Two simple graphs, which show how an economy can have a rapid increase in real spending, but as % of GDP, government spending remains constant.
UK government spending as % of GDP

Between the late 1940s and 2000, government spending as a % of GDP stays around 40%.

But, actual GDP triples from £100bn to £300bn

Government spending in real terms

(at 1995 prices means the actual spending is adjusted for inflation since 1995.

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The BBC have this infographic about what happens if Greece leaves the Euro.

Source: BBC

But, when I look at this. Everything has already happened.

• Greece is already in recession. It has been in recession for past 5 years.
• Greece already has bank runs. Multinationals are not keeping money in Greek banks
• Due to unemployment of 23% and youth unemployment of 53%, there already is a political backlash, with growth of extremism on both left and right of political spectrum
• The Markets are already in turmoil with bond yields very high, and stock markets falling.
• Greece has already partially defaulted. It already has a sovereign debt crisis.

What Would be Different if Greece did leave the Euro?

In the Short Term

• Devaluation of around 25-50%. This would lead to a significant rise in import prices. This would cause (imported) inflation and rising living costs.
• Greek goods and services would become much cheaper. It would create some very cheap Greek holidays.
• Greece wouldn’t get flows of EU bailout money (though IMF and EU may agree a different type of fund to help deal with crisis)
• Capital Outflows. The biggest problem is that in lead up to devaluation, Greeks would try to withdraw money from Greece and retain the value of their Euros. These capital outflows and bank withdrawals could be very damaging to the economy. It depends on the extent to which the Government is able to restrict capital flows. But, it could cause tremendous damage to (an already battered) banking sector.
• Greek default. Rather than partial default, we would see a full default as Greece had insufficient funds to meet interest payments.

In Long Term

• Domestic demand could benefit. In the long-term, Greece will see an improvement in domestic demand. Demand for imports would fall due to higher cost. Greece would benefit from higher exports and (if political situation stabilises) an inflow of tourism.
• Greece would no longer feel it is following dictates of EU (Germany) and would have greater economic and political independence.
• Countries can recover from default and devaluation
• It depends what happens in rest of Eurozone. If the rest of the Eurozone survive and see economic recovery, this would help Greece also recover. However, if the whole Eurozone fails, it would be much more difficult to develop a bigger export sector and recover.
• With a full default, it may be possible to end crippling spending cuts, though it would have a smaller tax base due to smaller size of economy.

Related

• Questions on Greek Exit

Readers Question: Is it better to sell more services/products with less profit, than sell less with high profits? What are the pros and cons to the employer, worker, and customer? i.e high revenue low profit, vs low revenue high profit.

Classical economic theory suggests firms will seek to maximise profits. The benefits of maximising profit include:

• Profit can be used to pay higher wages to owners and workers. (though if firm has monopsony power, the profit may not be shared equally amongst workers)
• Profit can be used to invest in research & development. This investment can potentially benefit consumer. For example, without large profits, drug companies would have less ability to develop new drugs. High profit is often a justification for pharmaceuticals to have a degree of monopoly power (e.g. patents) because ultimately it is essential for creating the incentive to develop new treatments. However, this argument about research & development may depend on the industry. For example, it is now clear how much supernormal profit supermarkets need to be able to invest in research & development.
• Profit enables the firm to build up savings, which could help the firm survive an economic downturn. For example, in a recession, a firm could see a temporary loss, but if the firm has a reasonable level of savings and history of profitability, the bank will be more willing to keep lending. However, profitable firms don’t necessarily save this profit for an economic downturn. Profit is often paid to shareholders in the form of dividends or used to finance expansion, such as mergers or takeovers. For example, commercial banks were very profitable in the boom years, leading upto 2007. But, when the credit crunch hit, they had very little resources to ride out the financial crisis.
• For firms listed on the stockmarket, high levels of profit will make the firm less susceptible to takeoevers. If profit is low, sharedholders may be dissappointed in the low level of dividends and willing to sell to a takeover bid. You could argue this incentive to be profitable is good for consumers because the firm has incentives to be efficient and cut costs, which can lead to lower prices for consumers. However, you could argue, that the pursuit of short-term profit has drawbacks because the firm may not invest sufficiently in the long-term development of products and services. For example, train operating companies listed on stock market may go for short-term profit, and ignore long-term investment for industry.

Benefits of Pursuing Revenue Maximisation

Some firms don’t make profit maximisation as their ultimate goal. They seek to maximise revenue or market share. Seeking to increase market share and sales will lead to lower profit, but can have advantages for firms, consumers and workers.

