As recession descends across Europe, fiscal policies have received extra scrutiny. Austerity measures have been promoted as keys for long-term economic stability, but the necessary short-term pains have been understated. Without preparation (or the ability) to endure the short-term tumult to get to "the other side," fiscal authorities will have an even more difficult time with long-term adjustments - especially when the short-term adjustments have been particularly severe. The divergent economic paths between the U.S. and the U.K. provide some initial insights on the short-term impacts of contractionary fiscal policies.
Total GDP in the U.S. has finally returned to pre-recession levels, whereas GDP in the U.K. is not likely to achieve that milestone this year thanks to a current stall in growth. The latest economic news showed that the U.K. economy officially dipped back into recession last quarter. This is the U.K.'s first double-dip recession since the 1970s.
U.S. vs U.K. GDP recovery since mid-2009
In a March 27, 2012 speech titled "Why is their recovery better than ours? (Even though neither is good enough)," Adam Posen, External Member of the Monetary Policy Committee (MPC), Bank of England (BoE) and Senior Fellow, Peterson Institute for International Economics, quantifies the differences between the U.S. and U.K. economies and attempts to explain the reasons for the gap in economic performance. The two countries experienced very similar economic shocks in 2008-2009. Posen observes that the Bank of England and the Federal Reserve followed very similar accomodative monetary policies in response to the financial crisis and recession: a tripling in the size of their balance sheets relative to GDP, maintenance of near zero interest rates, and multiple rounds of quantitative easing. Posen, of course, credits these actions for propping up the economies in both countries. One key difference was fiscal policy.
Of course, Posen makes it clear that the Bank of England has done everything it can and should do to prop up the economy in the U.K. For example, after noting that UK investment has little changed cumulatively during the recovery while U.S. investment has soared 12%, Posen remarks with relief:
"Had the MPC not followed a similarly aggressive path of monetary stimulus to that of the FOMC, right up through the additional measures undertaken since October 2011, it is frightening to imagine what would have happened to British private investment."
Perhaps it is no surprise that he thus points the blame elsewhere, especially fiscal policy:
- "Corporate investment rebounded much more in the US than the UK because
- there were more non-bank options available to provide financing for investment
- there was less spillover from euro area risks on to the US than the UK banks
- Household consumption rebounded much more in the US than the UK because
- there was significantly less net withdrawal of fiscal stimulus in the US than UK
- there was a greater rise in energy costs faced by the UK than US consumer
- Inflation was higher in the UK than in the US because
- the UK fiscal tightening took in part the form of a Value-Added Tax increase
- Sterling depreciated more and more rapidly than the Dollar did"
On the inflation point, Posen never directly identifies monetary policy as a key source of the currency's depreciation. Higher oil prices are also part of the U.K.'s inflation problem, but the BoE, much like the Federal Reserve, accepts little to no blame for higher commodity prices.
I took particular interest in Posen's description of the differences in private consumption between the U.K. and the U.S. Relatively more robust consumer spending in the U.S. helps to explain why the economy has not dipped back into recession despite the ardent expectations of economists like the ECRI (see for example "ECRI Still Adamantly Campaigning for A Recession" from November, 2011). Posen observes the following:
"It is clear…that both private consumption and investment grew much more strongly in the US than in the UK - so much more strongly that they more than offset the UK's boost from net trade and bigger stabilizers. Consumption grew by a whopping 3.8 percentage points in the US since mid-2009, while only growing by 0.7 percent cumulatively in the UK; investment grew by 1.7% in the US and only 0.6% in the UK over the course of this recovery."
U.K. vs U.S. Decomposition of GDP growth in the recovery
(Note: GFCF = "Gross Fixed Capital Formation." The left set of stacked bars provides the percentage breakdown of total GDP growth by component. The right set of stacked bars provides the cumulative contribution by component. Growth is measured from Q2 of 2009 to Q4 of 2011)
What also caught my eye in this chart is the huge difference in government consumption. Despite the more contractionary (net) fiscal policy in the U.K, the government's consumption there far outstripped the U.S. in terms of contribution to GDP growth. In fact, U.S. government consumption shrank. Posen explains:
"…government consumption rose in the UK while contracting in the US during the recovery. This is because fiscal automatic stabilizers are much bigger in the UK, and the UK was further from growing at trend in the recovery than the US, both of which pushed up the amount of outlays (which State and Local budget constraints in the US caused cuts offsetting Federal level transfers)."
