Wednesday, October 20, 2010

A Natural Experiment in the Making

Martin Wolf makes an interesting point today in his column.  He argues that the divergent policy paths of the United States and the United Kingdom are providing a natural experiment on the efficacy of "expansionary" fiscal austerity:
The US and UK have similarities that go beyond speaking the same language: both had huge expansions in household credit; both had to rescue their financial sectors; both have watched their central banks push interest rates close to zero and adopt “quantitative easing”; and both have experienced massive post-crisis increases in fiscal deficits. Yet a big policy divergence is on the way. The coalition government of the UK will on Wednesday announce details of their cuts in government spending. Nothing comparable is expected in the US...What we do know is that the UK has launched a remarkable policy experiment. The contrast with the US should at least be instructive.
While this will make for an interesting comparison going forward,  it will be difficult to disentangle the effects of monetary policy from that of fiscal policy.  Martin wolf cites an IMF study in his column that speaks to this issue.  This study shows that many of so called "expansionary" fiscal contractions  occurred because monetary policy was providing accommodation via lower interest rates and/or a currency depreciation.  Scott Sumner made a similar point a while back.  He argued it is nearly impossible to estimate the true size of the fiscal multiplier and thus the actual effect of fiscal stimulus because monetary policy will typically offset such actions.  Still, the diverging policy paths of the US and UK  will be interesting to watch. 

1 comment:

  1. I think there should be caution when making that comparison. There are a lot of fundamental differences between the two economies that make them hard to compare. It is kind of a shame the UK isn't a more closed economy to get a better understanding.

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