Trying to make sense of the UK budget deficit


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Trying to make sense of the UK budget deficit

  1. 1. The UK budget deficitKey terms:Austerity A policy of reducing government spending to tackle a budget deficit.Government The accumulated borrowing of the government. This has to be serviceddebt which means that part of government spending every year is made up of interest payments on this debt. The Government borrows by selling bonds – time-limited pieces of paper which promise the bondholder an annual interest payment and the value of the bond when it matures.Budget deficit Structural deficit – what the Government borrows to make up for a– is sometimes shortfall in revenue (when government spending exceeds tax revenue)divided into Cyclical deficit – an automatic consequence of the business cycle whichtwo means that in a recession, tax revenues fall and government spending increasesStimulus A policy of maintaining AD using either expansionary fiscal or monetary policyGovernment strategy – austerity or stimulus?View 1: the cyclical deficit will take care of View 2: the only way to reduce the structuralitself – it is vital to tackle the structural deficit is by generating growth. Austerity willdeficit. A large deficit will lead to higher not produce growth and will, therefore notinterest rates to fund the borrowing needed reduce the deficit.and this will hamper growth.This requires austerity. This requires stimulus. Growth with smaller government strategy Grow out of debt strategyContractionary fiscal policy: Expansionary fiscal policy will generate higherCut the fiscal deficit by cutting government tax revenues and reduce the deficit.spending and maintain the confidence of the‘financial markets’. Effective fiscal expansion needs – higher spending rather than tax cutsA period of stagnation is necessary and – spending on infrastructure and socialwages and prices should be allowed to adjust. transfers – any tax cuts should target lower income groups (who have a higher propensity to consume)Growth from supply-side policies: Growth from supply-side policies:Employment protection laws should be Government should invest in education,repealed to provide incentives for firms to modern infrastructure and research intake on more workers. emerging technologies.Taxes should be cut to provide incentives forentrepreneurs.
  2. 2. Estimates from the Autumn Financial Statement 2011 £ billion % of GDPGDP 2011/2012 1521 100Government spending 702 46Government revenues 575 38Budget deficit 127 8Structural deficit - c4% of GDP Cyclical deficit - c4% of GDPCauses: Cause: recession- expansion of health and education after - lower tax revenues (e.g. from taxes on1999 and a failure to raise taxes 2000-2007 spending, incomes and profits)to pay for this expansion - higher government spending (e.g. on- running budget deficits in a boom welfare payments)- funding military campaigns in Iraq andAfghanistanFuture liabilities: Future spending commitments:Governments have made promises on These higher costs may require higherpensions and health spending which will taxes and higher taxes may depresscause problems as we have an ageing economic activity. We might face a futurepopulation. of slow growth and high debts.‘Reducing debt should be the priority’ view: ‘Growth more important than deficit’ view:We must reduce debt so that future Governments should keep spending togenerations are not burdened. restore growth because growth will reduce the deficit.Government policy: Government policy:To eliminate the structural deficit by cutting To promote growth (through expansionary(the growth in) government spending and fiscal policy) as this would automaticallyincreasing taxes. increase tax revenues and reduce government spending.Credit rating argument: Cuts hurt growth argument:Important to cut the deficit to persuade Cuts will further weaken aggregate demandcreditors that they stand a good chance of and reduce economic growth which willgetting their money back as this will keep make it harder to reduce the deficit.interest rates low and make servicing thedebt cheaper.Run a programme of austerity to try and get But an austerity programme risks creatingback to a structural budget surplus. a debt trap. [This is where cuts to government spending push the economy into recession, increasing the level of government debt and leading potential creditors to demand higher interest rates making the deficit even worse and requiring further austerity measures.]Problem: Problem:Cutting government spending hurts lower Disagreements about how best to stimulateincome groups more growth. Boosting AD will only work if there is spare capacity in the economy. Supply side measures can take a long time to have an impact.
