Which country is right?

US vs. UK: Stimulus spending vs. hard-nosed austerity

Black Friday Shoppers Chase Deals At Wal-Mart, Best BuyIn late November crowds took to the streets in cities across the United States and Britain. As mobs rampaged and destroyed property, fights broke out and a number of victims were sent to hospital. By the time the ordeal was over, police had been called in to bring the unruly hordes under control, and two stunned nations were left to wonder how it had come to this. Mind you, those who rioted in the United Kingdom were students protesting deep government cuts to education spending. In America they were just Black Friday shoppers trampling each other to get to the discount bin at Toys “R” Us.

Since the Great Recession morphed into the Grudging Recovery last year, the U.S. and U.K. have taken radically different paths with their economic policies. In October, the coalition government of Tory Prime Minister David Cameron waged war on the country’s fiscal deficits with a vow to slash spending by $131 billion and raise taxes over the next four years. Meanwhile, across the pond, the Obama administration shook hands with Republicans last month to launch yet another round of stimulus in the form of temporary tax cuts and help for those out of work that will add US$892 billion to that country’s deficits over the next five years. While the British struggle to tighten their belts, American policy makers are doing everything they can to loosen theirs.

But this is about more than just two countries going their separate ways in the global economy. Ever since the 1930s, when economist John Maynard Keynes argued governments should boost spending to stimulate business and consumer demand, a battle has raged over the wisdom of that strategy. Each year, academics churn out papers arguing the matter, while many a politician has claimed to have saved his or her economy from recession by letting government spending flow. The issue has sparked a very public battle between Nobel prize-winning economist Paul Krugman, an avowed Keynesian, and Harvard University historian Niall Ferguson, a prominent deficit hawk. Krugman says Ferguson “hasn’t bothered to understand the basics” of economics with his warnings about America’s rampant spending, while Ferguson says “nothing would spook the markets more than for Paul Krugman’s advice [for more stimulus] to be accepted by the administration.” Yet for all the back and forth, no one has conclusively shown how fiscal policy affects the business cycle, and whether deficit-spending is a force for good or the route to economic collapse.

Which is why economists and financial experts are watching what’s happening in America and Britain so closely. With the U.S. pursuing a policy of expansion and stimulus at the same time Britain has opted for hard-nosed austerity, the two countries offer a real-world, real-time economic experiment that could reshape the way economists view the world and how it works. “It is a huge lab test on all of us in the U.S. and U.K. to see who will survive these alternative policy approaches,” says Ed Yardeni, the chief investment strategist at Yardeni Research in New York. “It could be very costly for those who turn out to be in the wrong trial sample, and could be surprisingly uplifting for those who happen to be the beneficiaries of the right policy.”

The question now is, which side will win as the greatest economic policy debate of the last 100 years plays out right in front of us?

All experiments require a benchmark from which to measure results, and for the showdown between American stimulus and British austerity, that may well turn out to have been the G8 and G20 summits held in Toronto last June. By the time world leaders met within the vast security perimeter, the economies of each country were on a relatively even footing. Both were growing again, albeit slowly. Both still suffered hangovers from their respective housing bubbles. And in both, unemployment was still far above historical norms.

Yet in the first face-to-face meetings between President Barack Obama and Cameron since the British election, it was clear the similarities would end there. While Obama warned that if stimulus was withdrawn too soon, the world risked plunging back into another recession, Cameron said developed countries needed to deal with their deficits in order to restore confidence and “live within our means.” The summit concluded with a declaration that set the stage for their divergent policies: “There is a risk that synchronized fiscal adjustment across several major economies could adversely impact the recovery. There is also a risk that the failure to implement consolidation where necessary would undermine confidence and hamper growth.”

Britain and the U.S. share something else in common—horrendous deficits and staggering debt loads. Last year, America’s federal deficit hit 9.9 per cent of GDP. The Congressional Budget Office predicts the U.S. debt load will hit US$20 trillion within a decade. Meanwhile, Britain’s fiscal deficit topped 10 per cent of GDP last year. According to Michael Wickens, a professor of economics at the University of York, over the last decade spending on heath care and welfare more than doubled, while revenues rose at half that pace. “This has been brewing for years,” he says. “The U.K.’s deficit problem has nothing to do with the recession.” But the financial crisis did bring the problem into sharp focus.

