Tighten or Stimulate? British v. American Economics

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In the ongoing American and British debates on the financial crisis and the best ways to bring the economy out of the woods, two opposite views repeatedly collide – the one represented by those who prioritize deficit reduction, the other by those who argue for recapitalizing the economy. The case of the United Kingdom shows that drastic cuts – if not supported by stimulus packages – instead of tackling the debt may actually inflate it. The American policy record on the other hand, proves that even substantial stimulus packages do not always lead to economic revival. It’s not enough to throw some extra money into the pool – equally important is what these resources actually fund and whether they are accompanied by structural reforms.

British clamps

Moody’s decision to downgrade UK’s rating from AAA to AA1 announced at the end of February was a serious blow to David Cameron’s government as it undermined the whole austerity program Conservatives embarked on precisely to regain the trust of both financial markets and rating agencies. Nonetheless, in a speech delivered on March 7th Prime Minister announced he would keep on the chosen course since – as his famous predecessor once asserted – for this policy “there is no alternative.”

Many British economists do, however, see an alternative, and their number grows as it becomes clear that the spending cuts introduced so far, instead of reducing the debt, have increased it (from 600 billion in 2008 to 1.1 trillion four years later to be precise). How is it possible to cut down on expenses and inflate the debt at the same time? Excessive savings lead to economic contraction, which in turn reduces state revenues and forces the government to continue on borrowing. “What truly is incredible” – argued Martin Wolf in his “Financial Times” column – “is that Mr. Cameron cannot understand that, if an entity that spends close to half of gross domestic product retrenches as the private sector is also retrenching, the decline in overall output may . . .

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