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What's a contractionary fiscal expansion?

As the General Election approaches we examine what the economic consequences of a Labour Government might be.

A decade ago the Conservative-Liberal Democrat Coalition Government embarked on a policy of deficit reduction which became synonymous with the epithet 'austerity'. At the time one of the arguments proposed in favour of austerity was the idea of an expansionary fiscal contraction or expansionary austerity. The idea that less public spending means more GDP growth went against the traditional economic textbook model whereby lower/higher public spending led lower/higher economic growth. A decade on this blog argues that implementation of the Labour Party Manifesto would lead to the emergence of a new and completely opposite idea, that more is less, namely a contractionary fiscal expansion. The primary reason for a contractionary fiscal expansion would be the negative supply-side effects on the economy, but there are likely to be very significant demand-side consequences as well.

Labour's economic manifesto has been sharply criticised by the Financial Times stating: "Jeremy Corbyn's hard left programme will wreck the UK economy. The combination of punitive tax increases, sweeping nationalisation and the end of Thatcher era union reforms turns the clock back 40 years. Set alongside a vast expansion of the state ... Labour's plans are a recipe for terminal economic decline". 

The Labour Party Manifesto (and subsequent spending pledges not costed in the manifesto) comprises £83 billion per annum in extra current spending by 2023-24, another £55 billion per annum in capital investment spending and nearly £12 billion per annum in WASPI compensation (£58 billion over 5 years). This totals an extra £150 billion per annum in spending. But this is not the end of the spending splurge. At least £10 billion could be added to public spending due to the economic fallout from labour market changes such as the shift towards a 32 hour week and the end of 1980s trade union reforms. So we've reached at least £160 billion per annum in extra spending and we haven't even factored in the costs of nationalisation of the Royal Mail, part of BT, the rail operating companies and the energy and water utilities. There are two extremes on how much this would cost. The CBI thinks the cost of nationalisation would be nearly £200 billion (i.e. £40 billion per annum over a 5 year Parliament). The Shadow Chancellor says the cost would be "zilch" because the public sector would acquire an asset and the costs of borrowing could be met by profits. This of course assumes that meddling politicians won't prevent the nationalised companies from making a profit. If the CBI estimates are correct (they have been challenged) then the extra public spending under a Corbyn Government would amount to £200 billion per annum. 

Despite promising to introduce punitive tax increases of £83 billion per annum, the gap between taxes and spending would be enormous, with an exploding budget deficit the likely consequences. Faced with this threat the stock market and sterling would plummet and gilt yields would spike. We would also very likely see an explosion in precautionary behaviour by individuals and companies, with an increase in saving at the expense of consumption and investment spending.

Labour's so-called Fiscal Credibility Rule promises to eliminate the current budget deficit over a rolling 5 year period and keep debt interest payments below 10 percent of tax revenues. There is a credibility problem with any fiscal rule given that only days after the manifesto was launched public spending was increased by £58 billion for WASPI compensation. But it has also not gone unnoticed that the rule could be easily satisfied by higher and higher taxation. The higher taxation rises the more damage is done to the supply-side of the economy and the incentive to work, save and invest.

All of the numbers above are predicated on the assumption of continued economic growth. But if economic history is any guide such fiscal policies would crash the economy into a recession. If that was the case spending could rise even higher. Recessions can easily add 4-5 percent of GDP to public spending. This could take total managed expenditure above 50 percent of GDP. Most economic models are demand-side focussed and so more spending tends to lead to more growth in such models. To the extent they acknowledge supply-side effects it is to maintain that higher infrastructure spending will raise productivity growth. These models are failing to allow for broad based negative supply-side effects from the increase in the size of the state and the burden of taxation.

Most disturbing of all however could be the threat pointed out by Roger Bootle, Chairman of Capital Economics, writing in the Daily Telegraph: "... whatever they may say, Labour's leaders realise that their programme would lead to economic disaster ... they take the view, often exposed by extremists, that it is only through a period of economic chaos that the country can be shifted radically towards the true socialist society that they want". Food for thought.