uk and u.s. fiscal policy

8/7/2019 UK and U.S. Fiscal Policy

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A Tale of Two Polities: UK and U.S. Fiscal PolicyUri Dadush, Bennett StancilAs the European debt crisis erupted a year ago, politicians in countries from Spain to Bri-tain to the United States were admonished with cries such as, Cut spending, or becomeGreece! But, unlike Spain and other debt-afflicted countries in the euro zone, the United

Kingdom and the United States maintained freely floating currencies and retained controlover domestic monetary policy, giving them a wider range of responses to the crisis. Onthe face of it, this meant the reduction of staggering deficits could proceed more graduallyin both countries than in many others.And yet, the fiscal policy paths of the United Kingdom and the United States have divergedto a remarkable extent. In one of the great surprises of 2010, a new British government an-nounced plans to cut public investment and reduce social spending by 80.5 billion ($131billion) and enact tax hikes of an additional 29.8 billion ($49 billion) through 2015. Theplanned reduction in Britains cyclically adjusted fiscal deficitnearly 8 percent of GDPfrom 2010 through 2015is in line with that of Greeces draconian austerity program andlarger than the planned reductions in Ireland (6 percent of GDP), Portugal (6 percent),

Spain (3.5 percent), and Italy (1.5 percent) over the same period.By contrast, U.S. leaders agreed last December to extend tax cuts and enact a payroll-taxholiday that the Congressional Budget Office (CBO) projects will cost 6 percent of 2010GDP over the next five years.What accounts for this extraordinary difference in British and American responses to theeconomic challenges they face, and what are the implications? The core reasons for thetwo countries divergent trends are political, but differences in economic policy and structu-re also play a role. An examination of these differences raises to tough policy questions.Its the Politics, Stupid

Britains Conservative Party, which has long pushed for smaller government, rose to power

through a coalition with the Liberal Democrats in the May 2010 election. After thirteenyears in office, the Labor Partyunder which government spending grew from 39 percentof GDP in 2000 to 52 percent in 2009saw its public confidence collapse. By the end of2009, GDP had contracted in six of the seven preceding quarters; the government deficitwas the largest since World War II and was projected to increase further in 2010. By the ti-me Prime Minister David Cameron took office last year, a sovereign debt crisis had engul-fed the euro zone, and Standard & Poors had downgraded the outlook for the UKs prizedAAA rating to negative.After the election, Conservatives swiftly proposed an emergency budget, and their auste-rity message resonated well with the British public. A BBC poll conducted in September2010 found that 60 percent of UK citizens supported measures to cut the budget deficit,

compared to a global average of 51 percent. The same poll found that 36 percent of UK ci-tizensthe most of any country surveyedsupported tax increases to help reduce the de-ficit.Moreover, under Britains parliamentary systemwhich gives the prime minister and hiscabinet extraordinary power to execute their agendathe proposed measures were all butguaranteed to pass. Once the coalition with the Liberal Democratsbased largely on anagreement regarding electoral reform, not economic policywas established, Conservati-ves could pursue their agenda with relative ease; compromise with the opposition was un-necessary.Contrast this with the United States. Deficits there are also at postWorld War II highs, andgovernment debt as a share of GDP is higher than in the UK. However, public outrage

over the financial crisis, bailouts of banks, and perceived government overreach produceda hugely influential grassroots movement, the Tea Party, which calls for deficit reductionbut overwhelmingly favors tax cuts. Polls show that only 23 percent of Americans support


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tax increases.In contrast to the British form of government, Americas system of checks and balances,biannual congressional elections, and the Senates dependence on supermajorities toovercome filibusters require that the president rally a diverse and independent Congressaround his agenda.Coming out of the 2010 midterm elections, the new Republican majority in the House of

Representatives was determined to prevent tax hikes, while the Democratic-led Senatesought to protect social spending. The only possible compromise in the late-2010 fiscaldeal, therefore, involved both lower taxes and increased spending on unemployment bene-fits. Meanwhile, President Obamas high-level, bipartisan deficit commission failed to evenreach agreement among its members on a plan to reduce the deficit in the medium term,much less to get Congress to debate its proposals.

The Economy Matters, Too

Alongside these major differences in governance and politics, divergent economic structu-res and trendswhich affect both the capacity and political will of a country to acthelp to

explain the UKs rapid move toward fiscal consolidation, and the United States inability todo the same.