He goes on to note that the key difference in fiscal policy is the way the actions in each country were transmitted through the economy:
"As has been widely argued, much of the recent US Federal Government stimulus had relatively low multipliers, while the cutbacks at the state and local government level had high multipliers. Similarly, I would argue, that the raising of the Value Added Tax in the UK was a relatively high multiplier form of policy, as were the cutbacks by local authorities (though much smaller in scale than in the US). Furthermore, because all of the UK's main trading partners besides the US, making up over 70% of UK export markets, were simultaneously undertaking fiscal austerity programs to varying degrees, the amount policy leakage was less in this case - if anything, UK austerity was being reinforced. So it seems reasonable to believe that the multiplier on UK fiscal measures since mid-2010 was on the order of 1.0 or higher. That would then constitute a sizable share of the growth differential between the US and the UK over this recovery period."
The chart below even more clearly contrasts the difference in consumption between the U.S. and the U.K. Total consumption in the U.S. has returned to pre-recession levels, but…
"Meanwhile, UK consumption did grow from 2009:Q2 through 2010:Q2, but has declined in five of the last six quarters (of data) since that time. This is an even more unusual pattern than flat investment growth, for the UK or almost any market economy, to have no recovery in consumption growth from the time that the economy troughed in GDP terms."
U.S. vs U.K. private consumption since the pre-recession peak in GDP
Posen attributes the difference to higher income uncertainty in the UK as unemployment has worsened whereas it has slightly improved in the U.S. (Note well that the BoE has the sole mission of price stability unlike the Federal Reserve which is supposed to maintain strong employment AND price stability). Moreover, real incomes have declined due to greater fiscal tightening and higher inflation, partially brought on by the sharp depreciation in the British pound.
Posen goes on to conclude that fiscal policy has had a dramatic impact on the difference in GDP between the U.S. and the U.K.:
"For almost the entire period since March 2007, and particularly since March 2010, the US has run a looser overall fiscal stance - a more stimulative fiscal policy - than the UK, even taking the full operation of the larger automatic stabilizers in the UK into account. Cumulatively, since 2007Q1, the difference has amounted to 3% of GDP."
Despite noting that stated government policies will further widen the gap in fiscal policy between the U.K. and the U.S., Posen posits that the U.K. will eventually (and soon) catch up because the differences are temporary or cyclical. I think of this assumption as a "reversion to the mean" assumption. Posen caveats his expectation by noting the on-going structural deficiencies in the U.K. banking system (including lower competition) that have severely restricted access to credit for the domestic economy. Certainly, Posen must be getting a tad bit more optimistic given his switch in the early April MPC meeting to the majority in the MPC that does not support increasing the size quantitative easing at this time. This switch has also been cited as a reason for the British pound's recent resurgence.
I think it is premature to forecast that the British pound will break out from its multi-year trading range against the U.S. dollar - shown below using the CurrencyShares British Pound Sterling Trust (FXB). In fact, the last thing the Bank of England needs or wants is a resurgent currency just as it needs to ensure a rapid rebound from this double-dip recession. I expect at least Governor Mervyn King to speak in ways to counteract any new currency momentum. He may speak with a particular urgency as talk gets louder about the pound serving as a safehaven currency. Accordingly, I have used current strength to begin rebuilding a short against the pound using the U.S. dollar (short GBP/USD).
The British pound tumbled from lofty pre-recession heights into the current trading range
The one big caveat for the U.S. is the big "fiscal cliff" coming in January, 2013. If Congress does not act ahead of time, the U.S. economy will be hit with a double-whammy of severe budget cuts and large tax increases. As we approach that date with Congress as bitterly divided and impotent as ever, the market is likely to respond by weakening the U.S. dollar (stocks will likely weaken as well). Making a resolution even more complicated is that Congress will likely need to start bills in motion AHEAD of the Presidential election in order to beat the January, 2013 deadline. Even if emergency sessions post-election can get the job done, it will happen during a lame duck, holiday-strewn period. If the U.S. fails to hurdle these challenges, the U.K. economy should quickly catch-up and zip right past the U.S. in short order.
Be careful out there!
Full disclosure: Short GBP/USD.