Less complex than fiscal policy?

In early July the International Monetary Fund revised the economic growth projections which it had made in April.  To the surprise of no one except perhaps George Osborne and Angela Merkel, the countries that maintain a fiscal stimulus had their growth rates adjusted upwards, while those committed to "sound" finances and budget cuts saw their prospects down-graded.
            As the table shows, the IMF raised the projections for both the US and Japan for 2010, also for 2011 in the case of the US, for a two-year up-grade of half a percentage point.  For the UK and Germany the story was the reverse, lower growth for 2010 and also 2011 for the UK, and decline for Germany in 2011.

            Would the gain for the "fiscally sound" governments be lower deficits that would somehow out-weigh the pain of decline?  For that fond hope to be realized, two outcomes are required:  that expenditure cuts will reduce the fiscal deficit, and a lower deficit will stimulate growth.  The fashionable argument for the lower-deficit-provokes growth is that by reducing public borrowing, interest rates will fall, making it cheaper for companies to borrow and invest.
            This recovery hypothesis can be rejected for the UK.  Commercial bank lending remains weak despite a Bank of England base rate below one percent.  Interest rates are rock-bottom with no recovery of lending in sight.  Net lending to UK businesses has been negative for twelve consecutive months through April 2010 (see Chart 1.1, Bank of England report of June 2010, cited below).
            However, the deficit-reduction-recovery argument is irrelevant because, strange as it may seem, experience shows that cutting expenditure will not reduce the fiscal deficit, as it did not in the early 1980s (see Leftfootforward, below).  There as several reasons for this, the most important being the decline in tax revenues as the cuts provoke falls in national income, and the automatic rise in recession-related expenditures such as unemployment benefits.
            If the deficit will not decline through cuts, how is it reduced?  The answer is not esoteric:  deficits are reduced by economic growth.  This can be demonstrated by simple example that understates the growth effect because it ignores indirect effects.  In 2009 government expenditure in the UK was 51.4% of GDP and the overall fiscal deficit was 11% of GDP.  A rational government would maintain the stimulus initiated in 2008-2009 by not cutting expenditure. 
            The hesitant recovery that began in the last quarter of 2009 would gather steam.  During the ten years 1998-2007 the average growth rate of the UK economy was 3.4 percent per annum.  If the growth rate recovered to an average of two percent for 2010-14, the deficit would decline to five percent by the end of that period, to four percent for a growth rate of 2.5 percent, and down to the famous Maastricht criterion of three percent for a growth rate of three percent.  If that rational government were to increase taxes, most equitably the personal income text, deficit reduction could be combined with increases in expenditure.
            In case Mr. Osborne, Ms. Merkel and their colleagues missed it, the scenario described above is what happened in the United States during the Clinton presidency.  The overall fiscal balance was minus 4.7 percent of GPD in 1992 (last year of Bush the First), moved into surplus in 1998, and reached a positive 2.4% of GDP in 2000, during which time the economy grew at four percent per annum (to revert to deficit under Bush the Second).
            The UK Coalition government may think it is common sense that one reduces the deficit by cuts.  This brings to mind the observation by the US economist Stuart Chase that common sense is the sense that tells us the earth is flat, which provides an insight to the general economic sophistication of the Coalition government.

Bank of England, Trends in Lending, June 2010
http://www.bankofengland.co.uk/publications/other/monetary/TrendsJune10.pdf
Cuts increase the deficit
http://www.leftfootforward.org/2010/06/cuts-wont-reduce-the-deficit-investment-will/
Growth and deficit statistics
http://www.oecd.org/statsportal/0,3352,en_2825_293564_1_1_1_1_1,00.html

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