Wednesday, December 23, 2009

Fiscal consolidation and Keynesian economics

In India, there is a clamour for swift return to fiscal consolidation. So also in the UK, despite the fact that the British economy has to still to recover from the crisis. Why fiscal consolidation? To prevent interest rates from rising and crowding out investment; and to prevent exchange rate appreciation and boost exports. In both ways, consolidation is seen as coming the way of growth.

Robert Skidelsky, the famed biographer of Keynes, questions these contentions:
If its borrowing is not rapidly reduced there will be a “gilt strike” – investors will demand higher and higher prices for holding government paper. Faced with the evidence that, despite increased government borrowing, gilt yields have been at a historic low, the critics say that this is only because the gilts are being bought by the Bank of England. Once the Bank stops buying government debt, interest rates will shoot up.

A parallel argument is that the expansion of the fiscal deficit is preventing a natural fall in the exchange rate sufficient to boost exports. The tortuous logic seems to be that “fiscal consolidation” will cause the rate of interest to fall and the fall in interest rates will cause the exchange rate to fall, thus increasing the demand for British exports......

Empirical evidence supporting the view that cutting the deficit causes the exchange rate to fall is very thin. A 1997 study by the International Monetary Fund showed that in only 14 out of 74 studied instances did fiscal consolidation promote a recovery via a fall in the exchange rate. In all the other cases fiscal policy either had no discernible exchange rate effect or it was the expansion of the deficit that caused the exchange rate to fall.
At the best of times, the arguments made for fiscal consolidation have sounded hollow; in crisis times, they sound ridiculous.


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