growth. They are correct to stress that the easiest method to reduce budget deficits is for private sector growth to boost tax receipts – the problem is how to combine demand growth in the private sector with the necessary control of demand in the public sector and the options are very restricted. Every pound or euro of public spending that is reduced as part of an austerity package is a pound or euro less of somebody’s income – this is why the savage austerity imposed on Greece, Ireland and Portugal (equivalent to 3% or more of GDP in a single year for several years) has led to recession as huge swathes of final demand were removed from the economy and business and consumer confidence collapsed. The UK is aiming to reduce its budget deficit only by about 1% pa, similar in fact to the pace of deficit reduction it achieved in the early 80s, and so far has avoided the severe recession seen in other European countries that had to make much sharper retrenchments of their government spending.

Monetary policy is the obvious starting point for pro-growth policies when fiscal policy has to be tightened. However interest rates have effectively already been cut as far as is meaningful, and the UK’s Quantitative Easing and the ECB’s trillion euro LTROs have meant a great deal of money has already been created in both the UK and Europe. The danger with these policies is that it is similar to filling a balloon with water – the balloon expands as water is added with no impact on its surroundings, until no more water can be contained and then the balloon bursts and drenches everything around it – there is very little impact on the economy from printing the extra money until it reaches a critical point and the money pours into the real economy creating inflation.

The IMF’s standard pro-growth policy used in conjunction with fiscal austerity for countries in need of support has always been a (large) devaluation. This provides a kick-start to the private sector which boosts export demand for its products at a time when the domestic market is struggling. Sadly for those countries inside the Eurozone, they voluntarily gave up the possibility of using this policy when they joined the single currency.

Politicians on the right of the political spectrum argue that lower tax rates increase the incentives to make money, and that this leads to growth and thus higher total tax revenues – and they point to point to the 1980s as evidence of this. It is true that there is an (unknown) optimum tax rate that yields the most tax; in the 80s marginal tax rates were very high (and probably above the optimum rate) and their reduction did spark more growth and higher revenues. However today’s marginal tax rates are much lower than then (and likely to be near or possibly already below the optimum rate), and it is not clear that it would have a very significant effect on growth today.

Increasing the efficiency of the economy by reducing bureaucracy and regulation is another policy often claimed to improve growth prospects. Certainly these impose costs and constrain the ability of business people to do more business. Reducing these requirements will boost growth in the long term but not necessarily in the short term. And in today’s society some degree of regulation is considered desirable (eg in healthcare and financial services) in order to protect consumers, so there is a need to distinguish between “good” and “bad” regulation and bureaucracy.

Infrastructure spending is generally viewed as a pro-growth policy since it creates jobs in the short term and boosts economic efficiency in the longer term. The problem for fiscally constrained economies is that the returns to this investment are very long term and so make the short term budget deficit even worse. There is however one option for the UK that would help to boost growth in the short term and that would be for the government to build directly or else to subsidise building a large number of new homes. The UK suffers from a shortage of housing, resulting in high rents and high house prices. Houses can be built and sold on for a profit reasonably quickly, leaving a small positive effect on public finances, providing jobs for thousands of construction workers and by boosting supply will tend to reduce the high rents and house prices which consume so much of the UK’s income.