Economics Help » Economics help blog Wed, 01 Jul 2015 09:55:16 +0000 en-US hourly 1 New AS Economics – Edexcel revision guide Wed, 01 Jul 2015 09:54:17 +0000 Edexcel-AS-Revision-GuideI have just finished the new version of AS Edexcl economics revision guide. It is updated for the new syllabus, which will be used for first exam in 2016.

The Edexcel AS revision guide is 108 pages, 20,800 words.

More details here: AS Edexcel Revision Guide £5.00

Network license for schools

For schools, I am making available as a network license allowing unlimited use, with word doc.

Coming soon

I will be finishing A2 revision guide.

I will soon be bringing out revision guides for AQA, OCR, Welsh board and Cambridge International

]]> 0
Effects of a budget surplus Sat, 13 Jun 2015 07:18:10 +0000 The chancellor George Osborne has recently announced a plan to enshrine budget surpluses in law. It is worth noting, that budget surpluses are quite rare in the past 120 years.


The argument of the chancellor is that with national debt ‘unsustainably high’ – periods of economic growth should be taken as an opportunity to pay down debt and reduce the burden for future generations.

What is the impact of a budget surplus?

1. Higher taxes / lower spending. To ensure a budget surplus, the government will have to cut spending and / or increase taxes. This could happen more than the government may like; there are certain long-term factors which work against the government’s fiscal position, such as the demographics of an ageing population. Also many tax revenue sources have been falling, (e.g. decline in use of petrol)

2. Impact on growth. If the government is forced to increase taxes / cut spending to meet a budget surplus, it could have an adverse effect on the rate of economic growth. If government spending is cut, then it will negatively affect AD and could lead to lower growth.

A budget surplus doesn’t have to cause lower growth. If the economy is booming, then a budget surplus could be compatible with strong economic growth. Also, even if the government increase taxes, the Bank of England could ease monetary policy to maintain strong growth. In fact, in a booming economy, Keynesian economics suggest that a budget surplus could help prevent excess growth and inflation.

The concern is that the government will be forced into creating a budget surplus when growth is positive, but not strong enough to absorb the deflationary fiscal policy (higher T, lower G). For example, with interest rates already at 0.5%, there is limited scope for the Bank of England to ease monetary policy further. The UK recovery is more fragile and unbalanced than we would like – it is arguably not strong enough to absorb austerity – and it is difficult to predict when it will. Targeting a budget surplus, we may still experience economic growth, but the austerity and fiscal tightening means that the economy runs below full potential and leads to higher unemployment than otherwise.

3. Impact on household debt. Austerity has a strong political appeal, because there is dislike of the idea of debt. But, a government budget surplus could ironically lead to higher household debt. In the financial crisis, household debt as % of GDP fell as consumers / firms tried to pay off debt. This led to fall in spending, which was partly offset by rise in government borrowing. However, with the ongoing real wage squeeze, the OBR predict a rise in household debt in the next five years.

  • In 2008, household debt was 169% of GDP. This has fallen to 135% of GDP. However, the OBR says by 2019 this will rise to more than 173%. (Guardian)

If the government pursue tight fiscal policy – higher taxes, lower spending cuts, this will squeeze household disposable income and they may have to respond by increasing debt levels. A budget surplus takes money from elsewhere in the economy. It doesn’t create money.

4. Impact on cost of borrowing. One argument for running a budget surplus is that it will reduce levels of national debt, and push down bond yields and reduce the amount of debt interest payments future generations pay. This will make it cheaper for the government to borrow. UK debt interest payments are already set to rise.


Interest payments on UK debt

However, as a % of GDP, debt interest payments have been more stable.


Also, bond yields in the UK are already very low. so running a budget surplus may have little impact on reducing bond yields. Though others may argue that without cutting deficit now, bond yields will rise in the future.

5. Impact on ability to survive future problems.

One argument for running budget surpluses is that it gives you more scope for meeting a future crisis. If you meet a future crisis with debt at 100% of GDP, it may be difficult to pursue expansionary fiscal policy. If debt has fallen to 50% of GDP, there is less need to panic.

However, if budget surpluses reduce the rate of economic growth, then this will damage the long-term potential of the economy. It is worth bearing in mind, that the UK began the 1950s with national debt at 200% of GDP, but it was no barrier to a golden age of economic prosperity and rising living standards. National debt doesn’t have to saddle future generations with poor prospects.

