Why Britain’s public spending cuts are good for the economy

Here’s a question for you: why is it that, when fiscal stimulus rarely has anything like the positive impact on economies that politicians hope for, is everyone so certain that its opposite (cutting back on government spending) will be such a disaster?

There has been a considerable amount of research done into the effect of government spending or the lack thereof on economic growth. On balance, says Andrew Milligan of Standard Life, the results show a fiscal multiplier of around 0.3-0.5. So a cut back in government spending of, say, 1% would only reduce actual GDP growth by something between 0.3% and 0.5%.

The research also shows that different types of retrenchment have different effects. Cutting spending has a less nasty effect on GDP than raising taxes, for example. It has “less effect on household incomes and confidence”, which makes a difference to consumer spending and the like.

At the same time the methods used to cut spending are vital. Retrenching by postponing retirement ages works particularly well. It might not be quite what today’s 60-somethings had in mind, but it nonetheless “has the potential to boost GDP growth while simultaneously raising government revenue and spending”.

However, possibly the most vital thing of all in this equation is credibility. A government that isn’t cutting spending into a sovereign debt crisis, or one that is cutting the wrong things, can easily lose it. And that is worse for GDP growth than almost anything else. Investors and entrepreneurs need to know that they have governments who understand that their job is to create an environment conducive to investment and long-term growth.

Right now, as Crispin Odey of Odey Asset Management points out, in the UK where the coalition is ignoring the can’t-cut-now crowd and just getting on with it, we appear to have one. The Americans do not. Which is probably why the pound has risen 15% or so against the dollar since the UK election.