  3. 3. Austerity- a good idea? Benefits of an austerity package Problems of an austerity packageUK facing unsustainable debt. Reducing the Reducing G lowers ADdeficit is an important part of reducing Lack of growth will increase the deficit.government spending as a percentage of the Private sector cannot quickly create jobs toeconomy. employ redundant public sector workersUK has to maintain existing servicing costs Waste of human capitalBuyers of government bonds need Long-term unemployed permanently leavereassurance the labour marketUK has benefited from the lower interest Scrapping EMA will reduce long-termrates which have resulted from a convincing productivity growthplan to reduce the deficit.The austerity package is an economic The austerity package is a political choice, notnecessity to correct the political failure to an economic necessity. It is being used toadhere to balanced budgets over the push through a right-wing ideology aiming toeconomic cycle. reduce government involvement in societyA stimulus package is a political choice by [e.g. in health, education and welfare].those who want bigger Government.Fairness – between generations. It is unfair Fairness – between income groups. It isto burden the young. unfair to burden the poor.OBR forecasts made in June 2010 and November 2011 2011/12 2012/13 2013/14 2014/15 2015/16Deficit in £billion June 2010 forecast 116 89 60 37 20 Nov 2011 forecast 127 120 100 79 53Deficit in % of GDP June 2010 forecast 7.5 5.5 3.5 2.1 1.1 Nov 2011 forecast 8.4 7.6 6.0 4.5 2.9Causes and consequencesIf you believe that the problem is … it might be logical to argue for deficitmainly a cyclical one and that financing to tackle recession with morethe deficit problem is due to a government spending…collapse in tax revenues as theeconomy went into recession…. BUT this could make the structural deficit worseIf you believe that the major … it might be logical to argue for a balancedproblem is the structural budget and cuts to government spending…deficit…. BUT this could make the recession worseIf you believe that the problem … it might be logical to argue for higherwas caused by excessively low interest rates and a period of stagnation tointerest rates which incentivized allow prices to adjust.over-borrowing, and an assetbubble….. BUT this might make it harder for debtors to service interest payments and the sale of assets would not cover their debts.
  4. 4. Policy options – encourage growth or balance the budgetView 1: View 2:Focus on the structural deficit: - government Focus on the cyclical deficit: - governmentshould eliminate the structural deficit quickly should act to stimulate growth and thisand leave the cyclical deficit to take care of growth will help reduce the structural deficit.itself - just avoid doing anything which mighthinder growth.Encouraging growth - on the demand side Policy Reservations The main influence on consumer Rising unemployment and the fear of spending is disposable income. If you unemployment mean that consumers areC cut disposable income in a recession reluctant to spend you won’t get growth. Consumers may choose to use an increase in real or disposable income to So.. pay off their debts rather than spend Falling asset values make people feel Encourage consumer spending by worse off and less likely to want to spend reducing spending taxes and/or Cutting taxes may not help balance the income taxes budget (in the short run) Some argue that government should encourage investment with lower The main influence on business corporate taxes and/or tax breaks and I investment is expectations about low interest rates. future market opportunities. Interest rates are set by the MPC and are evidence that in the opinion of the MPC So.. the economy is not growing Firms are using extra cash to pay off Boost consumer spending [see debts and buy back shares. above]. Firms will not invest if consumers are not spending. This will make the structural deficit worseG Use deficit financing to fund Multiplier effects might be weak infrastructure projects such as HS2, a third runway or new airport. Opposition from influential environmental or ‘nimby’ lobby groups. An export promotion strategy Relies on the strength of overseas targeting growing markets in Asia demand. Recession in the EurozoneX-M Import substitution via a policy of protecting or subsidising domestic would hurt exports. Tariff protection not allowed in EU and open to retaliation anyway. Protecting industries national champions not efficient.
