As the European debt crisis erupted a year ago, politicians in countries from Spain to Britain to the United States were admonished with cries such as, “Cut spending, or become Greece!” But, unlike Spain and other debt-afflicted countries in the euro zone, the United Kingdom and the United States maintained freely floating currencies and retained control over domestic monetary policy, giving them a wider range of responses to the crisis. On the face of it, this meant the reduction of staggering deficits could proceed more gradually in both countries than in many others.
And yet, the fiscal policy paths of the United Kingdom and the United States have diverged to a remarkable extent. In one of the great surprises of 2010, a new British government announced plans to cut public investment and reduce social spending by £80.5 billion ($131 billion) and enact tax hikes of an additional £29.8 billion ($49 billion) through 2015. The planned reduction in Britain’s cyclically adjusted fiscal deficit—nearly 8 percent of GDP from 2010 through 2015—is in line with that of Greece’s draconian austerity program and larger than the planned reductions in Ireland (6 percent of GDP), Portugal (6 percent), Spain (3.5 percent), and Italy (1.5 percent) over the same period.
By contrast, U.S. leaders agreed last December to extend tax cuts and enact a payroll-tax holiday that the Congressional Budget Office (CBO) projects will cost 6 percent of 2010 GDP over the next five years.
What accounts for this extraordinary difference in British and American responses to the economic challenges they face, and what are the implications? The core reasons for the two countries’ divergent trends are political, but differences in economic policy and structure also play a role. An examination of these differences raises to tough policy questions.
It’s the Politics, Stupid
Britain’s Conservative Party, which has long pushed for smaller government, rose to power through a coalition with the Liberal Democrats in the May 2010 election. After thirteen years in office, the Labor Party—under which government spending grew from 39 percent of GDP in 2000 to 52 percent in 2009—saw its public confidence collapse. By the end of 2009, GDP had contracted in six of the seven preceding quarters; the government deficit was the largest since World War II and was projected to increase further in 2010. By the time Prime Minister David Cameron took office last year, a sovereign debt crisis had engulfed the euro zone, and Standard & Poor’s had downgraded the outlook for the UK’s prized AAA rating to “negative.”
After the election, Conservatives swiftly proposed an emergency budget, and their austerity message resonated well with the British public. A BBC poll conducted in September 2010 found that 60 percent of UK citizens supported measures to cut the budget deficit, compared to a global average of 51 percent. The same poll found that 36 percent of UK citizens—the most of any country surveyed—supported tax increases to help reduce the deficit.
Moreover, under Britain’s parliamentary system—which gives the prime minister and his cabinet extraordinary power to execute their agenda—the proposed measures were all but guaranteed to pass. Once the coalition with the Liberal Democrats—based largely on an agreement regarding electoral reform, not economic policy—was established, Conservatives could pursue their agenda with relative ease; compromise with the opposition was unnecessary.
Contrast this with the United States. Deficits there are also at post–World War II highs, and government debt as a share of GDP is higher than in the UK. However, public outrage over the financial crisis, bailouts of banks, and perceived government overreach produced a hugely influential grassroots movement, the Tea Party, which calls for deficit reduction but overwhelmingly favors tax cuts. Polls show that only 23 percent of Americans support tax increases.
In contrast to the British form of government, America’s system of checks and balances, biannual congressional elections, and the Senate’s dependence on supermajorities to overcome filibusters require that the president rally a diverse and independent Congress around his agenda.
Coming out of the 2010 midterm elections, the new Republican majority in the House of Representatives was determined to prevent tax hikes, while the Democratic-led Senate sought to protect social spending. The only possible compromise in the late-2010 fiscal deal, therefore, involved both lower taxes and increased spending on unemployment benefits. Meanwhile, President Obama’s high-level, bipartisan deficit commission failed to even reach agreement among its members on a plan to reduce the deficit in the medium term, much less to get Congress to debate its proposals.
The Economy Matters, Too
Alongside these major differences in governance and politics, divergent economic structures and trends—which affect both the capacity and political will of a country to act—help to explain the UK’s rapid move toward fiscal consolidation, and the United States’ inability to do the same.