6. Impact on investment

If the government is committed to running a budget surplus, it is likely the government will need to cut back on public sector investment. – Investing in railways, roads, housing, communication, education, skills, training. These are all areas where this market failure. Private firms will not build new roads or fix potholes because they are effectively public goods. If the government cut back on investment, it could harm the long-term productive capacity of the economy.

Some feel the idea of government borrowing is very wrong. But, it should be remembered successful firms borrow for investment, households borrow to fund a mortgage. The economy can benefit from public sector investment. The rate of return on public sector works can be significantly higher than the current borrowing costs.

The real problem in the UK economy is not budget deficit, but poor productivity growth. The government can play a role in increasing productivity through investing in vocational training and dealing with transport bottlenecks. But, if the highest priority of the government is running a budget surplus, there will be limited resources to fund this.

7. Is national debt actually unsustainable?

It is much repeated that UK national debt is unsustainable, but is this actually true? For example, demographic trends will place increased pressure on government social security and NHS. These transfer payments are seen as unsustainable because it is not borrowing for investment. This is an important concern.

But, if UK debt is unsustainable – why are markets so keen to buy debt? Bond yields are very low, indicating that private firms don’t need a high interest rates to compensate for any perceived risk.


I often publish this graph to put UK debt levels into perspective. It is true that some circumstances were different in the 1950s. But, levels of debt are by no means unprecedented.

8. You don’t need a budget surplus to reduce debt to GDP ratio


The UK very rarely had a budget surplus 1950- 2013, but will still reduced debt to GDP ratio quite a lot – because economic growth reduces debt to GDP.


When growth is strong, it makes sense to improve the nations finances and reduce debt as a % of GDP. The counterpoint of expansionary fiscal policy in a recession, is that there need to be automatic stabilisers the other way.

However, the concern is that making budget surpluses a top economic priority could mean we take decisions which are not in the best interest of the economy. The value of budget surpluses is not that great, but they do come at an opportunity cost of taking money from elsewhere in the economy.

Governments and Central Banks need greater flexibility and not to be tied down with fiscal rules (which have proved so damaging in Eurozone)

Also, there is a very strong case for governments borrowing to finance public sector investment. We need investment in training, housing and transport to help long-term economic growth. It would be very short-sighted to target fiscal goals.


]]> 1
Can Labour be blamed for the economic crisis? Fri, 12 Jun 2015 08:54:42 +0000 Readers Question 1. Can Labour be blamed for the economic crisis (i.e. did they really ‘overspend’)?  My view is that the global economic crisis is to blame, and that Labour could have spent less but that this is easy to say with the benefit of hindsight.

I don’t think there is any economist who would try to blame the global financial crisis and global recession on the fact the Labour government increased spending on the NHS / education by a relatively moderate amount.

The global recession of 2008-13 was caused by the great financial crisis / credit crunch. The cause of this lay in several factors, but was primarily due to:

  • Excess mortgage lending, especially in US
  • Housing markets experiencing boom in prices that was unsustainable
  • Banks around the world taking risk with purchase of risky sub-prime mortgage debt, rebundled debt – leading ultimately to credit crisis.

This is only a very brief summary because I have written on this in more detail previously. But, it was essentially a failure of the financial sector.

It is true real government spending under Labour increased significantly. (see more detail at: Government spending under Labour)


But, as a percentage of GDP, the rise is far less significant – at least until the recession (2008-09) when GDP fell 6%. (causing spending/GDP to rise)


Was it a mistake to run a budget deficit during the boom years of 2000-07


I would say it was a small mistake to run a budget deficit of 3% of GDP during the boom years. From a Keynesian perspective it would have been more desirable to have run close to a balanced budget.

However, it is also worth mentioning

  • I don’t think a balanced budget would have done anything to prevent a recession. The recession would still have occurred with the same impact, even with a balanced budget. This is because the global recession had nothing to do with UK government spending / government borrowing.
  • I don’t believe governments have to run a budget surplus during boom years. Borrowing to fund investment in improving long-term infrastructure can reap long-term benefits. (I will write more on this in the future)

Tax receipts based on boom economics. One criticism about the UK finances (like many other countries) in the 2000s was that UK tax revenues were quite reliant on a booming financial and housing sector. When the financial market fell, tax receipts were very hit hard (and have struggled to recover). In other words, the UK fiscal position was not as good as it looked.

