During the years 2001-2007, there was a sharp rise in government spending. In real terms, government spending increased from just over £400bn (2009 prices) to £618bn in 2008-09.
As a % of GDP Government spending also increased from 36% of GDP in 2000 to 46% of GDP by the end of 2008-09
This increase in government spending contributed to budget deficits and higher public sector debt.
This article examines the macro economic impact of this increase in government spending. I have ignored the wider social / micro economic impact of higher spending. It follows on from article on – who is to blame for recession?
Causes of Higher Public Sector Spending
- During the period 2000-2007, the UK economy was growing strongly (at an average of around 2.5%). Therefore, the fact government spending as a % of GDP increased shows that the increase in government spending was at a greater rate than the increase in national income.
- It was only in 2008, that GDP started to fall. The subsequent rise in government spending to GDP post 2008, is largely due to this drop in GDP.
- Health care spending. The biggest beneficiary of the government’s higher spending was health care. Health care spending almost doubled in real terms between 1999 and 2010
As a % of GDP, health care spending rose from 5% of GDP in 1999 to over 8% of GDP by 2009. (Rather worryingly, the Institute of Fiscal Studies suggests the UK still faces a funding gap for the NHS of £20bn by 2020)
Impact of Government Spending on Budget Deficit
After a short period of budget surplus (due to spending restraint) in the late 1990s, the UK experienced a budget deficit of 2-3% of GDP between 2002-2007.
By historical standards, this is relatively low. It still met the Maastricht criteria of keeping budget deficits to less than 3% of GDP.
However, the budget situation was also improved by impressive tax revenues from the housing and financial boom. When the credit crunch hit, tax revenues rapidly dwindled causing a marked deterioration in public finances.
Impact on Public Sector Debt
Did Government Spending Contribute to the Economic Boom of the 2000s?
- The significant increase in government spending did contribute to rising aggregate demand. However, there was some crowding out, with higher borrowing leading to less private sector investment. Government spending took a bigger share of national income, reducing the size of the private sector as a % of GDP.Nevertheless, the sustained rise in government spending, contributed to the positive economic growth of the mid 2000s.
- However, the 2000s, wasn’t a classical inflationary boom (like for example, the Lawson boom of the 1980s). Inflation remained low. Outwardly, the economy appeared a model of low inflation stability. The deficit was higher than desirable, but at 2% of GDP, hardly cause for immediate concern. The real boom came through asset markets. Rising house prices, and a financial bubble.
- Greater restraint in government spending may have tempered this financial bubble. But, the causes of the financial boom were much more than simply higher government spending. Higher spending on the NHS was not the cause of the financial boom. Even if the government had restrained spending, there would still have been an asset bubble and credit crunch.
Was the Increased Budget Deficits a Failure of Keynesian Economics?
- Many associate Keynesian economics with higher government spending, but this is only half the situation. Keynesian economics calls for counter-cyclical spending and deficits. Thus, in a period of strong economic growth, Keynesian economics would advocate balancing the budget or even pursuing a budget surplus.
- If the government had entered the credit crunch with a budget surplus and lower public sector debt, the government would have had much more room to pursue a real and sustained economic stimulus. However, because there was already a deficit, the recession caused a rise in the cyclical deficit. The deficit of 2009-10 of 11% of GDP was primarily due to the deterioration in public finances, only a small part of this deficit was due to expansionary fiscal policy (VAT cut)
- A great failure of spending decisions of the 2000s, was to allow budget deficits during rapid economic expansion. A budget deficit of 3% of GDP may have sounded relatively low. But, in hindsight, this exaggerated the underlying deficit because tax revenues were boosted by tax revenues which evaporated during the credit crunch.
- It is worth pointing out the US pursued a similar picture. During rapid economic expansion of 2000s, the US budget deficit increased (partly due to generous tax cuts). Again, during this period in the economic cycle, they should have been reducing deficits, not increasing them.
Did Labour’s Spending and Deficits of 2000s Contribute to the Great Recession?
It was a mistake to allow an increase in public sector debt, during a period of economic expansion. If the government had pursued a balanced budget during the 2000-07, there would have been two macro economic benefits
- It would have slightly reduced the asset and housing boom of the early 2000s. If the boom was less significant, the subsequent crash would have been less damaging. However, I feel this is relatively minor, the asset bubble is still likely to have occurred even with lower government spending.
- Improved public finances would have Given more room for expansionary fiscal policy when the recession occurred.
A key factor in the double dip recession, was the government’s pursuit of austerity measures in 2010 and 2011. The coalition claim they had no choice because the previous government had left them with a large deficit. I don’t agree. The coalition could have taken more time to reduce long-term deficit, the pace of austerity was self-defeating and unecessary.
However, if the public – sector debt had been lower in 2010, the government may have not pursued austerity and the UK economy probably wouldn’t be in recession.
However, it is also possible, that even if we had lower public sector debt and lower budget deficits, the coalition may still have wanted to tackle the budget deficit and still pursued austerity. Austerity policies arguably appeal to Conservatives for many reasons. But, this is speculation over political motives.
Can we Blame Labour?
To some extent, the budget deficits made it harder to get out of the recession. By 2010, there was less room for maneouvre. Though, the coalition also exaggerated the necessity of having to tackle deficit in the short term.
- Who is to blame for recession
- A Survey of public spending in the UK – google docs
- A balancing act - Centre Forum
- Government spending as % of GDP