First, at 8.9 percent, the current unemployment rate is not only much higher in the United States than in the UK (7.8 percent), but it is also considerably higher than the historical average. From 1990 to 2007, U.S. unemployment averaged 5.4 percent compared to 6.9 percent in the UK. Additionally, U.S. long-term unemployment (measured as the percent of the total unemployed workers who have been unemployed for 27 or more weeks) reached 45.8 percent in June 2010—a figure 20 percentage points higher than its record high reached in June 1983—and has come down only slightly to 43.8 percent through February.
Furthermore, high unemployment is tougher to bear in the United States, where unemployment benefits are much less generous than in the UK. In addition, unemployed American workers typically lose their health insurance, whereas in Britain health care is provided by the publicly-funded National Health Service. Therefore, while the UK can rely partially on “automatic stabilizers” in tough times, the United States has to rely mainly on discretionary stimulus spending, which raises overall fiscal spending.
Second, the average UK worker—though perhaps less affluent than the average U.S. worker—has enjoyed a long period of rising incomes. Real wages for middle-quintile households in the UK have risen by 37 percent since 1977, the earliest available comparable data. Paring back on a small part of these gains to reestablish confidence in the government may seem a price worth paying.
In the United States, on the other hand, real wages for middle-quintile households have risen by only 13 percent over the same period. At the same time, Republican victories in last year’s midterm elections seem to preclude the possibility of increasing taxes on high-income earners, where nearly all income growth in the United States has been concentrated.
Third, Britain can rely more on foreign demand to offset the effects of budget cuts. Exports of goods and services are a much larger part of the British economy than the U.S. one—27 percent versus 11 percent, respectively, from 2000 to 2009. In addition, the British pound has depreciated sharply since the crisis erupted in 2008, declining by 22 percent relative to a basket of major currencies, which suggests that a global trade recovery could benefit the UK much more than the United States. The OECD projects that net exports will add nearly 1 percentage point to GDP growth over the next two years in the UK, while it subtracts 0.6 percent from U.S. growth.
Tough Questions
Markets initially welcomed Britain’s approach—since May 2010, bond yields dropped, stocks rose above levels in Europe and in line with those in the United States, and S&P upgraded the outlook on the UK’s AAA credit rating to “stable”—but problems are now emerging. Output unexpectedly contracted by 2.3 percent (q/q, annualized) in the fourth quarter of 2010 and business confidence has plummeted since May. Consensus forecasts for 2011 GDP growth have been cut from 2.2 percent in the first half of 2010 to 1.9 percent now. On Wednesday, Conservative leaders announced the new budget for 2011 and, while conceding that growth will be 0.4 percentage points lower this year than initially expected, reiterated their commitment to reducing the deficit.
Nevertheless, Britain’s sweeping spending cuts—particularly when combined with the large-scale fiscal consolidation across the rest of Europe—raise the stakes for the United States, where there is little sign that politicians are willing to confront their dismal fiscal outlook. As the club of countries with large and rapidly rising debt shrinks, those that remain—namely, the United States and politically paralyzed Japan—may be left increasingly at the mercy of market sentiment.
The U.S. fiscal problems are projected to worsen in the long term, with rising health care costs a prime culprit, as shown in the chart. The reforms needed to solve the problem are clear, but all remain politically thorny. These include means-testing Medicare and Social Security, increasing Medicare privatization, using comparative effectiveness research and other measures to control medical costs, increasing gas and value-added taxes, raising estate and income taxes, and reining in defense and other expenditures.
The jury is out on whether Britain’s radical approach will work, but this brief account should at the very least raise a number of questions:
Can the U.S. political system deal with its deficit problem before a fiscal crisis, such as the one in Greece, forces it to do so? Is the U.S. safe-haven status, which provides it with low borrowing costs, a blessing or a curse? Is America in need of legislative reform to help reduce the political obstacles that block deficit reduction? Would measures to reduce income inequality, and to strengthen the safety net for the unemployed, make deficit cuts easier to implement in America?
Leaders in the United States will be watching the UK closely, and should heed the lessons that Britain’s experience offers.
Uri Dadush is the director of Carnegie’s International Economics Program. Bennett Stancil is a researcher in Carnegie’s International Economics Program.
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