Borrowing and room for manoeuvre

One argument is that if the UK had run a balanced budget in the 2000s, public sector debt would have been lower and the UK would have had more room for manoeuvre in pursuing expansionary fiscal policy when the recession hit and we needed expansionary fiscal policy.

There is some credence to this, with a balanced budget and lower public sector debt to start with, governments may have felt greater confidence to borrow even more in the recession – when the UK economy needed expansionary fiscal policy.

However, it is also worth being sceptical. Public finances in the UK were very good in 2007; by comparison with the past 100 years, we were near a record low.

Spot the economic mismanagement of the Labour government 1997-2007.


The UK did have room for expansionary fiscal policy in 2008, bond yields were falling – there was never any fiscal crisis in the UK.

The lurch to austerity post 2010, was unnecessary driven more by Micawber economics and the strong political appeal of austerity. My feeling is that even if the UK had run a balanced budget in 2000-07, there would still be the same strong calls for austerity. People who think £180bn is ‘too much borrowing’ – would probably think – £80bn borrowing is too much as well.

The real economic mistakes of pre crisis period

The real mistakes of the pre-global recession period were not government spending or government borrowing (which were both pretty good by post war standards). The missed opportunities were:

  • Failure to regulate financial system. The 1980s saw a period of financial deregulation, building societies became profit oriented banks willing to take extravagant risks (e.g. Northern Rock, Bradford & Bingley) In the US mortgage companies behaved with complete irresponsibility. The lax controls on mortgages and bank ratios was a great mistake.
  • Failure to build up a bank bailout fund. In the boom years, it would have been a good policy to make banks pay into a fund for their potential future bailout should the market turn. This would have curtailed some of the banks risky expansion and meant that there was a government fund to use to bailout banks – rather than just relying on general tax payers money.
  • Housing market. The boom and bust in the US and European housing markets was a significant issue.
  • The Euro. The Euro is a deeply flawed economic policy, which has very strong deflationary bias. The pre-crisis period saw massive imbalances in the Eurozone area with countries in the south running current account deficits running into 10-12% of GDP. Without currency fluctuations, without a lender of last resort – in retrospect, this was a disaster waiting to happen.
  • Greek debt. The one country with a real debt problem was actually Greece. Other European countries, such as Ireland, Spain and Portugal had very low levels of government borrowing at the start of the crisis, but were forced into a debt crisis through the mechanism of the Euro.

Was anyone calling for regulation of banks / mortgages / housing market?

To be fair to Labour, they were not alone in ignoring the shadowy world of financial markets – just about everyone, including the majority of economists, didn’t realise what a hidden problem the financial markets were.

For example, I don’t think even the most ardent Conservative supporter would claim that the Conservatives would have taken on the banks and prevented the financial crisis.


On a personal note, I’ve found it quite difficult how it has become accepted conventional wisdom that somehow Labour economic mismanagement was responsible for the great recession. It is a bit worrying how the banks have got off very lightly with the blame rather disingenuously put onto this vague idea of Labour economic mismanagement.



]]> 1
New economics AS and A2 syllabus Thu, 11 Jun 2015 07:10:26 +0000 Revision-Guide-AS-A2There has been an update to the economic syllabus for those taking A2 exams in 2017.

It means that students starting to study Economics AS in Sept 2015, will be doing the new syllabus, with first AS exams in June 2016, and the first A2 exams in June 2017.

Students who have already started economics AS this year, will be unaffected and they will continue with the existing syllabus.

Major changes

  • AS and A2 will be linear. AS exams will not count towards final A2 result

New topics

  • Global financial crisis
  • Behavioural economics

New economics revision guide

I am currently updating all my economics revision guides. I have started with Edexcel and will move on to the other exam boards soon.

It is more of an evolution than radical change, but it is one thing I like about economics – the syllabus does naturally evolve. Core principles stay the same, but application to the real world does change.

I will be selling AS and A2 revision guides separately in the future, and will make available institute wide licenses for unlimited use in particular schools.

New Economics syllabus

]]> 0
Problems facing UK economy in 2015 Fri, 05 Jun 2015 06:45:37 +0000 Reader Question: What Are The Macro-Economic Problems Faced In UK In 2015? And What Are The Reasons And Causes?

