Tag Archives | austerity

Economic impact of welfare freezes

Readers Question: What is the economic impact of proposed welfare benefit freezes proposed by Chancellor, Mr Osborne?

Mr Osborne has proposed a welfare freeze, worth £3 billion of savings over two years. This benefit freeze includes Jobseeker’s Allowance, Income Support, Child Tax Credit and Working Tax Credit, Child Benefit and Employment Support Allowance (paid to those judged capable of work). It does not include pensions, disability benefits and maternity pay.

The Treasury said that about 10 million households would be affected, roughly half of which are working.

The freeze will raise around £1.6bn in 2016/17, rising to around £3.2bn a year in 2017/18.

An argument for freezing welfare benefits is that it will help reduce the budget deficit and also – since 2007, average earnings (+17%) have been rising at a slower rate than working-age benefits (+22%.)

Economic effects

Aggregate Demand (AD) / economic growth. Welfare freezes will (ceteris paribus) reduce consumer spending, and lead to lower aggregate demand. It is an example of deflationary fiscal policy. It will be quite significant because people receiving welfare benefits have a high marginal propensity to consume because, on low incomes, they don’t have the luxury of saving – therefore, lower welfare benefits will directly lead to less spending in the economy.  Welfare freezes will also contribute to a decline in consumer confidence because it will be a visible reminder of economic hardship. Combined with other spending cuts of up to £24bn, there is still scope for these planned spending cuts to derail the economic recovery and cause lower growth or even a future recession.

However, the strength of the recent recovery suggests the UK may be in a better position to absorb austerity than a few years ago. Also, the chancellor can rely on the Bank of England to maintain a very loose monetary policy, which will help to offset the impact of this deflationary fiscal policy.

However, we still don’t know the position of the economy in a couple of years. there is evidence that the recovery still is unbalanced with low productivity growth and low real wage growth making the economy still vulnerable. Continued recession in Europe could  also act as a drag on the UK economy; it is possible that these commitments to spending cuts could hold back economic growth, that even monetary policy can’t overcome.

Deficit reduction. The spending cuts will contribute £3bn to saved spending, helping to reduce the budget deficit. However, it is still a small % of the current budget deficit (£93bn). Also, the reduction in deficit may be less than planned because it will cause a fall in tax revenues (e.g. less VAT receipts from lower spending) and also lower economic growth from the austerity measures.

Some economists argue that deficit reduction is essential and there is no alternative but to cut spending. They hope that cutting the deficit will reassure markets and business about the long-term strength of the economy. Other economists argue that recent evidence suggests people don’t gain confidence from austerity – but actually the opposite. (see: Confidence fairy)

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Advice for giving an economics presentation on austerity

Readers Question: I have to visit the college I went to and give 5-10 min talk to A2 Economics students about anything economics related, preferably macro-economics.. something going on in the economy. Suggestions?

Giving a presentation on economics can be a daunting thing. I often ask students (at this time of the year) to come and give their own presentation on economics. Let them be the teacher for 5 minutes. But, it’s hard work and they don’t usually enjoy it.

Firstly, know your audience. A college of A2 students is good in that you know the level of economics to target. You can keep it fairly simple, and try and use A2 terminology – for example, bringing in AD and AS.

  • What I would suggest is choose a topic, that you like and is fairly topical. For example, you choose the issue of austerity. Alternative topics that spring to mind include – The Euro, traffic congestion, monetary policy, exchange rates.
  • Start off, with simple explanations – never assume that the audience knows everything. In fact try to keep the language as simple as possible.

Once, you’ve chosen a topic, divide it into subtopics, and keep a short list. This will give your presentation some focus and direction. If you’re worried about running out of things, you can always have some back up sub-topics. If you run over time, it is easy to leave out some of the sub-topics.

Make sure your first topic is your strongest and most interesting. It is always important to get off to a good start.

If it was me, I would think of these sub-topics for austerity.

  • What is austerity? – explaining what austerity is – preferably in the language of A2 economics. i.e. government attempts to reduce budget deficits through spending cuts and tax increases.
  •  Why austerity? – a short background on global credit crisis and  EU crisis. Euro countries were facing high bond yields and felt the need to reduce government debt. In the UK, government claimed UK debt too high. Though arguably also interest in reducing government spending in the long term.
  • Pros and cons of austerity. – At least in the beginning of the presentation, it is good to offer a balanced view, and both sides of the argument. Later you can offer a stronger conclusion whether you think it has been good or bad. But, avoid being one sided as A2 students need to learn evaluation and examining both sides. e.g. Pros – debt is lower. Cons, aggravated recession, leading to high unemployment. Debt reduc
  • Is Austerity  self defeating? - After a while, it’s good to pick a controversial sub-topic; this may regain interest. Start off by asking a question. Trying to keep the audience thinking is a way of engaging them and avoiding a one way dialogue.
  • Timing of austerity – Why did we pursue austerity in recession, when monetary policy was also tight in Europe.
  •  What is the impact of austerity? – impact on main macro-objectives of growth, inflation, unemployment e.t.c.
  •  What was the alternative? – Could we have kept borrowing more? The Bank of England created money electronically to partly finance deficit. Growth is the best way to increase tax revenues, not austerity.
  •  How did austerity impact Europe? - Talk about other countries, such as Greece and Spain will give a wider perspective on the issue. e.g. the political and economic cost

