The Government has hinted that it is considering injecting extra money into the economy via increased public sector spending and borrowing - a so-called fiscal boost - to try to limit the depth and length of the recession. Just how much scope does it have to do that and will it work?

At first sight, the answer to the first question might appear to be none at all. Public borrowing is already set to come in at about £60 billion in the current fiscal year, or about 4 per cent of GDP, well above the Chancellor’s March Budget prediction of £43 billion. And that is before the full effects of the downturn in the economy have been felt. These alone could push borrowing up towards £100 billion per annum over the next year or two. Meanwhile, public sector net debt, at 43.4 per cent in September, is already above the 40 per cent specified by Gordon Brown’s own “sustainable investment rule”.

However, the door to a fiscal injection may not be as firmly shut as it seems. For a start, bad though Britain’s current fiscal position is, it is certainly not without precedent. Public borrowing rose to 7 per cent of GDP (£100 billion in today’s money) in the mid-1970s and to almost 8 per cent in the early 1990s. In both episodes it then fell back quickly over the following years. Indeed, only five years after borrowing peaked in 1993-94, the Government was paying off debt.

At the same time, Britain’s financial position does not compare entirely unfavourably with that of its major competitors. Admittedly, its budget deficit of 4 per cent of GDP is among the highest in the developed world but its level of debt is among the lowest. Germany and France both have debt-to-GDP ratios of about 65 per cent, while Italy’s is above 100 per cent. This might suggest that there is room for Britain’s borrowing and debt to rise.

A second issue is the precise nature of any policy measures. The Government has hinted that any boost would probably come in the form of higher public expenditure rather than tax cuts. What’s more, this additional spending would itself be capital spending (investment), rather than current (day-to-day) spending on, for example, higher public sector wages. This means that it would be consistent with the premise of the Government’s golden rule - to borrow only to invest - perhaps increasing the chances that it would yield a “return” in terms of higher levels of economic activity and employment in the future.That this spending would probably be brought forward from plans already made for later years might suggest that it would not actually lead to higher borrowing over the long term. Indeed, if it helps to reduce the depth of the recession, it may end up leading to lower borrowing.

Finally, the case for fiscal action is arguably strengthened in the current circumstances by the likelihood that the alternative option of looser monetary policy, ie, lower interest rates, would be much less effective than usual in the light of the credit crisis. Lending criteria have been tightened significantly and lenders are unlikely to pass on cuts in official interest rates in full.

Of course, there is no guarantee that any of this will work. After all, a fiscal boost in the form of tax cuts in the US in the summer brought no more than a temporary pickup, with many recipients choosing to save the money rather than to spend it. Furthermore, the effects of increased investment would take time to come through. Accordingly, it seems unlikely that anything can now prevent a pretty deep recession. Meanwhile, some economists have expressed deep concern over how even bigger increases in government borrowing will eventually be paid for. At some point in the future hefty tax increases or spending cuts still look inevitable. But when things are this bad, anything is worth a try.

- Jonathan Loynes is chief European economist at Capital Economics

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