Only time for a quick answer. Off the top of my head 5 problems for UK economy

  1. Low economic growth
  2. Low productivity growth
  3. Budget deficit / perceived need to cut deficit.
  4. Low wage growth
  5. Unemployment


1. Low economic growth


This might not be most obvious because UK has experienced a recovery in the past two years. But, the economic recovery is still weak, with concerns weak growth in Europe and further austerity could cut forthcoming growth. The economy still has a big loss of output since the great recession, that we have not recovered from.

2. Low productivity growth


Productivity is output per worker. Productivity growth in the UK has been very weak. This is a concern because it suggests future long run economic growth will be poor with little scope for an increase in real wages.

Productivity affects growth of long run aggregate supply. If productivity is very low then we will have a lower long run trend rate of economic growth. Part of the reason for low productivity growth is firms keeping wages low, lack of investment and slowing down of new technological improvements.

3. Budget Deficit / perceived need to cut


Personally I don’t think the budget deficit is a pressing problem. Bond yields are low, the government is in no danger of getting into debt problems, but it has become a media and political issue. In the past few years, cutting the deficit is seen as necessary – whatever the consequences. The chancellor is committed to sharp reductions in government spending to reduce the deficit. This will likely worsen the already weak recovery.

Even the OECD recently warned the chancellor that he should be spreading out spending cuts over a longer time period. (OECD warn UK to reduce pace of austerity)

UK Budget deficit

4. Low wage growth

The UK currently has a weak wage recovery. The economy is growing, but the benefits are not felt by many workers. It raises the question of whether the recovery is sustainable. Though, there are signs that real wage growth is starting to pick up a little.

5. Unemployment

Falling unemployment is one of the success stories of the UK economy in the past four years. So this makes only number 5, but there are still areas of high unemployment, and the concern is that effective unemployment is higher – there is certainly a lot of under-employment – people on zero-hour contracts, people working less than they would like.

UK unemployment-rate

]]> 2
UK National Debt Tue, 02 Jun 2015 05:38:09 +0000 The UK national debt is the total amount of money the British government owes to the private sector and other purchasers of UK gilts.

  • In April 2015, public sector net debt excluding public sector banks (PSND ex) was £1,487.7 billion (80.4% of GDP)
  • Source: [1. ONS public sector finances ] (page updated June 1st 2015)


Budget deficit – Annual Borrowing

This is the amount the government has to borrow per year.

  • In 2012/13 net borrowing was £115bn (7.4%) (Excluding Royal mail and transfers)
  • In 2013/14 net borrowing is forecast at £105.5bn or 6.5% of GDP (Excluding Royal Mail and transfers)
  • In the financial year ending 2015 (April 2014 to March 2015), public sector net borrowing excluding public sector banks (PSNB ex) was £87.7 billion (4.8% of Gross Domestic Product (GDP)) a decrease of £10.8 billion compared with the previous financial year.
  • For the financial year ending 2015 (April 2014 to March 2015), the central government net cash requirement (CGNCR) was £93.6 billion;

UK Net borrowing


Latest statistics at OBR

Note this graph excludes sale of Royal Mail which temporarily reduced actual borrowing in 2012-13


Figures for 2013-14 onwards are forecasts.

View:  Latest statistics at OBR

Further reading on

Deficit down but Debt up?

One potential confusion is that politicians may say the budget deficit is coming down. But, at the same time, national debt is rising.

  • If annual borrowing falls from £80bn to £50bn, the annual deficit is lower. But, at the same time, the national debt (total debt) is still rising.

% of GDP

The most useful measure of national debt is to look at debt as a % of GDP. For example in 1950, UK national debt was £640bn (at 2005 prices) – but this was 250% of GDP.



Recent History of UK National Debt

After a period of financial restraint, from mid 1990s, public sector debt at a % of GDP fell to 29% of GDP by 2002. From 2002 – 2007 , national debt  increased to 37 % of GDP. This increase in debt levels occurred  despite the long period of economic expansion; it was primarily due to the government’s decision to increase spending on health and education (see: Government spending in this period). There has also been a marked rise in social security spending.

Since 2008, public sector debt has increased sharply because of:

  • 2008-13 recession (lower tax receipts, higher spending on unemployment benefits) The recession particularly hit stamp duty (falling house prices) income tax and lower corporation tax.
  • These cyclical factors have also exposed an underlying structural deficit. (deficit caused by spending greater than tax, ignoring cyclical factors)
  • Financial bailout of Northern Rock, RBS, Lloyds and other banks.

