For months, stimulus advocates have warned that raising taxes and cutting spending in a deficit could lead to a painful recovery, or even a double dip recession. We're about to find out if they're right. Ladies and gentlemen, meet the face of austerity: Great Britain will raise its value-added tax and dramatically cut spending to reduce its deficit by the end of 2011.
Time has the plan: six percent cuts in welfare; three-year child benefits freeze; three-year salary freeze for six million public workers. Most of the attention is on the VAT, which will increase from 17.5% to 20%, but the public spending cuts are actually 50% higher than the VAT increase.
How could this possibly work? By work, I mean reduce the deficit meaningfully without plunging the nation into some long, dark recession-like morass? John Cassidy outlines three scenarios:
1) Consumers will feel richer because they will realize that their future tax burdens are being reduced. Consequently, they will go out and spend more.
2) Investors will welcome the moves to restore fiscal balance and will buy more government bonds. This will bring down long-term interest rates and produce a surge in interest-sensitive spending, such as residential and non-residential investment.
3) As China, India, and other developing economies continue to expand, exports from the developing economies will surge, providing a boost to domestic manufacturing industries and their workers.
Like Cassidy, I'm rooting for these things to happen without any good expectation that they will. First, Ricardian equivalence is a perfectly elegant theory, but I doubt higher taxes at the grocery store and lower child benefits will inspire British families to break out their wallets soon. Second, investors might seek austerity projects but they're also looking for lights at the end of the tunnel, and if the UK's recovery slows, that tunnel gets longer. Third, in terms of imports/exports, only 2% of British exports go to China. If British exports are going to recover, the European consumer will have to recover, and the European consumer can't recover if the entire continent squeezes its families for cash simultaneously.