Just in case you run out of things, perhaps bring up issues like

Ask questions

If you feel confident, you can also leave time for questions, which can be a productive use of time, as long as questions are reasonably relevant.

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The UK’s weak recovery – What counts as success these days?

On the day Spain, announced its unemployment rate had increased to a truly staggering 27%, many see the UK’s anaemic growth rate of 0.3% in Q1 2013 as a ‘success’. But, it is worth noting UK real GDP is still considerably below its 2008 peak.

trend-real-gdp

Dataset ABMI at ONS

When you look at GDP like this, the lost output and scale of the recession becomes more evident.

Using a very rough rule of thumb, if we had maintained the pre-crisis trend rate of economic growth, we might expect something like £425bn for Q1 2013, rather than the £361 bn. That’s very roughly £64bn less output than pre-trend growth. To get an annualised figure, GDP is roughly £248bn less than pre-trend output growth.

Given the loss of output, it raises the interesting question – how much structural deficit do we really have? Is the deficit not a consequence of this unprecedented economic stagnation?

economic-growth-uk-ons-quarter2

Source: ONS

Given the scale of the credit crunch and global downturn, a deep recession was inevitable; in this climate to maintain pre-trend growth is unrealistic – but the recovery since 2010 has been very disappointing. It is an example of missed opportunities and a failure of political will to aim for full employment and economic growth; falling public sector investment came at  the wrong time. Given the weakness of private sector spending, it is no surprise this created a large multiplier effect and a double dip recession.

If in 2010, a government had made its primary macro-economic objective as strong economic growth, we could have seen higher GDP, and ironically, they would be in a stronger position to reduce the budget deficit.

The fact we have avoided a triple dip recession, doesn’t change the fact that the current recession is longer lasting than the great depression and all subsequent UK recessions. See recessions compared. Usually, after a recession, you expect a bounce in growth as the economy makes use of spare capacity. The anaemic recovery suggests that the prolonged recession has led to a persistent loss of output and that means lost tax revenues and higher borrowing.

At least we are not Spain or Greece

If ever there was a question of damning with feint praise, we could claim justification that at least we are not Spain or Greece, who seem to be rushing headlong into an austerity induced depression of an unprecedented scale.

It is true that in comparison to several European countries, UK austerity is relatively mild. Spending cuts are relatively modest compared to other countries. However, it should be remembered in a recession with falling private spending, fiscal policy should be expansionary. Even mild spending cuts create strong downward pressures on demand. (see: do we really have austerity)

In the past few years, the UK has also experienced loose monetary policy, and a depreciation in the Pound. Both monetary policy and the exchange rate have been disappointing in boosting growth, but it is still better than nothing. The combination of low interest rates, a weak Pound, and a government muddling its way through fiscal policy will enable some recovery. But, if policy had been bolder – or even willing to adapt to changed facts, it could and should have been much stronger

Italy hopes to leave austerity behind

After a rather lengthy post on evaluating EU fiscal rules, a more immediate and simple political criticism of the EU’s general austerity policies from Mr Bersani of the Italian Democrats (Pd). The new Italian political leader has argued:

“We must leave the austerity cage,”

“A change of course is absolutely necessary given that five years of austerity and attacks on workers have pushed up public debt levels across Europe,” he said.

“The vicious circle between belt-tightening and recession is putting representative government at risk and making it impossible to govern. The immediate emergency is the real economy and joblessness,” (link)

The unfortunate situation is that if Italy does reject austerity and pursue a more accommodative fiscal policy, the ECB is likely to end its bond purchase programme. This could send Italian bond yields soaring. Bond yields will soar because there is no Central Bank to ensure liquidity. If Italy had its own Central Bank, it could easily pursue a fiscal policy more concentrated on economic recovery. But, unfortunately, an attempt by Italy to halt austerity could effectively vetoed by the intervention (or non-intervention of the ECB). Unless there is a change of heart within European economic policy, but that is hard to see.

It is an unfortunate situation, to say the least.