It’s against that backdrop that Chancellor of the Exchequer George Osborne laid out the government’s austerity plan in October, the most sweeping cuts to spending since the end of the Second World War. The goal is to cut the deficit back to nearly zero by 2014, and begin paying down the debt at that point. “Today is the day when Britain steps back from the brink, when we confront the bills from a decade of debt,” he said. “It’s a hard road, but it leads to a better future.”

Any way you look at it, the government’s ruthless assault on spending was designed to send a high-voltage shock through the British psyche. The average government department will see its funding slashed by 19 per cent, while roughly half a million government jobs—or nearly one in 10 civil service positions—will be axed. Millions more government workers will face pay cuts and reduced benefits. (The public sector accounts for roughly 20 per cent of all jobs in the U.K.) Britain will cut its military spending by eight per cent by 2014 and will slash the budget for its diplomatic corps by a full quarter.

The list goes on. University tuition fees will double—which has prompted weeks of riots—while rail fares are expected to jump 30 per cent over the next four years. The government will increase the retirement age for both women and men to 66 by 2020 (it’s currently 60 for women, and 65 for men), saving it $8 billion a year. Child-benefit payments to middle-class households will be slashed, and nearly $200 million may be cut from school sports programs. Even the royals will feel the pinch—funding to maintain Queen Elizabeth II’s household will be chopped by 14 per cent. All these cuts and many more will be accompanied by a hike in the value-added tax to 20 per cent from 17.5 per cent.

Needless to say, it’s a far cry from the continued profligacy on display in America. There was the first round of Keynesian intervention in November 2008, which included nearly US$1 trillion in new spending and tax reductions. At more than six per cent of GDP, the American Recovery and Reinvestment Act was four times larger than the stimulus plan rolled out at the same time in Britain. Yet for all the talk of funding for “shovel-ready” infrastructure projects, US$111 billion of America’s first stimulus plan has yet to be spent. Even so, Obama and Senate Republicans reached a compromise in December to extend Bush-era tax cuts for two more years in return for further cuts to payroll taxes and extended benefits for the unemployed. Though the deal wasn’t officially billed as a stimulus plan, analysts have called it stimulus by stealth, since the tax cuts would have expired on Dec. 31 and acted as a drag on the economy.

Nor do U.S. legislators—seemingly convinced of the sheer invincibility of the American economy—show signs of letting up on the stimulus gas pedal. Two bipartisan groups recently put out recommendations for how to deal with America’s deficits and rising entitlement costs (via a mix of spending cuts and tax increases), yet the plans have been panned by Democrats and Republicans. And when Republican legislators refused to renew the Build America Bonds program, a stimulus measure launched in 2009 as a way for Washington to subsidize state borrowing, many fretted its demise would make it harder for states to finance themselves. No matter. John Mica, a Republican set to become chairman of the House transportation and infrastructure committee, now says he’ll introduce a replacement program this year. The Congressional Budget Office estimates the program has already added another US$30 billion to the deficit over the next decade—though with the U.S. forecast to run a deficit of US$8 trillion over the same period, that’s chump change.

Eagerly watching the two countries veer off in different directions are economists like Gary Becker, the Nobel-prize winning professor of economics at the University of Chicago. On his blog, which he co-authors with appeal court Judge Richard Posner, Becker said that in analyzing Keynesian theory, economists have typically had to rely on imperfect theoretical models. “The reason that it’s so hard to draw hard conclusions is that most of the time countries are taking these stimulative actions during recessions, and there’s so much going on you can’t separate it out,” he told Maclean’s. “The British approach is so valuable because it is very rarely that you have one country taking very hard action to reduce government spending and fiscal deficits at the same time another country is going the opposite route, and I think within two years we’ll start to see results.”

