The Least Blunt Instrument

I am often accused of being overly critical of the government. I am certainly critical and whether I am overly so depends to some extent on your personal perspective. I should be clear though, that I do think they have been unfortunate to be in power at such a difficult time. If you compare their predicament with those of many previous governments you would have to concede that they didn’t have much luck with the hand they were dealt.

In normal times, the UK has been shown to have a remarkably robust economy, able to deal with a huge amount of bad governing and still somehow manage to achieve growth. These aren’t normal times though and unfortunately for the current government they came to power at a time when the usual robustness of the UK economy could not be relied upon to deliver growth in the short-term. When Labour came to power in 1997, they would have had to implement something fairly ludicrous to avoid economic growth over the next couple of years. Cameron’s government was not so lucky – the choices they would have to make would decide whether, with natural robustness absent, the UK would recover or stagnate.

Anyway, this week the IMF warned that the UK economy was still all busted up and the government should start to think about a Plan B to encourage some growth. Well hoorah for that.

As I mentioned, the government has a tricky economic problem to solve and unfortunately only has four fairly blunt instruments trying to do it. Those four blunt instruments are:

Monetary Policies:

• Cutting interest rates
• Increasing the money supply (also, more confusingly, called “quantitative easing”)

Fiscal Policies:

• Cutting taxes
• Increasing government spending

With that usual robustness gone, I am very strongly in favour of some action to stimulate the economy. My favourite of the above is to increase government spending but as an alternative, the IMF suggested all three of the others. I suppose they might be reluctant to promote my favourite, having, at the start of the mess, advocated spending cuts to promote growth (oops!), but let’s look at how the other three compare.

Cutting Interest Rates
Cutting interest rates makes borrowing cheaper. If the private sector can borrow more cheaply then they are more likely to do so, thereby financing business expansion and job creation. We do have a problem though.

UK interest rates have been at 0.5% for three years. We could cut them a tiny bit more but we’re already so close to zero, there’s little room to make any real difference.

Despite the current low rate from The Bank of England, the banks themselves have not passed low borrowing rates on to the private sector. I logged onto my Internet banking the other day and saw an advert for me to take out a loan at 7.9% APR. I’m fairly sure I saw the same advert when interest rates were 4%. Banks simply don’t want to lend cheaply at the moment. Due to the economic climate they see people and companies as risky. And in fairness why shouldn’t they? The last time they lent to risky people their lending led to a global financial crisis. Banks are not going to start lending before the economy has recovered. Interest rate cuts won’t solve the problem.

Increasing the Money Supply
The Bank of England can print some money (they have the keys to the money printer). When they create money they can use it to buy bonds and other long term assets from the banks. By doing this they replace those bonds with cash that is free to lend. This blunt instrument has the same problem as the previous one though. It still requires the banks to actually lend to someone. If a bank thought it had a liquidity problem it would sell some bonds to the Bank of England and keep the cash. Its liquidity problem has been solved but no more money has actually been lent.

Don’t misunderstand me, low interest rates and an increase in the money supply have made things better than they would have been otherwise but while banks don’t want to lend, these measures are not enough to solve the problem.

Tax Cuts
Cutting taxes can stimulate the economy because people have more money to spend and in the economy your spending is my income. More spending means more income, more jobs and more growth.

This is ok as an idea as long as the tax cuts actually lead to more spending. So why might they not?

We could aim tax cuts at rich people but rich people already have plenty of money to finance their lifestyles so most of the extra money would simply go into their savings. Your spending is my income; your savings are not. Or at least they aren’t going to be any time soon. This is an inefficient way to try to make a short term stimulus to the economy.

We could aim tax cuts at the middle classes. This would be a bit better as they would spend more of it than the rich people. However, the middle classes at the moment, despite low interest rates, are firmly in save mode. Because the depression has no end in sight, middle income people are still worried about their jobs and many are probably regretting how little they squirrelled away in the good times. It’s more efficient to give them tax cuts than the rich but a lot of the extra money will still be saved. It’s still not that efficient.

So who’s left? Yes, the poor. If we cut taxes on the poor, much more of the money will be spent. Poor people for obvious reasons, save a much lower proportion of their income. If the government puts extra money in their pockets through tax cuts they will spend it.

So tax cuts can be good if they are focused in the right places.

Now that I’ve looked at the first three blunt instruments, I’ll talk about the other one – the one I like the best.

Increasing Government Spending
Let me start by making it clear that I am not such a lefty that I think all spending should always come from the government. I would love it if we had a private sector that was rapidly expanding and eating up all of the job applications from the unemployed.

I think even the austerity fans can probably admit this is not a fair reflection of reality though. So if the private sector doesn’t want to spend on something then the government can do so instead and as long as the public sector isn’t treading on private sector toes then every pound spent is a pound that would otherwise not have been spent and the economy has a very efficient boost. You might say that this logic makes it a policy that only works when we have high unemployment. Yep, it would be a terrible policy to pursue if employment was high and government spending were competing with the private sector. We’re a long way away from that situation at the moment though.

Like tax cuts, government spending needs to be carefully focused. If we choose this option we should spend the money on infrastructure improvements, renewable energy, school buildings etc. These are things we need to spend money on anyway. Far from being an excuse not to do these things, the depressed economy should be seen as an opportunity. The government can, at the moment, spend without any competition with the private sector and can later reduce its spending once the private sector is ready to run. This policy is, I think, efficient.

So in summary, cut taxes for poor people and increase government spending. Yes, I know I sound like a terrible lefty for proposing that but I hope you see that I have taken time to explain why I think those policies have the best chance of ending the depression. If you think that the other options are better I would love to hear from you.

If, like the government, you feel that any kind of stimulus is a bad idea then that’s also ok. But bear in mind – no stimulus = no growth for a long time. It’s that simple.

RedEaredRabbit