Italy has a relatively low budget deficit, but still the EU rules call for more austerity.

italy-deficit

Italian Deficit. Source: ECB

Excluding interest payments, Italy has a significant primary budget surplus.

primary-budget-deficitsSource: OECD Economic Outlook June 2012

Related

Osborne, UK Debt and Credit Ratings

I was going to write a lengthy post on George Osborne, UK debt  and Britain’s credit rating downgrade, but fortunately Simon Wren Lewis said pretty much everything I wanted to say:

What George Osborne did with his austerity programme was the equivalent of putting a sick patient on a starvation diet accompanied by cold showers. The UK economy without accelerated austerity would still have been in poor shape, but under George Osborne it has been a disaster.

The final verdict on George Osborne Economics at Mainly Macro

Other relevant posts

  • George Osborne Economics A post I wrote in 2010 – not very extensive or particularly insightful. Just a bit of basic A Level economics that if you cut government spending in a recession, economic growth will tend to be lower, and the deficit will get worse. A reminder that austerity in a recession can fail to solve the debt problem.
  • Alternatives to spending cuts (2010)

Since 2010, there have been numerous studies and evidence which give much more confidence in criticising the approach of the current government:

Panic Driven Austerity

One of the striking feature of the Eurozone crisis was how countries with relatively low levels of government debt, rushed into severe austerity. And as a consequence of this austerity saw a drop in the rate of economic growth, and an increase in their debt to GDP ratio.

One of the main reasons for the rush to austerity was the rapid rise in bond yields that occurred in 2010-2011.

eu-bond-yields-7-countries

Bond yields rose in the Eurozone because markets feared illiquidity. (temporary shortages of people to buy bonds, causing widespread selling and drop in prices)

deficit

Budget deficits 2012

 

The highest budget deficits in 2012– Ireland, Japan, UK and US.

Japan, UK and US all maintained low bond yields. It was only countries in Eurozone which saw rapid increase in bond yields. Portugal’s deficit in 2012 was just over 4% of GDP. Italy had a primary budget surplus, but both saw very high bond yields.

With the exception of Greece and perhaps Ireland, the rise in bond yields wasn’t due to concerns about insolvency. (debt levels were manageable by historical standards. Spain’s public sector debt was lower than UK) but was because without a Central Bank willing to act, markets had no confidence in their bonds.

The episode revealed a fundamental weakness in the Euro project. Countries experienced unnecessary panics about their bond market because there was no Central Bank willing to act as lender of last resort. (problems with Euro)

In recent months, after years of prevarication, the ECB has finally been willing to buy unlimited bonds. This has, so far, led to a sharp drop in bond yields. Showing that it was always the lack of strong Central Bank action that was unnecessarily causing bond yields to be too high.

The Tragic Consequences of Panic Driven Austerity.

Unfortunately, the damage has been done. Two years of austerity, and the double dip European recession is much deeper than the EU and ECB ever expected. Unemployment in peripheral countries is dangerously high; it will be very difficult to get out of the deflationary debt spiral.

Paul De Grauwe, Yuemei Ji, 21 February 2013, produced a study on this theme ‘Panic driven austerity‘, and showed how panic driven austerity has led to dire economic consequences.

022213krugman4-blog480

Source: Vox

Strong correlation between the extent of austerity and negative impact on GDP growth

022213krugman5-blog480

Strong correlation between greater austerity and higher debt to GDP ratios. Straightening the idea of ‘self-defeating austerity

This report is important because:

  • I am unconvinced everyone in Europe appreciates the structural weakness of the Euro. There is no guarantee that the ECB will maintain a commitment to act decisively. There are strong pressures from people in Germany to pull back from unlimited bond purchases. There is still a very strong risk for future bond panics within the Eurozone.
  • There is still a great reluctance in Europe to appreciate the damage that austerity has done to both economic growth, and ironically debt to GDP ratios.

Is Austerity Self Defeating?

Question from the Economist. – It is easy to understand the case that European austerity is self-defeating. But it is also easy to see that one cannot run large deficits year after year without limit, and that some countries (Greece, Portugal) have exhausted the willingness of private investors to finance them.

Is Austerity self-defeating?

Austerity means efforts to reduce the budget deficit. Austerity involves higher tax and cuts in government spending. In theory,  this should reduce the budget deficit. However, austerity policies also have an impact on economic growth.

  1. Higher taxes reduce consumer spending
  2. Government spending cuts also lead to lower aggregate demand, for example, public sector pay freezes reduce consumer spending.  Public sector job cuts lead to higher unemployment
  3. Loss of confidence associated with ‘austerity policies’ – encourages higher saving and less spending.

The impact of austerity policies will be to reduce the rate of economic growth and possibly push the economy into recession. This will increase the cyclical part of the budget deficit. Lower economic growth reduces tax revenues, higher unemployment leads to higher benefit spending.

Therefore, if you pursue austerity policies you have to expect a smaller reduction in the budget deficit because of these cyclical factors.

