Market Review 15 June 2010

A debate rages on about the implications and wisdom of reduced government spending, especially in Europe.  The truth is that different economists have sharply divergent views as to the likely impact of government spending or lack of it on economic activity.  The mature Friedman dismissed the effectiveness of fiscal policy as a stimulus to economic activity.  And this is certainly our view. 

He felt that the notion that extra government spending would naturally boost demand and output in anything other than the short-term was a thought that might appeal to common sense but it was not necessarily true.  He preferred that governments should aim their attention directly at the quantity of money not government spending.  Asked in later life what he saw as the role for fiscal policy in macroeconomic context, he answered,

“I believe that fiscal policy will contribute most if it does not try to offset short-term movements in the economy.  I am expressing a minority view here but it is my belief that fiscal policy is not an effective instrument for controlling short-term movements in the economy.  One of the things I have tried to do over the years is to find cases where fiscal policy is going in one direction and monetary policy is going in the opposite.  In every case the actual course of events follows monetary policy.  I have never found a case in which fiscal policy dominated monetary policy and I suggest to you as a test to find a counter example.” 

Implicitly, Friedman repudiated a view, held almost universally among Keynesians, that the best policy response to the Great Depression of the 1930s would have been a large programme of public words and an associated increase in government deficits.  Indeed, Friedman condemned as futile the increases in budget deficits, which the Japanese government embarked upon in the 1990s in an attempt to break out of its macro economic doldrums.  In his judgement, the Japanese were “wasting time and money in trying to have an expansive fiscal policy without an expansive monetary policy”. 

This is a radical view.  It implies that increased US government spending is pointless and, inversely, that reducing government spending is not nearly as dangerous as people might think.  The new British Office of Budget Responsibility has just concluded that the UK’s adjusted net borrowing should fall from 8% of gross domestic product this year to 2.8% by April 2015 instead of the 2.5% predicted by the UK Treasury in March and that the UK economy will expand at a slower pace than forecast. 

The OBR, now led by Alan Budd, forecast the overall deficit will be £22 billion lower over the next five years than the UK Treasury predicted in March.  The deficit will narrow from £155 billion in this fiscal year to £71 billion by April 2015 or 3.9% of GDP.  Net debt will increase to 74.4% of economic output.  On the surface, this reduced number looks positive or, at least, a move in the right direction.  The critical question is what the structural deficit will be ex the cyclical effects.  Clearly, there are swings but at some points there should be structural equilibrium. 

Friedman advanced two reasons for the virtual irrelevance of fiscal policy, as he saw it.  The first was that fiscal policy is “much harder” to adjust in “a sensitive short-term way” than monetary policy and the second, more fundamental, was that “the Keynesian view that a government deficit is stimulating is simply wrong.”  A deficit, he asserted, was not stimulating because it had to be financed and the negative effects of financing it counterbalance the positive effects, if there are any, on spending. 

Elsewhere, the growth picture is strengthening.  We certainly do not expect a double dip.  In May, China’s exports jumped 48.5% from a year earlier.  This was the biggest gain in more than six years.  The increase surpassed all 32 estimates in a Bloomberg News survey of economists.  Imports rose 48.3%, leaving a trade surplus of $19.53 billion.  Interestingly, shipments to the European Union jumped 50% from a year earlier, compared with 29% in April.  Those to the US climbed 44%, up from 19%.