• Increased brand loyalty. If a firms is able to cut prices and gain more customers, it will gain bigger exposure and brand loyalty. This enables the firm to be more prominent in the market. For example, in supermarkets, price is very important and getting a reputation of being cheapest supermarket can help attract customers. Continue Reading →

Readers Question: Should Greece pull out of the euro ? They are in the fifth year of recession despite EU bailouts – it seems like pouring money down a black hole.

Yes. I believe they should leave the Euro. I put some arguments for and against here – Should Greece leave the Euro. Leaving the Euro will cause economic turmoil, especially in the short-term and it is hard to predict exactly how bad it will be. But:

1. At least the Greeks will no longer feel their disastrous situation is being imposed by other countries (i.e. Germany)
2. Fundamentally, Greece is completely unsuited to being in a single currency with other Eurozone countries. Even if they struggled on for the next few years, the structural problems would remain. At least leaving gives them a better structural situation in the long term.
3. Countries forced to devalue often do less badly than expected – i.e. Argentina, Iceland spring to mind.
4. Things are already so bad, in Greece why fight to keep that?

The Greek public apparently want to keep the euro but they don’t want to pay for it.

Yes. They wanted benefits of Euro, but lacked both competitiveness and fiscal discipline.  They also don’t wont the austerity, job losses and continued depression which is a consequence of being in the Euro. If I was Greek, I would be angry that we ever joined the Euro. The Euro has made all of Greece’s problems worse.

Wouldn’t it just be easier to default on their debts and reinstate the drachma at a lower value than the euro ? This would boost exports and invite Tourism though I’m not sure what manufacturing Greece has to export.

Yes, Greek exports are relatively limited. But, a significant devaluation would create new opportunities. If nothing else, a devaluation would encourage foreign holidays, which would be now cheaper. For Greeks, it would make foreign goods less attractive and boost domestic demand instead. Don’t forget Greece has had a current account deficit of over 10% of GDP for a few years (currently around 9% of GDP) – This indicates a massive misalignment of currency. (UK is 2-3% of GDP by comparison)

Leaving the Euro, would help realign Greek competitiveness and boost domestic demand – even if they don’t have significant export industries.

If they defaulted could they be made to repay their debts at some point anyway or could they just declare themselves bankrupt like an individual and pay back little or nothing ? How does it work ?

They have already partially defaulted. If they leave the Euro and replace with a new currency, they would repay part of the debt, but it would be in the new currency. Therefore, after the devaluation, people holding Greek bonds would see a fall in the value because of the devaluation. Countries have defaulted on debt before, but have been able to regain some kind of prosperity, e.g. Argentina.

If an individual goes bankrupt they generally cant have a bank account or credit for years but surely that wouldn’t apply to a nation.

People would be much more reluctant to buy bonds from a country with history of default. They can expect higher interest rates. But, who wants to lend to Greece at moment anyway? Again, Argentina defaulted in the past, but it is now borrowing again. If the fundamentals of the economy are sound, then some investors will be willing to lend, at least for a risk premium.

Readers Question: I here of large withdrawals of euro by Greeks from their banks in panic but whats the point in that if they are not actually going to leave Greece ? They would still have to convert to drachma anyway.

If Greece leaves the Euro, it will see a 40-50% devaluation in the currency. Therefore, if you have Euros in Greek bank account, these savings will be worth a lot less after the devaluation. Therefore, people would rather keep the Euros.

If they are afraid the banks will run out of money they are themselves hastening it.

Related

• Will The Eurozone breakup?

A discussion of policies that can be used to promote economic growth (increase real GDP). Essentially policies to increase economic growth involve either an increase in aggregate demand or aggregate supply. Demand side policies become important during a recession or period of economic stagnation. Supply side policies are important for determining long run growth in productivity.

Demand Side Policies

Demand side policies aim to increase aggregate demand. This needs to be done during a recession or a period of below trend growth. If there is spare capacity (negative output gap) then demand side policies can play a role in increasing the rate of economic growth. However, if the economy is already close to full capacity (trend rate of growth) a further increase in AD will mainly cause inflation.

1. Monetary Policy. Monetary policy is the most common tool for influencing economic activity. To boost AD, the Central Bank (or government) can cut interest rates. Lower interest rates reduce the cost of borrowing, encouraging investment and consumer spending. Lower interest rates also reduce the incentive to save, making spending more attractive instead. Lower interest rates will also reduce mortgage interest payments, increasing disposable income for consumers.

