The fact that UK retail sales plunged in March is an important data point that “expansionary contraction” policies are failing there, which should have important implications for the debate here.
It seems clear that if you’re running a small open economy and you’re facing an economic downturn, that what you want to do is batten down the fiscal hatches. This is painful, but it’s better than the alternative of becoming insolvent, and you can get plenty of demand from elsewhere as low interest rates and currency depreciation boost net exports. During the current crisis, some folks have tried to extend this analysis to large countries like the United States, Japan, and Germany that have less scope for externally-led recovery (especially in a global downturn) and who don’t face the same kind of fiscal risks because we borrow in deep markets denominated in our own currencies.
The government of the United Kingdom, meanwhile, is offering us an interesting kind of test case. It’s interesting for three reasons. One is that they’re clearly attempting such a strategy of “expansionary contraction.” Two is that the Bank of England is explicitly cooperating in this strategy and attempting to offset fiscal policy’s hit to aggregate demand with loose money. And three is that the UK is a kind of ambiguous case as to whether we should think of it as a large economy or a small one. What we’re learning here is that the British economy is responding how a pessimist would worry that a large economy would respond, even though it’s not really all that big. British net exports simply don’t have the capacity to expand rapidly enough to offset the impact of tax hikes and spending cuts. If Britain were facing terrifying borrowing costs (the way that, say, Portugal and Ireland are) then it would have no good choice but just to deal with this. But Britain isn’t facing terrifying bargaining costs. Like the United States, it faces a situation where investors are eager to lend money, but the ruling coalition insists on rowing in the opposite direction.