State stimuli won't work without fall in interest rates, says research
GOVERNMENT stimulus measures are unlikely to do much good unless they are accompanied by reductions in interest rates. In developing economies, they tend to do more harm than good, a comprehensive new study finds.
The argument over whether governments should borrow more to help their economies has raged since the recession began.
There have been splits in the Bank of England, and opposing views between the Irish government and the opposition parties and trade unions
The authors of the new report from the UK-based Centre for Economic Performance say part of the problem is lack of evidence. New sources and better statistics have allowed them to collect data from 20 high-income countries and 24 developing ones. They find that in richer countries, an increase in government consumption of 1pc of GDP on average produces only a 0.4pc of GDP in the short term.
"This implies a significant degree of 'crowding out' of private economic activity by fiscal expansion," said Prof Ethan Ilzetzki, who led the research.
The effect rises to 0.8pc of GDP over several years, but advocates of such policies are seeking rapid stimulus.
However, the data may also explain why this "multiplier" effect appears to differ from country to country and from one time period to another.
The differences seems to be caused by the response of the central bank to the extra government spending.
Where central banks were trying to keep a fixed exchange rate, they tended to reduce rates by 1.25 percentage points; reinforcing the stimulus.
If they were targeting inflation, they tended to raise them by 0.6pp, which wipes out most of the fiscal stimulus.
Euro countries like Ireland have no control over their interest rates.
One interpretation of the study is that the impact of any increase in Irish government investment or consumption would depend on how much, and how quickly, the European Central Bank raised interest rates in the following years.