Black Wednesday and inescapable cuts

April 07, 2011 10:50 AM

The Organisation for Economic Co-operation and Development (OECD) has predicted British economic growth will be sluggish due to the Government’s austerity measures coming into effect yesterday, dubbed “Black Wednesday” by Shadow Chancellor Ed Balls. The club of 34 developed nations expects the Government’s fiscal tightening to depress GDP growth figures as state benefits, jobs and purchases are cut while the National Insurance rise and January’s VAT hike all take their toll on economic activity:
“The substantial but necessary fiscal tightening and weak real income growth create headwinds and growth is projected to remain subdued in 2011. The recovery will gain a bit more momentum in 2012 when exports are expected to increase further and business investment to grow more robustly.”

While the fiscal tightening could directly reduce economic activity, the effect is temporary and largely offset by businesses and households increasing their own spending as they reduce their saving as they no longer expect a fiscal tightening in the future, a phenomenon known in economics as ‘Ricardian Equivalence’. It is temporary because, at some point, the money that is no longer being paid to redundant government employees, benefit recipients or suppliers for government contracts will be redirected as the private sector expands to use the resources freed up by public sector cuts. When this happens, economic growth will be faster than it would otherwise be; probably disproportionately greater than the initial downward effect.

[caption id="" align="alignright" width="240" caption="Inescapable"][/caption]

And the OECD forecasts and the “Black Wednesday” phrase interestingly give lie to the fact that, so far, there has been no cut to overall public spending levels. John Redwood, the Conservative MP for Wokingham, has found that while the growth in public spending may have been cut by the Government, the total spending figure (the amount of cash distributed by the Treasury) has continued to rise despite all the talk of “cuts”. But cuts will have to happen, one way or another.

Almost everyone accepts we have an unsustainable budget deficit. The Government simply cannot raise enough revenue to cover spending. Borrowing currently makes up the shortfall, but this can’t continue indefinitely. When lenders start to worry that their loans to the government can only be repaid if they lend ever larger sums, they’ll stop lending, which is what has happened to Greece and Ireland recently. If that happened to us on a Wednesday, that really would be a ‘Black Wednesday’: unlike these small economies we’re just too big for German and other taxpayers to bail us out. But even in the short term borrowing isn’t without cost to the wider economy. In order to maintain unsustainable levels of public spending, the government is borrowing money that would otherwise have been available for businesses to expand and for consumers to finance the things they want. The well-publicised difficulties businesses face when applying for loans and overdrafts are in no small measure a consequence of government borrowing. This is why reducing the deficit has to be a key component in any strategy to boost economic growth.

Other than borrowing, the two alternatives for closing the deficit are either cuts in government spending or rises in taxation – in other words, cuts in private sector household and business spending. So we have to cut something. There is no escape from the need to cut when the fiscal deficit is as large and unsustainable as Britain’s currently is. The question is what do we cut: household living standards (by raising taxes), business investment (by borrowing) or government waste (by cutting spending)?The Organisation for Economic Co-operation and Development (OECD) has predicted British economic growth will be sluggish due to the Government’s austerity measures coming into effect yesterday, dubbed “Black Wednesday” by Shadow Chancellor Ed Balls. The club of 34 developed nations expects the Government’s fiscal tightening to depress GDP growth figures as state benefits, jobs and purchases are cut while the National Insurance rise and January’s VAT hike all take their toll on economic activity:
“The substantial but necessary fiscal tightening and weak real income growth create headwinds and growth is projected to remain subdued in 2011. The recovery will gain a bit more momentum in 2012 when exports are expected to increase further and business investment to grow more robustly.”

While the fiscal tightening could directly reduce economic activity, the effect is temporary and largely offset by businesses and households increasing their own spending as they reduce their saving as they no longer expect a fiscal tightening in the future, a phenomenon known in economics as ‘Ricardian Equivalence’. It is temporary because, at some point, the money that is no longer being paid to redundant government employees, benefit recipients or suppliers for government contracts will be redirected as the private sector expands to use the resources freed up by public sector cuts. When this happens, economic growth will be faster than it would otherwise be; probably disproportionately greater than the initial downward effect.

[caption id="" align="alignright" width="240" caption="Inescapable"][/caption]

And the OECD forecasts and the “Black Wednesday” phrase interestingly give lie to the fact that, so far, there has been no cut to overall public spending levels. John Redwood, the Conservative MP for Wokingham, has found that while the growth in public spending may have been cut by the Government, the total spending figure (the amount of cash distributed by the Treasury) has continued to rise despite all the talk of “cuts”. But cuts will have to happen, one way or another.

Almost everyone accepts we have an unsustainable budget deficit. The Government simply cannot raise enough revenue to cover spending. Borrowing currently makes up the shortfall, but this can’t continue indefinitely. When lenders start to worry that their loans to the government can only be repaid if they lend ever larger sums, they’ll stop lending, which is what has happened to Greece and Ireland recently. If that happened to us on a Wednesday, that really would be a ‘Black Wednesday’: unlike these small economies we’re just too big for German and other taxpayers to bail us out. But even in the short term borrowing isn’t without cost to the wider economy. In order to maintain unsustainable levels of public spending, the government is borrowing money that would otherwise have been available for businesses to expand and for consumers to finance the things they want. The well-publicised difficulties businesses face when applying for loans and overdrafts are in no small measure a consequence of government borrowing. This is why reducing the deficit has to be a key component in any strategy to boost economic growth.

Other than borrowing, the two alternatives for closing the deficit are either cuts in government spending or rises in taxation – in other words, cuts in private sector household and business spending. So we have to cut something. There is no escape from the need to cut when the fiscal deficit is as large and unsustainable as Britain’s currently is. The question is what do we cut: household living standards (by raising taxes), business investment (by borrowing) or government waste (by cutting spending)?

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