Comparison With Other Countries

Although 77% of GDP is a lot, it is worth bearing in mind that other countries have a much bigger problem. Japan for example has a National debt of 225%, Italy is over 120%.  The US national debt is close to 75% of GDP. [See other countries debt]. Also the UK has had much higher national debt in the past, e.g. in the late 1940s, UK debt  was over 180% of GDP. Nevertheless, there are reasons why the UK couldn’t borrow the same sums that we did post-war.

History of National Debt

UK National Debt since 1900.

Source: Reinhart, Camen M. and Kenneth S. Rogoff, “From Financial Crash to Debt Crisis,” NBER Working Paper 15795, March 2010. and OBR from 2010.

See also: Historical National debt

These graphs show that government debt as a % of GDP has been much higher in the past. Notably in the aftermath of the two world wars. This suggests that current UK debt is manageable compared to the early 1950s. (note, even with a national debt of 200% of GDP in early 1950s, UK avoided default and even managed to set up the welfare state and NHS. In the current climate, the UK would struggle to borrow the same as in the past.  For example, private sector saving is lower, and the US wouldn’t give us big loan like in the 1950s.

But, how did the UK reduce its debt so much from 1950 to early 1990s – despite rising levels of real government spending? – See:  how the UK reduced debt in the post-war period


Historical budget deficit

Annual borrowing since 1950


Debt and Bond Yields

Bond yields reflect the cost of borrowing. Lower bond yields reduce the cost of government borrowing.


Since 2007, UK bond yields have fallen. Countries in the Eurozone with similar debt levels have seen a sharp rise in bond yields putting greater pressure on their government to cut spending quickly. However, being outside the Euro with an independent Central Bank (willing to act as lender of last resort to the government) means markets don’t fear a liquidity crisis in the UK;  Euro members who don’t have a Central Bank willing to buy bonds during a liquidity crisis have been more at risk to rising bond yields and fears over government debt.

See also: Bond yields on European debt | (reasons for falling UK bond yields)

Cost of Interest Payments on National Debt


The cost of National debt is the interest the government has to pay on the bonds and gilts it sells. In 2011/12, the debt interest payments on UK debt are anticipated to be £48.6 bn (3% of GDP). This is a sharp increase from two years ago, but still quite manageable.  See also: UK Debt interest payments

As a % of GDP, debt interest payments are relatively low.


In 1985-86, debt interest payments reached 4.5% of GDP


How to reduce the debt to GDP ratio?

  • Economic expansion which improves tax revenues and reduces spending on benefits like Job Seekers Allowance. The economic slowdown which has occurred since 2010 has pushed the UK close to a triple dip recession and therefore the further squeeze on tax revenues has led to deficit reduction targets being missed.
  • Government spending cuts and tax increase (e.g. VAT) which improve public finances and deal with the structural deficit. The difficulty is the extent to which these  spending cuts could reduce economic growth and  hamper attempts to improve tax revenues. Some economists feel the timing of deficit consolidation is very important, and growth should come before fiscal consolidation.
  • See: practical solutions to reducing debt without harming growth

 What will be impact of Chancellor’s plan to run budget surpluses?

Is it a good idea to enshrine in law the idea of a government being forced to run a budget surplus?

What is the real level of UK National Debt?

It is argued by some that  the UK’s national debt is actually a lot higher. This is because national debt should include pension contributions and private finance initiatives PFI which the government are obliged to pay.

The Centre for Policy Studies (at end of 2008) argues that the real national debt is actually £1,340 billion, which is 103.5 per cent of GDP. This figure includes all the public sector pension liabilities such as pensions, and private finance initiative contracts e.t.c (and Northern Rock liabilities).

  • However, these pension liabilities are not things the government are actually spending now. Therefore, there is no need to borrow for them yet. It is more of a guide to future public sector debt. I don’t accept the fact that future pension liabilities should be counted as public sector debt. In 2006, the Statistics Office did change calculations to include some PFI into public sector debt figures [pdf –]
  • However, it is a sign that it will be difficult to improve finances in the future.

Another problem is that with the financial crisis, the government have added an extra £500bn of potential liabilities. Note: the Government has offered to back mortgage securities. They are unlikely to spend this money. But, in theory the government could be liable for extra debts of up to £500bn. If we include this bailout package as a contingent liability National debt would be well over 100% of GDP. However with a modest improvement in the bank sector, the necessity for these bailouts look unlikely, unless there is a very sharp deterioration in global finance markets – which is always possible.