  5. 5. QE – Quantitative EasingThe monetary policy of cutting the interest rate to boost growth cannot be used becauseinterest rates are as low as they can go. So, if the Bank of England can’t change the price ofdebt it can act on the quantity.The Bank of England creates money for itself and uses it to buy government bonds frombanks, pension funds and insurance companies. The hope is that these institutions will usethe money to increase lending to firms and individuals at attractive rates. [In theory, if theBank of England buys government bonds it makes them more expensive and a less attractiveinvestment for banks etc. which means that they are more willing to lend to firms.] The longterm aim is that when the economy recovers, the Bank of England will sell the governmentbonds it has bought and destroy the cash it receives.QE has helped the cash position [and the bonus pools] of the banks. It hasn’t led to highergrowth because firms do not want to borrow to invest because expectations of future growthare so low. Banks are also scared to lend because they don’t believe that the economy willgrow.An alternative suggestion has been that the government should set up a National InvestmentBank to offer ‘patient capital’ [i.e. not looking for fast returns] and thereby release funds forlong-term innovative investments – in particular ‘green’ investments.The case of Japan: very low interest rates, QE and no recoveryA boom in the 1980s saw an expansion of debt secured against property. Come therecession, asset prices fell which meant that for many [firms and households], the value oftheir assets was lower than their debts. This made them disinclined to borrow more – thepriority was to reduce debt and low interest rates helped. An ageing population made theproblem worse – retirees are less likely to boost consumer spending than workers.If UK firms and households behave in a similar way to Japan then QE may not work.Low interest rates may not be a good ideaThere is also an argument that low interest rates in the 2000s lead to unproductiveinvestment and were to blame for the speculative bubble which led to the financial crisis inthe first place.Low interest rates made some projects appear viable that wouldn’t otherwise have been. Thismeant that after a period of time, for example when teaser rates on mortgages came to end,the rate people paid would rise, and those who were unable to pay the higher rate defaulted.This resulted in the start of the downturn, as banks would no longer lend to other businessesat such attractive low rates. Low interest in other words lead to poor investment decisionsand a misallocation of resourcesLow interest rates also encouraged an unsustainable boom in the housing sector.This argument would suggest that interest rates should be allowed to rise and prices andwages should be allowed to adjust. Supporters of this view would be opposed to anystimulus measures and would argue that the austerity package does not go far enough – it ismerely slowing the rate of growth of government spending, not actually reducing it.
  6. 6. Encouraging growth - on the supply sideDeregulation Aim ReservationsCutting/abolishing the To encourage hiring and cut This increases the amountminimum wage employer costs the taxpayer has to pay via tax credits to make up the shortfall between a low wage and a living wage.Weaker health and safety To reduce employer costs Killing and maiming workerslaws may not help the recoveryWeaker employment rights To encourage hiring by Reducing job security reducere. dismissals reducing risks of employment loyalty, motivation and tribunal costs productivityEducationRestore the EMA To encourage young people Takes a long time to have an to stay in education and impact increase their skill levelsBoost apprenticeships To encourage employers to Takes a long time to have an train their staff and increase impact general skill levelsTax incentivesReduce top rate taxes To encourage ‘trickle down’. Trickle down doesn’t happen - this just increases inequality. More likely to ‘trickle out’ to tax havens. To encourage enterprise. There needs to be a distinction between enterprise and rent-seeking.Political EconomyEconomics can provide us with a way of looking at things but cannot provide a ‘correct’solution. Economic data can be found to support all of the competing views expressed above.The reality is that different economic policies serve the purposes of different interest groups(and are focused on different time frames), this means that policy decisions are made withina political context.Politicians interpret the economy for us [the general public] and tell us a simplified story toexplain how things are and what we should do. Studying economics can help us to questionthe stories they tell us!Possible questions 1. What is meant by the term budget deficit? [K] 2. Distinguish between a structural and cyclical deficit. [Ap] 3. Explain the arguments which might be used a. by a supporter of an austerity strategy b. by an opponent of an austerity strategy. [An] 4. Analyse the OBR forecasts and suggest reasons why forecasts might change.[An] 5. Assess the choices facing the UK government and comment on the policies which the government has chosen to pursue. [Ev]
  7. 7. AcknowledgementsI would like to thank Professor David Myddleton of the Institute of Economic Affairs and IanMarcousé of the Institute of Education – the two speakers who presented their ideas to agroup of teachers at the Royal High School in Bath on February 21st 2012.Ian Marcousé used this presentation to support his argument.The data used above was prepared by and presented to teachers by Professor Myddleton andI am grateful to the two speakers and the teachers who attended for their contributions andideas. I have included some of their ideas in the above. Any mistakes are mine.Colin Leith