Friday 3 August 2012

The impact of alternative paths of fiscal consolidation on output and employment

NIESR has just published research estimating the economic impact of immediate versus delayed fiscal  consolidation in the UK.  The research was undertaken by Dawn Holland (NIESR), John Van Reenen, Professor of Economics at the London School of Economics and Director of the Centre for Economic Performance, and Nitika Bagaria, a Phd student also at LSE and CEP.  John and I have written an article for the FT(£). 

Using NIESR's macroeconomic model, NiGEM, the research looks at the economic impact of implementing the same consolidation plan - the same tax rises and spending cuts - as under current policy, but delaying implementation for three years.  In addition, it examines what would have happened in the absence of any consolidation.  

Alternative timings for fiscal consolidation are likely to matter for a number of reasons.   First, interest rates, both short and long term, are currently extraordinarily low, despite very high deficits. The response of monetary policy to fiscal policy may be different if consolidation is undertaken at  a time when interest rates are close to the zero lower bound. Second, some households and firms may be unable to borrow under current conditions - they may be "credit constrained".  Third,  protracted high levels of unemployment may have an impact on the supply side of the economy over the medium term.   All these effects are well known to economists, but have not in general been incorporated into standard macroeconomic models.

The research shows that the "no fiscal consolidation" scenario would have led to unsustainable debt ratios.  So some loss of output from consolidation was inevitable.  In both alternative scenarios, consolidation reduces growth and raises unemployment.   However, the research finds that these impacts would have been substantially less, and less long-lasting, if consolidation had been delayed.  

As the table shows, the resulting cumulative loss of output over the period 2011-21 amounts to about £239 billion in 2010 prices, or about 16 per cent of 2010 GDP.   Unemployment also remains considerably higher for longer.   Over the longer run, however, the economy eventually returns to long-run equilibrium. 

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