Forecast for National Debt

  • Current forecasts for UK debt predict that the UK public sector debt to GDP ratio will peak at 79.9% in 2015/16. However, in the past few years, government forecasts have regularly been revised upwards due to poor growth and disappointing deficit reduction
  • What are the prospects for UK debt default?

Debt including financial sector intervention

UK debt

Potential Problems of National Debt

  1. Interest Payments. The cost of paying interest on the government’s debt is very high. In 2011 Debt interest payments will be £48 billion a year (est 3% of GDP). Public sector debt interest payments will be the 4th highest department after social security, health and education. Debt interest payments could rise close to £70bn given the forecast rise in national debt.
  2. Higher Taxes / lower spending in the future.
  3. Crowding out of private sector investment / spending.
  4. The structural deficit will only get worse as an ageing population places greater strain on the UK’s pension liabilities. (demographic time bomb)
  5. Potential negative impact on exchange rate (link)
  6. Potential of rising interest rates as markets become more reluctant to lend to the UK government.

However, Government Borrowing is not always as bad as people fear.

  • Borrowing in a recession helps to offset a rise in private sector saving. Government borrowing helps maintain aggregate demand and prevents a fall in spending.
  • In a liquidity trap and zero interest rates, governments can often borrow at very low rates for a long time (e.g. Japan and UK) This is because people want to save and buy government bonds.
  • Austerity measures (e.g. cutting spending and raising taxes) can lead to a decrease in economic growth and cause the deficit to remain the same % of GDP.  Austerity measures and the economy | Timing of austerity

Who Owns UK Debt?

The majority of UK debt used to be held by the UK private sector, in particular, UK insurance and pension funds. In recent years, the Bank of England has bought gilts taking its holding to 25% of UK public sector debt.

Overseas investors own about 30% of UK gilts.


More at: who owns UK debt?

Total UK Debt – Government + Private

  • Another way to examine UK debt is to look at both government debt and private debt combined.
  • Total UK debt includes household sector debt, business sector debt, financial sector debt and government debt. This is over 500% of GDP.Total UK Debt

Private sector savings


When considering government borrowing, it is important to place it in context. From 2007 to 2012, we have seen a sharp rise in private sector saving (UK savings ratio). The private sector have been seeking to reduce their debt levels and increase savings (e.g. buying government bonds). This increase in savings led to a sharp fall in private sector spending and investment. The increase in government borrowing is making use of this steep increase in private sector savings and helping to offset the fall in AD. see: Private and public sector borrowing


Government spending


More statistics on UK government spending

Other Countries Debt

See also:

]]> 299
Diverted profit tax Sat, 23 May 2015 07:02:36 +0000 Firstly, sorry for the low levels of blogging recently. I am working on a new site, waiting for some outside developers. Secondly I am working on completely new Revision Guides for the new economic syllabus coming out soon.

It meant I didn’t do much blogging around the general election – which is perhaps a blessing in disguise. It still annoys me it is so hard to separate fact from political spin (e.g. Government spending under Labour government)- but that’s life.

I do try to be ‘balanced’ – though I’m not sure how good a job I do…

I genuinely think George Osborne has been a bad chancellor. Everything seems motivated from a political standpoint, not an economic standpoint.

Having said that – I feel very relieved that at last I have found something that Osborne has done that seems a good policy.

Diverted profit tax

This is a scheme to put a punitive 25% tax on companies who are considered to be artificially routing profits overseas. A very good example is – making £5.3bn of sales in Britain but routing it through Luxembourg to avoid British tax.

It seems to be working with Amazon finally giving up their obvious tax avoidance. (Guardian article)


]]> 0
Government Spending under Labour Fri, 01 May 2015 07:13:45 +0000 During the years 1997-2007, there was a significant rise in government spending, though as a % of GDP the rise was less marked.


Source: ONS Public Sector Finances MF6U – October 2014

Government spending as a % of GDP

A more meaningful comparison is to look at the share of government spending as a % of GDP.


  • In 1996-97 – Government spending as a % of GDP 40%
  • In 2007/08 – Government spending – 41% of GDP
  • In 2008/09 – 44.5 % of GDP

The large increase in government spending as a % of GDP in 2008/09 was a direct result of the deep recession. In a recession GDP falls, tax revenues fall and government spending on benefits rise.

