The Debate on Austerity

1864 words (7 pages) Essay in Economics

22/02/19 Economics Reference this

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The adoption of austerity post the financial crisis in 2010 by the UK government is heavily debated. This essay evaluates the arguments for and against this fiscal contraction deliberating on the applied and possible fiscal policy measures and the limitations of monetary policy after the fiscal stimulus provided in 2008.

When the housing bubble burst and Lehman Brothers collapsed in 2008, the subprime mortgage crisis magnified into a global financial crisis. Governments had to rush in and save banks. If not, the fall of public confidence in the banking system would have made the problem far more severe. Large fiscal stimulus packages were rolled out to cushion the blow. But for how long would a government be willing to take further debt for expansionary fiscal policy? They could have continued to increase public expenditure to compensate for the fall in private expenditure in accordance with the Keynesian theory. Or increase savings, let the wage rate drop and have the demand rise due to a price advantage in the long run (Hayek, 2006). By 2010, United Kingdom’s national debt reached 75.6% of its GDP (Eurostat). Had bond yields increased due to falling market confidence, the fiscal situation would have been worse off. It would imply that the risk associated with government bonds is higher and have negative implications about the government’s credibility, all raising the cost of public debt in the future. Thus, in the 2010 elections, the campaigns of both the Conservative and Labour parties suggested reducing the fiscal deficit. No one spoke in favour of further stimulus and austerity was adopted.

The UK government feared a Greek-style meltdown. A country having borrowings in its own currency and a friendly central bank may not have to fear public debt as much. It could always keep a control on interest rates or postpone repayment by issuing new bonds. However, then governor of the Bank of England, Mervyn King, appeared to favour austerity. It remains uncertain if he would have sanctioned further quantitative easing. Typically, central banks reduce interest rates to stimulate the economy in such conditions. Lower interest rates promote consumption which would have decreased due to lower fiscal expenditure. The drop in interest rates from 5.5% in 2008 to 0.5% generated £350 billion to inject into the economy (Giles, 2018). But with interest rates at an all-time low of 0.5% since 2009, there wasn’t much that could be done on the monetary policy front (Bank of England). The drop in interest rates from 5.5% in 2008 to 0.5% generated £350 billion to inject into the economy. the Value Added Tax (VAT) was raised to 20% and public expenditure was cut to bring down the deficit (Finch, 2010:1). The combination of additional revenue and a lower deficit would cut down the need for further debt and help service the existing.

Austere spending decisions lowered the welfare expenditure. The employment level decreased because of lower government expenditure. As a result, demand plunged and so did the gross domestic product. High uncertainty had lowered the public confidence. The GDP growth rate was insufficient to counter the shrinking in the economy caused by austerity. International Monetary Fund (2012) warned that the country might face permanent damage to its productive capacity if the same policies were continued. The government’s tax revenues took a hit owing to lower output. This resulted in a higher debt to GDP ratio as the budgetary deficit grew. As real wages of public sector workers and local council budgets fell, homelessness and reliance on food banks rose. Social care for the elderly was negatively impacted and help from Red Cross was called in to shoulder the increased pressure on the NHS (Gillett, 2017). Mark Blyth (2013) noted that there was disparity in the impact of austerity across different levels of society. He pointed out that the consequences were felt more severely by the larger share of public service users who didn’t have enough wealth to counter the cut in welfare spending. 

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In theory, falling deficit would result in lower taxes in the future. This should increase consumer confidence in the economy. However, critiques of austerity blame the government for the plummeting consumption levels. They believe the government should have continued with quantitative easing when the private spending shrank. Wage rates fall with falling public expenditure. This gives the economy a cost advantage as compared to its competitors in the global markets. To benefit from this, it is necessary that foreign demand for the domestically produces goods increases. But many Eurozone were implementing austerity themselves and thus, there was no substantial increase in foreign demand for British goods. Moreover, countries like China had induced a fiscal stimulus in their economies despite not having been impacted as greatly by the crisis. Hence, there was already enough supply in the market for any country to benefit from rising demand.  There was perhaps not once cause to the declining consumer spending in the UK. While UK’s own fiscal policy changed in 2010, the economic environment globally was also impacted by several countries introducing policy changes. The commodity prices changed and the Federal Reserve was keeping global rates low, all of which had some impact on the UK economy (Buttonwood, 2015). In spite of the falling consumption, there was a need to reduce government expenditure to reduce the deficit. Further fiscal stimulus, after what was introduced during the financial crisis, would have led to a sharp increase in government debt. Such a high debt level would make fiscal policy unsustainable and repayment challenging (Emmerson, Keynes and Tetlow, 2013).