First, at 8.9 percent, the current unemployment rate is not only much higher in the UnitedStates than in the UK (7.8 percent), but it is also considerably higher than the historicalaverage. From 1990 to 2007, U.S. unemployment averaged 5.4 percent compared to 6.9percent in the UK. Additionally, U.S. long-term unemployment (measured as the percent ofthe total unemployed workers who have been unemployed for 27 or more weeks) reached45.8 percent in June 2010a figure 20 percentage points higher than its record highrea-ched in June 1983and has come down only slightly to 43.8 percent through February.Furthermore, high unemployment is tougher to bear in the United States, where unemploy-ment benefits are much less generous than in the UK. In addition, unemployed American

workers typically lose their health insurance, whereas in Britain health care is provided bythe publicly-funded National Health Service. Therefore, while the UK can rely partially onautomatic stabilizers in tough times, the United States has to rely mainly on discretionarystimulus spending, which raises overall fiscal spending.Second, the average UK workerthough perhaps less affluent than the average U.S. wor-kerhas enjoyed a long period of rising incomes. Real wages for middle-quintile hou-seholds in the UK have risen by 37 percent since 1977, the earliest available comparabledata. Paring back on a small part of these gains to reestablish confidence in the govern-ment may seem a price worth paying.In the United States, on the other hand, real wages for middle-quintile households have ri-sen by only 13 percent over the same period. At the same time, Republican victories in lastyears midterm elections seem to preclude the possibility of increasing taxes on high-inco-me earners, where nearly all income growth in the United States has been concentrated.Third, Britain can rely more on foreign demand to offset the effects of budget cuts. Exportsof goods and services are a much larger part of the British economy than the U.S. one27percent versus 11 percent, respectively, from 2000 to 2009. In addition, the British poundhas depreciated sharply since the crisis erupted in 2008, declining by 22 percent relative toa basket of major currencies, which suggests that a global trade recovery could benefit theUK much more than the United States. The OECD projects that net exports will add nearly1 percentage point to GDP growth over the next two years in the UK, while it subtracts 0.6percent from U.S. growth.

Tough Questions

Markets initially welcomed Britains approachsince May 2010, bond yields dropped,


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stocks rose above levels in Europe and in line with those in the United States, and S&Pupgraded the outlook on the UKs AAA credit rating to stablebut problems are nowemerging. Output unexpectedly contracted by 2.4 percent (q/q, annualized) in the fourthquarter of 2010 and business confidence has plummeted since May. Consensus forecastsfor 2011 GDP growth have been cut from 2.2 percent in the first half of 2010 to 1.9 percentnow. On Wednesday, Conservative leaders announced the new budget for 2011 and, whi-

le conceding that growth will be 0.4 percentage points lower this year than initially expec-ted, reiterated their commitment to reducing the deficit.Nevertheless, Britains sweeping spending cutsparticularly when combined with the lar-ge-scale fiscal consolidation across the rest of Europeraise the stakes for the UnitedStates, where there is little sign that politicians are willing to confront their dismal fiscal ou-tlook. As the club of countries with large and rapidly rising debt shrinks, those that re-mainnamely, the United States and politically paralyzed Japanmay be left increasinglyat the mercy of market sentiment.The U.S. fiscal problems are projected to worsen in the long term, with rising health carecosts a prime culprit, as shown in the chart. The reforms needed to solve the problem areclear, but all remain politically thorny. These include means-testing Medicare and Social

Security, increasing Medicare privatization, using comparative effectiveness research andother measures to control medical costs, increasing gas and value-added taxes, raising es-tate and income taxes, and reining in defense and other expenditures.The jury is out on whether Britains radical approach will work, but this brief account shouldat the very least raise a number of questions:Can the U.S. political system deal with its deficit problem before a fiscal crisis, such as theone in Greece, forces it to do so? Is the U.S. safe-haven status, which provides it with lowborrowing costs, a blessing or a curse? Is America in need of legislative reform to help re-duce the political obstacles that block deficit reduction? Would measures to reduce incomeinequality, and to strengthen the safety net for the unemployed, make deficit cuts easier toimplement in America?Leaders in the United States will be watching the UK closely, and should heed the lessonsthat Britains experience offers.Uri Dadush is the director of Carnegies International Economics Program. Bennett Stancilis a researcher in Carnegies International Economics Program.

uk and u.s. fiscal policy

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