Cutting Government Spending

January 20th, 2010 | economics -

Readers Question: Discuss the Impact of A Decrease in Government Spending?

Due to the high levels of government borrowing, many analysts suggest the UK government (and also many other countries) need to cut government spending. What would be the economic impact of a cut in spending?

Firstly, government spending (G) is a component of Aggregate Demand (AD). In 2007-08, UK spending totalled £557,400m. So (G) is a significant component of AD

The demand side impact of a cut in government spending will depend largely on the state of the economy.

The problem is government borrowing is often highest during a recession, but, this is the worst time to reduce (G) and AD.

Impact of a Fall in AD

If the government made plans to cut spending at the end of 2010, early 2011, there is a fear this could damage a fragile economic recovery. If house prices are falling, if consumer confidence is still low, if banks are still unwilling to lend then a cut in government spending could push the economy back into recession. This return to negative growth would also increase the size of government borrowing – In this case a cut in government spending could be counter-productive for reducing a deficit.

However, if the economy recovers strongly, if banks see an increase in their liquidity and become willing to lend, then the economy may be strong enough to shrug off a cut in spending. (e.g. imagine C, I and E components of AD are rising.)

Therefore, we need to be very careful about cutting spending, especially when some economists argue the degree of spare capacity in the economy suggests we need further fiscal stimulus not less.

However, if we have a weak pound (to boost exports) and loose monetary policy, then it may be possible to cut spending and maintain strong growth.

Spending and the Deficit

One of the main benefits of cutting government spending is that it will help reduce annual government borrowing and help the total public sector debt. In fact some economists argue it is essential to cut spending because borrowing is becoming dangerously high and the bond markets may start to downgrade UK debt because they feel it is too high. However, if a cut in spending does cause a further downturn the improvement in finances will be limited

Depends What Areas of Government Spending We Cut?

This question is open ended, it doesn’t say what areas of government spending will be reduced. In the run up to the election, you can guarantee all political parties will be talking about reducing bureaucracy and redtape e.t.c. But, when you have to wield the spending axe, you suddenly find many vested interests and/or public opinion against you. It is easier to talk of reducing government spending than actually to do it.

Some government spending e.g. roads, infrastructure, transport arguably have an important effect on the long run productivity of the economy. If we cut these areas of spending, then the UK’s productive capacity may suffer in the long term. (Aggregate Supply AS will increase at a slower rate)

From an economic perspective cutting spending on Social Security (£133m 2008) will have the least impact on economic productivity. In fact you could argue cutting spending on welfare benefits might actually increase the incentive for those on benefits to join the labour force. This could actually increase productivity.

However, cutting spending on welfare benefits risks increasing the level of inequality and relative poverty.

(Note: it is rare for governments to actually cut spending in real terms. In practise, we usually get a smaller rise in government spending. For example, for all the rhetoric of the Reagan and Thatcher governments about rolling back the frontiers of the state – government spending grew in real terms during the 1980s.)

One aim may be to reduce government spending as a % of GDP. Assuming GDP growth of 2.5%. Government spending can increase by 1.5% in real terms and still be a smaller share of the national cake.

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