Public sector debt


In 2007, UK public sector debt was close to a historical low ( post 1914) .


More detail at: UK national debt

A more detailed graph of that period. Shows that public sector debt went from 42% of GDP in 1997 to 50% by 2010.

government spending labour
Source: A view of UK public spending

Causes of higher public sector spending

  • During the period 1997-2007, the UK economy was growing strongly (at an average of around 2.5%), this rise in tax revenues allowed the government to spend more on public services, such as health and education. However, towards the end of 2000-07 government spending increased at a slightly faster rate than GDP growth.
  • The biggest beneficiary of the government’s  higher spending was health care. Health care spending almost doubled in real terms between 1999 and 2010.

health care spendingAs 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.

Did Government spending contribute to the economic boom of the 2000s?

  • The significant increase in government spending did contribute to rising aggregate demand. But, it was only one factor out of many things contributing to strong economic growth (e.g. strong housing market, rising consumer spending, high global economic growth)


The UK great moderation from 1992 to 2008 low inflation, positive economic growth.

  • 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. In retrospect, 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 only very marginally. The causes of the financial boom was not really related to government spending on the NHS. It was due to the over-exuberance, de-regulation and booming housing markets. See causes of credit crunch. Even if the UK government had restrained spending, there would still have been a global 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 more room to pursue a real and sustained economic stimulus.Yet, even a budget deficit of 11% of GDP in 2009/10 did not cause higher bond yields; there was strong demand for purchasing UK government bonds.
  • 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 (though it must be said a relatively small increase by historical standards). If the government had pursued a balanced budget during the 2000-07, there would have been two macro economic benefits

  1. 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.
  2. Improved public finances would have given more room for expansionary fiscal policy when the recession occurred.

Did higher spending in 2007 justify austerity?

A key factor in the UK 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 the long-term deficit; the pace of austerity was self-defeating and unnecessary. A recession is not the time to reduce the deficit.

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 – such as reducing welfare and the size of the state.

To some extent, the budget deficits of 2000s made it harder to get out of the recession. By 2010, there was less room for manoeuvre. Though, the coalition also greatly exaggerated the necessity of having to tackle the deficit in the short term.

Debt and borrowing under Labour



]]> 11
The effect of tax cuts Wed, 22 Apr 2015 08:26:49 +0000 Question: What are the effects of reducing tax?

Let us take the example of a cut in the basic rate of UK income tax from 20% to 18%

In this case, workers will see an increase in their discretionary income. With lower income tax rates, they would keep more of their gross income, so effectively they have more money to spend.

In this case, we could expect to see a rise in consumer spending because workers are better off. (AD=C+I+G+X-M). Because consumers spending is a component of AD (roughly 60%) then a rise in consumer spending should cause a rise in aggregate demand (leading to higher economic growth)
AD-increaseBut, does a cut in tax really increase aggregate demand? Firstly, it depends how the tax cut is financed.

  • Suppose the government offer £4 billion of income tax cuts, but at the same time cut £4 billion from welfare spending. In other words the tax cut is financed by cuts in government spending. In this case, we will not see an increase in AD because some people are better off from the tax cut, but others will cut their spending due to lower welfare payments.
  • Alternatively, the government could finance the tax cut by increasing government borrowing. Would this increase AD?
    • In a recession, we probably would see higher AD. This is because the government borrowing will be financed by people wanting to save anyway. In this case, the government is injecting unused resources into the circular flow. In a recession,  the tax cut makes a big difference to people’s spending power
    • If the government increases borrowing in a boom to finance a tax cut, we may get crowding out. This essentially means the government borrow more by selling bonds to the private sector. If the private sector buy government bonds, they have less money to invest elsewhere. Also, during high growth, higher borrowing may lead to higher bond yields and these higher interest rates cause financial crowding out.
  • If the tax cut is financed by by higher productivity, rising tax revenues, and a growing economy, then this is more likely to allow higher consumer spending.

Impact on Productivity

If we take a cut in income tax, it could also have an effect on the supply side of the economy.

  • Lower income tax rates may encourage people to work longer. Overtime is more worthwhile if you get to keep more of your income. This is the substitution effect – work is more attractive with lower tax rates.
  • However, there is also the income effect. With lower tax rates (and effectively higher wages), it is easier to get your target income by working fewer hours. Therefore, tax cuts may not increase labour supply because people don’t need to work more, if work is more highly paid.