What exactly those results will be is still up for debate. Those in favour of prudence in fiscal policy, such as Becker, say that when government spending grows too large, it crowds out private investment and innovation. They also argue that when consumers see governments amass unsustainable levels of debt, they retrench, anticipating that taxes and inflation will rise. So by cutting spending and reducing deficits, businesses and consumers are more likely to open their wallets. Nobel economics laureate Joseph Stiglitz has dismissed this notion as blind belief in a “confidence fairy,” but others say the effect is real. Wickens, at the University of York, looks to Britain’s experience under former prime minister Margaret Thatcher as an indicator of how this new round of austerity will play out. “At a time of recession she broke all the rules by cutting government expenditures, and the consequence was 30 years of unprecedented economic growth,” he says. “I think we’ll see something similar to that in the future.”

The European debt crisis has also offered stark examples of what can happen when a country lives beyond its means. In the case of both Greece and Ireland, investors lost confidence in the countries’ ability to repay their debts, which in turn drove up borrowing costs to the point they risked defaulting. It’s only because the European Union has stepped in with a US$1-trillion bailout fund that those fears began to subside. Many believe Britain’s soaring deficits threatened to expose it to a similar fate. “Britain was facing a crisis of credibility in financial markets, and there was a real chance we’d end up in the sort of position Greece and Ireland found themselves in,” says Roger Bootle, a prominent London economist and managing director of Capital Economics. Though he considers himself a Keynesian, he says the consequences of a debt crisis in the United Kingdom “would have been potentially deadly for real economic activity.”

Despite such fears, though, detractors have lined up against Britain’s assault on government spending. One fear is that the cuts are simply too much, too fast, says Robert MacCulloch, a professor of economics at Imperial College in London. “It’s a huge gamble,” he says. “They’re laying off tens of thousands of public servants, and there’s a real risk there could be a sudden collapse in demand.” There were signs of that in the third quarter, when unemployment in the U.K. rose slightly to 7.9 per cent amid 33,000 new job losses—all of which were in the public sector.

Yet the job market has deteriorated in the U.S., too. In November, unemployment inched up to 9.8 per cent, near where it was last April. But to Keynesians, the worsening job market isn’t a sign that stimulus has failed. It’s evidence there wasn’t enough stimulus to begin with.

At its most fundamental, the idea behind fiscal stimulus is that when consumers stop spending and businesses stop investing during a recession, governments can jump-start the economy by injecting money—say, by building a new bridge, which puts people to work, who in turn go shopping and spur other businesses to hire and produce more goods. (The sorely neglected flip side to Keynes’s theory is that once the economy recovers, governments should run surpluses.)

But Mark Thoma, an economics professor at the University of Oregon, says Washington’s intervention in 2008 simply wasn’t large enough to compensate for state and local government cuts. Cash-starved states like New Jersey, California and Illinois are slashing even deeper now, so the second round of fiscal stimulus probably won’t make up the difference either. “My great fear is we’re going to have a long, slow recovery and we need to do something to speed that up,” he says, adding he’d like to see a program that offers more direct support to states as well as targeted tax measures to assist homeowners. In the meantime, economists have upped their growth forecasts for next year to factor in the boost from the latest tax and spending program. Mark Zandi, the chief economist of Moody’s Analytics, now predicts the U.S. economy will grow by four per cent next year, up from his previous forecast of 2.7 per cent.

As an economic science experiment, the matchup between the two countries isn’t perfect. The U.S. Federal Reserve has been far more aggressive than the Bank of England when it comes to monetary policy tools like quantitative easing, which involves buying government bonds to push down long-term interest rates. And so long as the world views America as the safest place to invest, it can keep borrowing and spending, while the U.K. may have no choice but to cut—though at some point even American profligacy will find its limit.

Still, as Yardeni at Yardeni Research in New York watches the experiment unfold, he believes the British approach will win out in the end. “Even if austerity hurts in the short run, it’s going to be very good for Britain in the longer term,” he says. “Our short-term fix here is probably going to create a real nightmare longer term that may eventually force us to do what the Brits are doing anyways.” Only by then, the cuts will hurt even more.