Austerity Measures and the Economy

Discuss impact of Spending Cuts on economies in the OECD?

This is a question I am setting my macro economic students at the moment. If you have a good knowledge of macro economics there is a huge range of issues you can raise. In particular, there is a great opportunity for evaluating – i.e. displaying awareness of how the impact of spending cuts will vary depending on economy and situation.

Essay Plan

Government Spending is a component of AD. A fall in G, will lead to lower AD and therefore could lead to lower GDP and higher unemployment.

  • However, if other components of AD increase, then the economy may manage to avoid recession. For example, if there is a growth in exports (from depreciation or growth in global economy) or if a rise in private sector spending and private sector investment offset the fall in government spending then the economy may keep growing.

Cuts in government spending will reduce budget deficit. This may be necessary to avoid difficulties in selling government bonds. Without cuts, some fear a rise in bond yields and worries over UK credit worthiness.

  • However, if spending cuts do cause lower growth, it will lead to lower tax revenues and more spending on  unemployment benefits. In this case spending cuts could be self-defeating.
  • However, reducing budget deficit will reduce spending on interest payments in the long term.

Evaluation and Examples

A key issue is the state of the economy and other policies which might be able to offset fiscal austerity. If we take Euro countries like Spain, Ireland, and Greece they are having to cut government spending, but, they don’t have potential of loosening Monetary policy, i.e. they have to cut government spending, but there is no interest rate cut, quantitative easing or depreciation in exchange rate. They are relying on private investment and rise in exports. But, given size of budget cuts, the private sector is quite fragile. This is why we are seeing falls in GDP in Ireland and Greece.

The UK may have a better chance of avoiding a second recession. The Pound Sterling has depreciated in past two years, making exports more competitive. Also the Bank of England has done more to offer monetary stimulus (through quantitative easing). This is reflected in higher inflation rate in UK than Eurozone.

However, the UK could still suffer a fall in growth if:

  • We see a fall in UK house prices which weaken confidence
  • If the rise in job losses and spending cuts are not offset by the private sector.

Micro Economic Impact of Spending Cuts

Another issue is the Micro Economic impact of spending cuts. In short spending cuts:

  • Impact distribution of income. Many spending cuts have been targeted on low income earners. e.g. removal of welfare benefits.
  • Delaying infrastructure spending may damage long term productivity.

Related

5 thoughts on “Austerity Measures and the Economy

  1. Good article, but I think spending cuts only influence the distribution of income if they are not applied proportionately.

    It also depends on the type of jobs dependent on public spending – i.e. you’d think it would mainly impact admin/blue collar type workers, but a lot of public money goes to big consultancies like Capita etc… So this would impact management consultants and other senior positions.

    1. Well we are now in 2013 and the evidence says you are wrong. The government have tried public sector cuts and austerity and the result is flatlining growth and rising national debt. What many have missed is the huge private sector debt levels and a liquidity trap that means no one in the private sector wants to invest in the real economy. We’ve seen this before: the 1930s, 1870s etc and what history tells us is the only way out is a large government stimulus to prevent a collapse in demand and jobs…….

      What we need is targetted spending though – on projects that will give a lasting benefit to society. This will give confidence to the real economy. We obviously also need banking reform – preferably a break up of TBTF banks.

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