Evaluation of Monetary Policy. Lower interest rates may not always boost spending. In a liquidity trap, lower interest rates may not boost spending because people are trying to pay back debts. In 2009, UK interest rates were cut to 0.5% but spending remained low. Banks were unwilling to lend because of liquidity shortages. Therefore, although in theory, it was cheap to borrow, it was hard to actually create credit. Therefore, this shows monetary policy can be ineffective in boosting economic growth

Another criticism of monetary policy, is that cutting interest rates very low could distort future economic activity. For example, the US cut interest rates following the economic uncertainty of 9/11. These low interest rates encouraged people to take on ambitious loans and mortgages; this was a factor behind the US housing bubble. Therefore cutting interest rates, at the wrong time, can contribute to a future housing and asset bubble which will destabilise economic growth. However, in 2009-12, the depth of the financial crisis means there is no immediate danger of a housing bubble, so it was appropriate to keep interest rates at zero.

2. Quantitative Easing. In a liquidity trap, where lower interest rates fail to boost demand, the Central Bank may need to pursue more unconventional types of monetary policy. Quantitative easing involves increasing the money supply and buying bonds to keep bond rates low. The hope is that the increase in the money supply and lower interest rates will boost investment and economic activity. The fear is that increasing the money supply could cause inflation. Though evidence from 2009-12 suggests that the inflationary impact was minimal. Without quantitative easing, the recession was likely to be deeper, though QE alone failed to return the economy back to a normal growth projectory.

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The confidence fairy refers to the criticism that cutting government spending will lead to renewed confidence and economic recovery.

In response to the economic crisis of 2008, many economies faced large budget deficits – due to cyclical factors (e.g. falling tax revenue in recession) and also underlying structural deficits (e.g. growing welfare bills). Some countries in the Eurozone also experienced rapidly rising bond yields as markets feared there was risk of default.

Therefore, many economists suggested it was necessary for the government to cut spending and target deficit reduction. The argument was that cutting government spending would reassure markets because it shows governments have a clear strategy for reducing debt levels and avoiding default. With a rapid cut in government spending and deficit reduction, it should help bond yields remain low. These low interest rates and strong action would encourage business to invest. Therefore, the private sector should take over the role of the public sector.

However, critics (notably Paul Krugman) argue that cutting spending in a recession does not improve consumer or business confidence. In fact, it can actually make things worse. Cutting government spending leads to a further fall in demand, lower growth, higher unemployment and actually a decline in confidence.

Furthermore, in a serious balance sheet recession and liquidity trap, some economists argue there is little risk of rising bond yields in the short term. (The Eurozone has separate issues because no lender of last resort)

This is because in a liquidity trap, there is a rise in private sector saving and strong demand for government bonds. The Keynesian approach is therefore to increase government spending to offset the rise in private sector saving. This enables economic recovery and an improved cyclical deficit. When the economy has recovered and is showing signs of private sector growth, only then should the government should tackle its budget deficit.

Confidence Fairy in UK

In June and October, 2010, the chancellor announced spending cuts of up to £81bn over the next 4 years. In particular, this raised prospect of public sector job cuts.

Up to 500,000 public sector jobs could go by 2014-15 as a result of the cuts programme, according to the Office for Budgetary Responsibility. (Spending Review 2)

What Happened to Consumer Confidence in the UK

UK Consumer Confidence

After recovering from worst of 2008, consumer confidence  fell to record low by start of 2012.

UK business confidence also fell from +12 in 2010, to -7.5 in 2011. Though it was more resilient than consumer spending.

What Happened to Economic Growth?

After brief recovery 2009 Q3 to 2010 Q3. The spending review co-incided with an end to the recovery and subsequent double dip recession at the start of 2012.

In other countries, Ireland, Greece and Spain, have also pursued austerity policies. This has led to similar falls in economic output, and has also failed to reassure bond markets. Despite spending cuts, bond yields have continued to rise because of fears over long term growth prospects in Eurozone.

Related

• Death of a fairy tale – Krugman NY Times
• Budget deficits and bond yields
• Is austerity self-defeating?

Aggregate Demand is the total demand in the economy. AD = C + I + G + (X-M)

• C= Consumer spending (Household consumption)
• I = Investment (gross fixed capital formation)
• G= Government  spending (Government investment and Government consumption)
• X-M = Net Exports.

