Will Cutting Government Spending Bring Economic Growth?

Readers Question: Will Cutting Public spending bring economic growth?Do Countries with lower government spending as a % of GDP have higher economic growth rates?

After recent data on -0.7% growth in Q2 2012, several experts offered suggestions for restoring economic growth to the UK.

In the Guadian, Sheila Lawlor suggested (link):

The UK’s output figures, which show a quarterly drop of 0.7%, are not surprising. Economies with big public spending to GDP ratios have difficulty growing.

But there is a solution, to cut public spending and embark on structural reform, proven as the sure path to growth. The evidence from a variety of economies shows that cutting public spending and structural reforms brings growth: Brazil since 1990, Ireland in the 1990s, Sweden from the 1990s.

Basically, the argument is cut government spending and the private sector will have the freedom to take over inefficient government spending and then we can enjoy rapid economic growth. Whilst some blame austerity measures for pushing UK into double-dip – this analysis suggests we just haven’t done enough austerity.

Firstly, it is possible to cut government spending and still enjoy economic growth and an improvement in economic growth. Lawlor could have pointed to Canada in the 1990s, which also enjoyed rapid growth – despite cutting government spending. However, these periods of cutting government spending usually have other factors to stimulate growth.

  • Countries have own exchange rate
  • Countries can pursue a loosening of monetary policy
  • Strong global growth, leading to higher demand for exports.

Cutting government spending in an economic boom can be absorbed. It is fine to cut spending – if the private sector have the opportunity to replace government demand.

Ireland’s cuts¬† in the 1990s were quite successful – helped by independent currency, strong export demand and loosening of monetary policy. But Irish austerity policies since 2008 have been a disaster for economic growth. The problem is that government spending cuts in the 2000s, have not led to the private sector taking the place of the government.

The idea that cutting government spending is the ‘sure’ path to economic growth hardly fits with the picture in Greece, Spain, Italy or Ireland in the past three years. I would have thought even the most optimistic austerian would see that cutting government spending doesn’t always lead to an economic miracle. (e.g. Spain crisis)

In the current climate, the private sector is unwilling to invest because it is uncertain there is the demand in the economy.

Therefore, cutting government spending in the current climate, is unlikely to cause ‘crowding in’ of the private sector.

It is not enough to just rely on supply side policies and strutural reforms, a key factor determining private sector investment is not just amounts of red tape – but is the demand there to buy the goods?

Cutting Public Sector Investment

The UK Government has cut spending by 1.5% in 2011/12. Many of these cuts have fallen on public sector investment projects, such as building new schools.

Source ONS | NTV

The sector with the biggest falls in output in the last quarter were construction spending. – Suggesting that the cut in government infrastructure have not been offset by a rise in private sector investment spending.

Shouldn’t the Private Sector Take the Place of Government Spending?

Many economists believe that if you cut government spending, then the private sector has now the opportunity to invest.

But, it all comes down to timing.

  1. If the economy was booming then the private sector is willing to take the risk and invest. But, given the prolonged recession, concerns over Europe and the collapse in consumer confidence, the private sector confidence isn’t there.
  2. Saving Rates. Currently, the private sector is trying to pay off debts and increase its savings. The UK saving rate has increased from a low of 1% to over 6%. This reflects a fall in the proportion of income spent.
  3. Bond Yields. UK bond yields have fallen. Many would expect higher borrowing to push up bond yields. But, this has not occurred – bond yields have fallen because:
  • People want to save in secure assets
  • Prospects for growth are low, therefore they would rather hold bonds than invest in private sector investment.

Because bond yields are so low, cutting government spending wouldn’t push down bond yields. We are in a liquidity trap, where rates are low despite high levels of debt. The government can borrow at very low rates to finance investment the private sector is currently unwilling to undertake.

Confidence

confidence

UK consumer confidence is very weak. Talk of spending cuts and public sector job losses have been a key factor in pushing UK confidence lower. If the government announced even more spending cuts than previously announced, this would reduce private sector confidence even further. Some high profile government investment projects, can improve confidence and create a positive multiplier effect which will create demand for the private sector.

Crowding In

Crowding in occurs when cuts in government spending lead to higher private sector spending.

Crowding in of the private sector could occur if.

  • Spending cuts could be offset by a loosening of monetary policy.
  • Bond yields were high to attract sufficient private sector saving. Therefore, cutting spending helps to reduce bond yields.
  • There was evidence of reasonable strength of private sector demand.
  • Opportunity for boost to exports from weaker currency or strong overseas demand.

At the moment, private sector confidence is too weak to offset cuts in government spending. The government need to temporarily offset the fall in private sector investment and spending. Now is not the time to be cutting government spending.

Do Countries with Lower Government Spending as a % of GDP grow at a faster rate?

There are so many variables affecting economic growth that looking at the % of Government spending as a % of GDP is highly prone to ‘cherry picking’.

If you look at this table here: list of spending as % of GDP, you can really take your pick and choose your countries to support your point of view.

Some of countries with highest levels of government spending as a % of GDP have best living standards. Developing countries, often have a low ratio. This means they may have scope for faster rates of economic growth, but it may not.

Sweden 52.5% of GDP
Denmark 51.8% of GDP

To come back to the question: will cutting UK government spending by £100bn increase economic growth?

No, the most likely scenario is that it could push the UK into a serious depression, which is being experienced by Spain and Greece. In the current economic climate real spending cuts of upto 5-10% of GDP would not be offset by a boom in private sector spending and investment.

spending

Also, if you look at government spending as % of GDP – it is highly cyclical – government spending rises in recession (because of automatic stabilisers on unemployment benefits). In a boom, it falls, because GDP rises and automatic stabiliser spending falls.

It is possible, if the economy recovers sufficiently then government spending as a % of GDP could fall.
If the economy recovers, if we leave the liquidity trap, if the savings rate starts to fall, if bond yields start to rise as people want to invest in private sector rather than save in bonds

2 Responses to Will Cutting Government Spending Bring Economic Growth?

  1. W at Off-Road Finance July 26, 2012 at 5:46 pm #

    I think it really depends at some level on the national spirit too. If a country with a strong entrepreneurial spirit cuts government spending, it’s easier for the private sector to take over. But that’s not the case in all countries, or all of the time. High spending seems to work better in collectivist cultures than in independent ones.

  2. Simon October 23, 2012 at 1:06 pm #

    W – the private sector will only ever “take over” the profitable aspects of the shortfall, rather than the unglamorous ones such as keeping people healthy/alive, educating non-privileged youngsters etc. Where crowding in does occur – at least under a Tory government – it’s nothing more than asset stripping.