Plan B stimulus could push us into recession

New IEA research released

Research published by the Institute of Economic Affairs today highlights how stimulus measures pursued by Western governments in response to the economic crisis have not worked, and why, without drastic fiscal and tax reform, Western countries will not resolve their sovereign debt crises.

Taken from a lecture delivered for the Institute earlier this year by Prof. Robert Barro, the report provides a stark warning to the coalition government to hold the course on deficit reduction and resist temptation to embark on any ‘Plan B’.

Key findings:

  • Fiscal stimulus packages might increase output in the short-run, but the long-term effect is negative
            - Growth might be boosted in the first year; but the effect drops in the second
            - By the third year, the public debt has been inflated substantially and it has to be repaid – not through
              further borrowing, but through tax rises
            - This has a further negative effect and can dampen economic growth, or even risk another recession
            - Indeed we may currently be feeling the negative effects of the stimulus packages embarked upon in
              2009. If they had not happened, we might well be having faster growth now
  • If fiscal stimulus packages are to be used, they should be based around tax cuts, so the reductions stimulate work, investment and enterprise
  • Increasing spending is simply wasteful, and in certain circumstances can be very damaging
            - e.g. In the US, an increase in unemployment entitlements has seen long-term unemployment increase
              by between 1 and 2 per cent
  • The next financial crisis will be one of government debt – not just in the Eurozone but more widely
            - The problem is as acute in the USA as it is for EU Member States.
  • The government debt crisis involves both explicit borrowing and implicit liabilities (public sector pensions, etc.)
            - Public spending cuts, coupled with robust tax reform, are needed

Solutions:

  • Cutting marginal tax rates has a positive effect on economic activity
  • Low interest rates brought in since the recession have had a positive effect and it is reasonable for them to stay in place for the foreseeable future
  • Current efforts at deficit reduction are focused on cutting current expenditure;