What do we know about effects of fiscal consolidation on short term growth? Implications for the UK

This chapter analyses the economic situation in the UK as it attempts to recover from the financial and economic crisis that began in 2008. In particular, we focus on the probability that the fiscal consolidation, introduced by the new coalition government in 2010, is likely to be expansionary or contractionary. To analyse this we first briefly survey the large economic literature on the impact of government borrowing on economic growth. We identify the key factors that empirical evidence suggests affect the probability that a fiscal consolidation will be expansionary. We then examine these factors in the context of the UK to identify whether they are favourable or not towards the consolidation being expansionary.

Can the UK fiscal consolidation be expansionary?

This research project reviews the economic literature which has investigated empirically the conditions under which a fiscal contraction, of the kind currently in process in the UK, may be expansionary. Five factors are identified as being likely to be of significance: the size of the consolidation; the composition of the consolidation between spending cuts and tax increases; the initial level of public debt; whether interest rates are at a lower bound; and whether there is a devaluation of the exchange rate. Of these, there is more empirical support for the importance of the first two. Both of these factors are positive for the UK. Of the others, only the low interest rates points in the opposite direction. However, this optimistic position should be treated with caution for two reasons. First, there are number of weaknesses in the empirical literature. Second, the favourable probability of the consolidation being expansionary is only relative to other consolidations. Despite the relatively good position of the UK, there must still be considerable doubt as to the eventual outcome.
 
Katarzyna Bilicka, Michael Devereux and Clemens Fuest