Components of Aggregate Demand

A graph showing components of AD as a %

In the above charts, I left out 2 minor factors NPISH and change in inventories to make it simpler.

Source: HM Treasury Data

Aggregate Demand curve

AD slopes downwards because:

• At a lower price level people are able to consume more goods and services, because there Real income is higher
• At a lower price level interest rates usually fall causing increased spending.
• At a lower price level, exports are relatively more competitive than imports.

Notes

 Related

• What does the UK produce?
• Aggregate Demand

Source ONS | NTV

A possible unit 4 A Level question this summer could be:

Discuss the Impact of a fall in public sector investment on the UK economy?

The graph shows a fall in public sector investment from 3.5% of GDP in 2008  to 1.5% in 2011. This means cuts of approximately £30bn a year.

It means the government is spending less on capital investment projects such as new schools, new roads and other infrastructure investment.

That is quite a significant fall. With a fall in government investment, the first impact will be to reduce aggregate demand, lower economic growth and lead to higher unemployment.

Investment spending in the construction sector also tends to have a high multiplier effect (1.7 – 2.0). This study by RICS claims a multiplier of 2.84 . If there are less investment projects, construction workers will be more likely to be unemployed, and therefore, they will spend less causing a further fall in demand in the economy. Therefore, a fall in investment spending could cause a bigger fall in AD, than the initial cut in government spending.

Furthermore, given the weakness of other areas of the economy, this fall in government spending will lead to a significant fall in AD. If the economy was in robust shape with growing private sector demand and a strong export sector, this fall in public sector spending would not be so serious. But, the UK economy remains in a double dip recession with the uncertainty of the Euro crisis discouraging private sector investment.

One benefit of cutting public sector investment is that it will help reduce government borrowing. In the UK borrowing is forecast to be £123bn in 2011-12. Therefore, without a plan to reduce government spending and deficit, we may see a rise in bond yields as markets are concerned about the rise in government debt. An increase in interest rates would be very damaging for the UK economy given the levels of household debt and fragile nature of spending.

Another argument is that cutting government spending should enable ‘more efficient’ private sector spending and investment. It is argued, government spending can ‘crowd out’ the private sector spending. Reducing government spending helps reduce government borrowing, keeps interest rates low and encourages the private sector to spend and invest.

However, it is debatable whether interest rates would actually rise if the government invested an extra £30bn. Interest rates have fallen since 2008 because there has been a rise in private sector saving and demand for buying secure bonds. The interest rate on long term index linked yields is low at 0.5%. This suggests public sector investment could be finances for a very low annual interest payment.

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According to one Bond trading firm, austerity is a con and government spending hasn’t fallen significantly. (Telegraph)

• Government Spending 2011-12 – £681.4bn
• Tax 2011-12 – £558.1bn
• Deficit in finances – £123.3bn
• Changes in government spending 2009-10   +4.6%
• Changes in Government spending 2010-11  +0.3%
• Change in government spending 2011-12   -1.5%

Tulllet Prebon, a bond trading firm have argued that the government have hardly reduced spending at all. They argue that it is improbable that the bond markets would continue to fall for this ‘spin job’ when spending cuts don’t really exist.

However, a few notes:

• With inflation running at 3.5 – 4%, in real terms, government spending has fallen by 5.5%.
• Government spending has been rising because of automatic fiscal stabilisers, such as higher unemployment benefits. The government has made real cuts, but these cuts have been offset by rising welfare benefits associated with the recession.
• The government has found it easiest to cut spending from capital investment. As a % of GDP, public sector investment has shrunk from 3.5% to 1.5%. This has adverse long-term impacts on performance of economy.
• Some spending cuts are still to be implement. Reforms to public sector pensions, will help improve the structural deficit.
• It is certainly not easy to reduce public spending, public spending creates vested interests and some spending cuts become politically very difficult.
• The average growth of public spending has been around 3% in real terms in past years. For example, because of automatically rising pension spending commitments and rising welfare payments. Therefore, it can take effort just to stop this annual rise in spending.
• The important thing is not the short term deficit, but long term spending commitments.
• In 2008, many said that higher government borrowing would push up interest rates. In the UK, this has not happened. Bond yields on 30 year bonds continue to be very low. An even bigger cut in government spending would have made the double dip recession even worse – Bond markets might not like deficits, but they don’t like recession either.

Osborne outlines £6.2bn of spending cuts BBC

Related

• Spending cuts and the economy
• Key spending review – HM Treasury