Fiscal threat to global growth

Can cuts in government borrowing really increase economic growth? This question is more important than ever before because 2012 will be the year of fiscal tightening.

Jamie Dannhauser at Lombard Street Research estimates that, on current plans, developed economies will tighten fiscal policy by the equivalent of 1.2 per cent of GDP next year. This, he says, "is the biggest coordinated fiscal consolidation in 30 years." And this is before any possible spending cuts in the US arising from an agreement to raise the debt ceiling.

There is some evidence that this mighn't be terrible for the world economy. There are several cases since the 1980s of countries cutting government borrowing and enjoying surprisingly strong growth.

Sadly, however, it's unlikely that 2012 will repeat this experience. This is because the mechanisms whereby lower public borrowing might boost growth won't operate. For example:

1. "Central banks reduce interest rates in response to tighter fiscal policy, and this stimulates spending."

However, loose policy - low interest rates and quantitative easing - has not led to loose monetary conditions. Figures from the OECD show that in the last 12 months the stock of money, on its broad definition, rose by just 1.3 per cent after inflation. With banks rebuilding their balance sheets - and they might have to do so to a greater extent than hitherto if the euro area debt crisis worsens - this is unlikely to change much. It's unlikely, therefore, that private borrowing will replace public borrowing.

2. "Tighter fiscal policy causes the exchange rate to fall, which boosts exports."

This obviously cannot work next year. Countries can't all see their exchange rates fall.

3. "In averting a debt crisis, tighter fiscal policy reduces long-term interest rates which encourages firms to invest."

But it is not high interest rates that are stopping UK and US firms from investing now. It is uncertainty about future demand and, more fundamentally, a long-term lack of profitable innovations. Tighter fiscal policy will not alleviate these problems.

It is, then, unlikely that we'll see an expansionary fiscal contraction next year. This is all the more true because some recent IMF research has found that such episodes are rare anyway. "Fiscal retrenchments are contractionary" it concludes, estimating that a tightening of one per cent of GDP reduces GDP by 0.6 per cent after two years.

However, it does not follow that developed economies will contract in 2012. This only tells us that fiscal consolidations reduce GDP, other things being equal. But other things are not equal. There are, or could be, two boosts to growth for developed economies next year.

One is not so much a stimulus as a non-recurrence of a depressing factor. It's unlikely - though not impossible - that next year will see a repeat of the sharp rise in commodity prices we had earlier this year. This means we shouldn't suffer the fall in real incomes we've had recently.

The other is that emerging markets should continue to grow nicely, thus raising demand for the developed world's exports.

These factors, among others, mean that most economists expect some modest growth next year in developed economies, of around 2-3 per cent. This, however, will not be enough to reduce significantly the unemployment created by the financial crisis and recession of 2008-09. It will, instead, corroborate the depressing consensus among many economists - that financial crises have long-lasting depressing effects upon economies.

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