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cutting the deficit

Posted by on June 10, 2010 in Debt, Economic Theory, Inflation, Recession | 0 comments

The new Government’s plans to reduce the deficit much more sharply than most people expected. Will this stimulate or depress the economy?

Not surprisingly there is a fierce debate about this.

But it is a situation in which econometric evidence is not going to be of much use at all in arbitrating the dispute. So much depends upon sentiment, upon mood.

Obviously, a reduction in public expenditure – sacking some public sector workers to take a clear example – takes spending power and demand out of the economy. On the face of it, it is an open and shut case that cutting spending depresses the economy.

But here is where sentiment comes into play, in several dimensions:

1. Suppose the cuts lead to the interest rate on long dated Government bonds (‘gilts’) being lower than it otherwise would be. This is likely, but we don’t know by how much

2. This leads to an increase in the value of existing bonds, held by individuals, companies and pension funds. So wealth increases. It may also stimulate the commercial property market, for example. Investors compare yields on property with those on bonds, so property becomes more attractive, prices rise, and the debt problems of developers are eased

3. Firms in general may become more optimistic as a result of lower long rates – their ‘animal spirits’ are more buoyant: this is Keynes’ phrase, he set great store by the long run rate of interest as a determinant of sentiment. If this happens, investment increases, jobs are created

4. Household wealth rises, so consumption may rise

The extent to which all these sentiment-related effects operate – from the amount by which long rates are lower than they would otherwise be to the household wealth effect – the impact of cutting public expenditure will be offset.

There is a further offset, rather esoteric but which might apply in the current circumstances. Deficits mean higher taxes in the future, and some people might save in anticipation of this. A lower deficit may encourage spending not saving.

But all of this is a matter of judgment, of appraising sentiment, not of formal economic modelling.

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