There is much debate about the extent to which tax cuts increase productivity and economic growth. If marginal tax rates are very high e.g. 80%, cutting tax rates is likely to have some increase in labour supply and productivity. But, with tax rates of 20 or 30%, cutting income tax rates is no guarantee of increasing productivity and growth.

Cut in indirect tax

If the government cut an indirect tax like VAT, the effect is similar. If goods are cheaper because of lower tax, consumers will effectively have more purchasing power. After buying the same number of goods, they will have more money left over, therefore consumer spending may rise.

Again the effect depends on the state of the economy.

For example, cutting VAT at the start of the recession was expansionary fiscal policy and helped to make consumer spending higher than it otherwise would have been.

Other impacts of a cut in tax?

  1. It depends on consumer and business confidence. If consumer confidence is low, then a cut in tax may not increase spending because they prefer to save the extra income. Alternatively, some argue, that lower tax will increase confidence and general motivation because they feel less government intervention.
  2. It depends what else is happening in the economy. If we cut tax, during a global recession, AD may continue to fall. Even though tax cuts are helping to increase disposable income, we will see a fall in exports, fall in house prices, and a rise in unemployment. In other words, the expansionary effects of tax cuts are outweighed by other factors in the economy.
  3. It depends which taxes are cut. If you cut excise duty on alcohol and tobacco, then many people on low income will see a significant increase in discretionary income, this is likely to be spent. If you cut higher marginal tax rates (e.g. 50% tax rate on incomes over £100,000) this is more likely to be saved. People earning over £100,000 have a lower marginal propensity to consume – they can afford to save. Therefore, if you cut tax for high earners, there will be a smaller impact on increasing AD, than cutting tax for low income earners.


]]> 0
An end to globalisation? Tue, 21 Apr 2015 08:35:55 +0000 Readers Question: Why doesn’t WTO make into law that all manufactured goods should either be assembled or made in the continent where its been sold? There is so many reason why this should be put in place in our globalised world

Saltaire Mill Yorkshire. UK once exported clothes, now we import.

I don’t agree. The benefits of a globalised world are that we can benefit from goods and services produced in many different continents.

If Japan is relatively better at producing cars, it makes sense for Latin American, Asian and African countries to import cars and concentrate on producing goods where they have a comparative advantage.

Would it help Africa to insist they only bought cars manufactured in Africa?

No, it wouldn’t help because, at the moment, they don’t have a developed car industry. It would take a long time, and cost a lot of money in investment to start producing cars. African nations can’t afford to devote a high percentage of GDP to developing a car industry, when they would gain more benefit from investing these scarce resources into education, infrastructure and health care.

If you made a law that only African cars could be sold in Africa, you would probably see a large fall in the quantity of cars bought and so many Africans who could have bought an imported car are now no longer able to drive a car. This would have an adverse effect on African economies.

Would it help the UK to be unable to import clothes from Asia?

If the UK had to produce its own clothes, it would have to restart its own textile industries. These labour intensive industries would take workers away from relatively more productive industries in the service sector. Because of higher labour costs in the UK, it would also lead to more expensive clothes, and lower discretionary income for consumers. Because we would spend more on domestically produced clothes, other UK industries would suffer from the decline in spending.

If Asian countries like Pakistan, India, China are unable to export clothes to the West, these textile industries would effectively close down. This is because many Asian clothing factories are specifically built for export markets. If factories closed down it would lead to unemployment, falling wages and lower GDP.

Economies of scale

Another problem with discouraging international trade is that we would see lower economies of scale. If each country / continent had to produce its own aircraft, we would need more smaller firms. Therefore, we would get higher average costs and less efficiency. Global production enables significant gains from economies of scale – leading to lower prices.

Are there any arguments to encourage manufacturing in developing economies?

If we take a less extreme view, we could say there are good reasons to consider policies which help promote manufacturing industries in developing economies. For example, many African countries have a comparative advantage in primary products. But, this can limit long-term development. There is the infant industry argument which makes a good case for allowing developing countries some tariff protection to encourage diversification. But, this is different to a complete ban on importing goods from other continents.


Also, it should be remembered the WTO doesn’t have the authority to implement such a law. It is set up to help resolve trade disputes not to implement law prohibiting trade.


]]> 1