Spending Cuts and the Economy

Discuss the Effect of Spending Cuts on the UK Economy?

The new government have promised to cut spending by £6bn. Out of a budget of £620bn, this may not sound a lot. But, with inflation of 3.7%, the real cut will be greater. What will the economic impact be of government spending cuts?

The first factor will be to reduce the growth of Aggregate Demand. Government spending is a component of AD. Therefore, reducing government spending by £6bn will be a significant factor in reducing AD. This will lead to slower growth, and could even push the economy back into recession.

A key issue is how other variables in the economy are affected. Domestic demand could remain strong because:

  • The Pound has been depreciating in past 12 months, making exports cheaper and imports more expensive. However, if the Eurozone slips into recession because of fiscal retrenchment, export growth may remain subdued.
  • Interest rates are still very low (0.5%) making borrowing cheap and giving homeowners low mortgage repayments. However, so far lower interest rates haven’t boosted demand because we are in a liquidity trap and banks don’t want to lend
  • House prices are rising creating a positive wealth effect. But, house price rises are limited.

Although the spending cuts are deflationary, Monetary policy can remain loose, but in the aftermath of the credit crisis, loose monetary policy may be insufficient.

There is the prospect of weaker growth in EU, and also we are still suffering after effects of credit crunch with banks reluctant to lend.

At the last budget, the Chancellor was forecasting growth of 3%. With the spending cuts and tax rises, this looks optimistic.

Where will Cuts Come From?

Unfortunately, it is easier to cut capital investment than spending on wages and benefits. If you cut wages or public sector jobs, there is a strong political fallout. It is easier to shelve investment in building new roads, universities. However, this lack of capital investment could hold back the long term growth in productivity.

If the government was able to raise pension retirement age and reduce welfare benefits, this would probably have least economic impact. Raising retirement age would save money and could increase the supply of labour. But, politically it would be unpopular. Cutting benefits could also increase inequality.

It is a difficult balancing act – cutting spending without derailing recovery. But, given concern in bond markets, it has become important to tackle the record peace time deficit of 11%. However, the timing of austerity is important. If we cut in a recession, cuts could be self-defeating. Real budget cuts should come when the economy is stronger.

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By on May 21st, 2010

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