In terms of real total spending, the cut wasn’t as much from 2010 to 2015. Britain’s general total disbursements as a percentage of national income were the third highest amongst the G6 nations between 2007 to 2009 and remained so in 2013 (OECD, 2014). Annualised average real increase in spending on social security and health rose and real spending on working age and pensioner benefits grew between 2010 and 2013 (Keynes and Tetlow, 2014: 16-17).

The economy’s recovery in 2013-2014 sparked another debate. Had austerity worked or was it the result of policy alteration in 2012? Klein (2015) asserted the growth was a result of a reversal from austerity. Smith (2015) refuted, stating that the government was still austere in spending decisions with the fiscal tightening being larger than 3% of GDP. Krugman (2015), however, maintained that abandoning further fiscal cuts after two years of austerity led to the economic growth.

Whether the economy would have been in a better position without austerity will remain unknown. What can be concluded though is that austerity was not an economic necessity then. But with UK’s ageing population, welfare expenditure will only increase in the future. Such a welfare cap will become necessary for better policy decisions as the pressure on NHS and public services escalates. Continued quantitative easing in 2010 would have made public finances more unsustainable and fiscal austerity in future more drastic. Spending cuts or higher taxes, no matter when, will always be met with heavy criticism. Hence, a developed country with ageing population could aim at increasing sources of income, reducing income inequalities and reducing the dependence on welfare expenditure.

Bibliography

Bank of England [online] Available from: http://www.bankofengland.co.uk/boeapps/iadb/Repo.asp (Accessed 24 April 2018)

Blyth, M. The Austerity Delusion. Foreign Affairs [online] Available from: https://www.foreignaffairs.com/articles/2013-04-03/austerity-delusion (Accessed 15 April 2018)

Buttonwood (2015) What is austerity?. The Economist [online] Available from: https://www.economist.com/blogs/buttonwood/2015/05/fiscal-policy (Accessed 15 April 2018)

Emmerson, C. & Keynes, S. & Tetlow, G. (2013) Public finances: outlook and risks. The IFS Green Budget: February 2013. London: Institute for Fiscal Studies. Available from: http://www.ifs.org.uk/budgets/gb2013/GB3013_Ch5.pdf

Eurostat [online] Available from: http://ec.europa.eu/eurostat/tgm/table.do?tab=table&init=1&language=en&pcode=sdg_17_40&plugin=1 (Accessed 24 April 2018)

Finch, J. (2010) Budget 2010: VAT rise to 20% ‘could cause double-dip recession’. The Guardian [online] Available from: https://www.theguardian.com/uk/2010/jun/22/vat-rise-recession-fears (Accessed 15 April 2018)

Giles, C. (2018) Bank of England defends response to financial crisis after criticism. Financial Times [online] Available from: https://www.ft.com/content/4231c5a0-3caf-11e8-b9f9-de94fa33a81e (Accessed 24 April 2018).

Gillett, F. (2017) NHS calls in Red Cross volunteers and staff amid ‘humanitarian crisis’. Evening Standard [online] Available from: https://www.standard.co.uk/news/uk/nhs-calls-in-red-cross-volunteers-and-staff-amid-humanitarian-crisis-a3434901.html (Accessed 15 April 2018)

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Hayek, F. A. (2006) The Paradox of Saving. [online] Available form: https://mises.org/library/paradox-saving (Accessed 15 April 2018)

International Monetary Fund (2012) United Kingdom : Staff Report for the 2012 Article IV Consultation. [online] Available from: https://www.imf.org/en/Publications/CR/Issues/2016/12/31/United-Kingdom-Staff-Report-for-the-2012-Article-IV-Consultation-26083 (Accessed 15 April 2018)

Keynes, S. & Tetlow, G. (2014) Survey of public spending in the UK. London: Institute for Fiscal Studies. Available from: https://www.ifs.org.uk/publications/1791

Klein, M. W. (2015) Eurozone Recovery and Lessons About Austerity. The Wall Street Journal [online] Available from: https://www.blogs.wsj.com/washwire/2015/05/16/eurozone-recovery-and-lessons-about-austerity/ (Accessed 15 April 2018)

Krugman, P. (2015) The case for cuts was a lie. Why does Britain still believe it? The austerity delusion. The Guardian [online] Available from: https://www.theguardian.com/business/ng-interactive/2015/apr/29/the-austerity-delusion (Accessed 15 April 2018)

The Organisation for Economic Co-operation (2014) Economic Outlook No 95 – May 2014 – OECD Annual Projections. [online] Available from: https://stats.oecd.org/Index.aspx?DataSetCode=EO95_INTERNET (Accessed on 24 April 2018)

Smith, D. (2015) The Myth of Abandoned Austerity. [online] Available from: http://www.economicsuk.com/blog/002094.html (Accessed 15 April 2018)

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