Consider mid 2010. The economy appeared to be returning to normal growth, albeit slowly. The fiscal and monetary stimulus given to the economy appeared to have been successful, but debt levels were rising rapidly. Forecasts told governments that they could expect modest growth that would allow them to restore the public finances.
But the forecasts were incorrect. Growth faltered and then fell and is now virtually non-existent. Further monetary stimulus has kept heads above water, but now there is a danger that withdrawing more of the fiscal stimulus could do harm.
At present the fiscal stimulus provided by the government is over £160bn in the financial year. That is a huge boost to demand. But the plan is to reduce this through expenditure cuts. The IMF and others have now warned that this could be too much.
Policy must react to the current situation. Stimulate the demand side of the economy in recession, and work on the supply side during growth periods. Monetary conditions require stability at all times and right now that means boosting the money supply (Plan B) to prevent a 30's style contraction (so high marks to Mervyn King on that one).
So now may be the time to call a halt to cuts. Further stimulus is likely to have little effect and would scare the markets. However cutting expenditure will have a negative multiplier effect on Aggregate Demand and that could tip the economies of Europe into recession. That seems to be the concern of the IMF and others and you can probably see their point.
Though tackling the budget defecit is essential for many western economies, the IMF are correct to warn them of the dangers of significant expenditure cuts. In the current state of our economy it is vital that the government aims to increase aggregate demand which it has successfully done through expenditure and quantitative easing. However, there is a real danger of a possible double dip recession if the government cuts this boost to the economy. Innovations in technology would of course improve productivity but any miracle in that form seems unlikely. If the government believes it necessary for a cut in expenditure, they should focus on growth in small businesses; by cutting red tape and providing tax breaks they can allow small firms to grow significantly, providing jobs and thus decreasing aggregate demand. This type of fiscal policy was pledged by David Cameron but was ineffective last year. If this should be implemented with greater efficiency, this policy could be beneficial for any western economy.
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