However, some suggest the negative impact on economic growth could be so significant that the fall in economic growth will outweigh your efforts to reduce spending. Therefore, despite increasing tax rates, and cutting spending, in some circumstances you actually see a rise in your budget deficit (as a % of GDP)

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Economics and Positive Thinking

If you read any number of self-improvement books, you will come across ideas such as ‘what you think, you will become’. Over, 2,500 years ago, the Buddha said: “All that we are is the result of what we have thought. The mind is everything. What we think we become.

When overused these positive thinking mantras can become a bit tiresome. But, maybe there is still some relevance to modern macroeconomics.  Not least, we have the phrase of ‘talking ourselves into a recession’. The idea that if key people in the economy keep talking about a recession, this can become a self-fulfilling prophecy. With a threat of recession, people spend less, firms invest less and this creates falling aggregate demand. Cynics may say, people wouldn’t talk about a recession unless there was some economic justification so it will be hard to attribute it all to merely negative talk. Nevertheless, it does show the potential of strong opinions having a significant bearing on the outcome.

If you wish for Austerity, you tend to Get it

The next thing that springs to mind is the recent attitude to the economy and debt. We could characterise the EU and UK’s attitude as ‘austerian’. Generally austerians take a very pessimistic view towards the economy. They are deeply worried about levels of debt and government borrowing. They fear bond markets will very soon penalise these high levels of debt. Austerians spend a lot of time telling the electorate how the economy is in a bad shape and we need to respond with strict spending cuts and tax increases. There is also a sense of morality attached to this austerity approach. ‘Debt got us into this mess, we can’t use debt to get out of it.’

The consequence of austerity measures has generally been higher unemployment and lower economic growth. In the Eurozone, austerity policies have generally failed to reduce debt to GDP ratios because of the recession. Therefore, with budget deficits failing to fall, austerians take this as evidence to cut spending more deeply. Again it is accompanied by a sense of morality. “We almost deserve a period of austerity in response to the previous lending boom of the mid 2000s.” ‘We can’t spend money, we don’t have’. Those of an Austerian nature have an instinctive dislike to the idea of printing money  – even though all evidence of the past five years is that increasing the monetary base has not caused any significant inflation. Perhaps it’s related to the idea ‘we don’t deserve to create money from nothing, but we do deserve a recession.’

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The wasted years of the UK Economy 2008-12

By any standards, 2012 has been a dismal year for the UK economy. Despite a temporary Olympic bounce, GDP remains below 2008 levels, and the Bank of England is as pessimistic as it’s ever been. Unemployment might be lower than other European economies, but with 1 million underemployed – official statistics perhaps mask the wasted resources in the economy.

recovery

A woeful recovery. Worst than the Great Depression of the 1930s.

GDP is 3.1% below where it was when the recession began 18 quarters ago in early 2008.

The Chancellor has a lot of bad news to contend with.

  • He will miss his deficit reduction plans.
  • His forecasts for economic recovery proved overly optimistic. Instead Britain has entered into the first double dip recession since the 1970s. It is quite possible, we might see first triple dip recession in 2013.

In his defence, you might point to the Eurocrisis and say it is inevitable the UK economy was harmed by the slowdown across the channel.. But, despite the recession in the Eurozone (which have problems relating to single currency), it is hard to avoid the fact that two and half years into the job, he has to take responsibility for the direction of the economy.

Essentially, Osborne started the job with great fanfare about reducing the deficit. Deficit reduction was sold as the most important objective – the implication was that without immediate cuts, the UK could end up like Greece or Italy.

But, unfortunately, the experience of the past two and half years is that fiscal consolidation during a recession tends to be counter-productive (austerity will increase deficit). Freezing public sector spending, whilst the private sector is still very fragile, has led to a large negative multiplier effect. It is hard to avoid the conclusion that the double dip recession is largely the fault of economic policy.

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What is Austerity?

Readers Question: What is Austerity?

Simple Definition of Austerity

  • Austerity involves policies to reduce government spending and or higher taxes in order to try and reduce government budget deficits.

Austerity policies are often associated with higher unemployment and lower economic growth.

More Complex Points and definitions of Austerity

The term austerity is more likely to be used when government spending cuts and higher taxes occur during a recession or period of very weak economic growth. Austerity implies that spending cuts and tax increases are highly likely to have an adverse impact on aggregate demand and economic growth. For example, if the government increased taxes during an economic boom, this would probably not be referred to as austerity. But, if the government cut spending during a period of negative growth, this would be referred to as austerity policies.

What Constitutes Actual Austerity?

  • A simple definition of austerity implies actual spending cuts. However, some may refer to austerity policies – even if there has just been a limit in the growth of government spending. For example, in the past 10 years, government spending may have increased on average by 3% in real terms. If the government now freezes public sector spending, this may be termed ‘austerity policies’ – because government spending is not increasing at the same rate as previously. Continue Reading →
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