Fiscal stimulus: Too much of a good thing can prove a country’s undoing

IN THEORY, when the economy is performing below its potential, governments can get things moving with a well-designed fiscal stimulus. Sadly, in practice, a stimulus is rarely well-designed, and even their greatest advocates are forced to ignore history and argue that “this time will be different”.

Nobel prize winner Joseph Stiglitz has admitted that the US 2009 stimulus was “not as well designed as it could have been”. But even if a fiscal stimulus – perhaps one where Stiglitz himself gets to sit behind the wheel – were perfect, certain preconditions are required. Foremost is the ability to borrow more money without making borrowing unsustainable.

When the economist John Maynard Keynes helped pioneer the fiscal stimulus in 1936, countries tended to run low budget deficits. Many economists view his advice as supporting a temporary deficit of around 2 per cent of GDP when an economy is in a recession. The problem, as James Buchanan and Richard Wagner argued in the 1970s, is that the political incentives are asymmetric. While voters may reward politicians who promise to spend our way to full employment, it is less popular to promise to pay off the national debt. For this reason, permanent budget deficits have persisted, with a deficit of 2 to 3 per cent of GDP common in many developed countries even in the boom time. This constant attempt to stimulate has two effects.

Firstly, a stimulus is no longer a stimulus when it becomes the norm. If it’s defined as an increase in the permanent deficit, it’s a lot harder to get bang for your buck. Some economists now suggest that growth will improve if we splurge 4 to 5 per cent of GDP. But there is little evidence to back this up, and the downside risks are vast.

Secondly, for as long as there is a deficit, there will be a build up of debt. Historical evidence suggests that, once public debt exceeds 90 per cent of GDP, a government runs a serious risk of default. That is why countries joining the euro were supposed to keep their public debt below 60 per cent of GDP.

In the UK, 10 years ago public debt was about 30 per cent of GDP. It went above 60 per cent in 2010/11. Now, there is little scope for increasing the deficit beyond already historic levels.

When the Labour government launched its £20bn stimulus package in November 2008, it didn’t just borrow money to invest in new projects. Part of the package involved bringing forward £3bn worth of planned investment projects from 2010/11. In other words public spending was cashed in early. Part of today’s growth was sacrificed to fuel a bigger stimulus in 2008.

Economists debate whether the 2008 stimulus failed, or whether it simply wasn’t enough. But they cannot ignore reality. Too much of a good thing can be your undoing and, when governments get hooked on stimulus, it should be no surprise that the impact is muted when the economy really needs it. With high debt levels, the best you can hope for is a single shot. And if that fails, you’ll have sold your future with nothing to show except more debt.

Anthony J. Evans is associate professor of economics at ESCP Europe Business School:
Twitter: @anthonyjevans