The Risk Of Running Substantial Budget Deficits Economics Essay

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Time and again economists have critiqued government responses to economic contractions of the past in an attempt to deduce the most effective strategy to rejuvenate the economy. Economic contraction is when a country's real GDP has declined for two or more consecutive quarters (investopedia, n.d.) [1] . Such a situation of economic decline provides the government with two options; either to provide a fiscal stimulus to recover from the recession or let the 'automatic stabilizers' restore the economy. Fiscal stimulus in the form of government spending carries with it the risk of running substantial budget deficit as the budget balance is dampened by lower tax collections along with the increased government spending. Budget deficit is when government spending is more than the government revenues and the budget balance is in negative. Despite such risk the advocates of Keynesian school of thought believe that government spending can be used to increase economic activity through increased aggregate demand ultimately reducing unemployment and inflation.

In this graph, y-axis denotes aggregate demand while x-axis denotes national output. The aggregate demand (in blue) will increase with government spending and equilibrium (point of intersection of aggregate demand curve and the black line representing equality of total income and output) will be reached at a higher national output. This means more production, less unemployment and revival of the economy.

Monetarists however, are against the use of fiscal policy and argue that excessive fiscal stimulation is inherently inflationary. Freidman, the founding father of Monetarism argued that rapid increase in money supply causes high rates of inflation.

Given the recent turn of events (the financial crisis of 2008) it is clear that recession can turn into lasting trouble if no fiscal stimulus is provided. The monetary policy can help so far as to lower down the interest rates to almost zero but what if that doesn't work? If the economy is contracting, the average household income is decreasing and so is the average household expenditure. Under such circumstances, the only way the economy can grow is through more government spending.

Real World Examples

Let's take into account the responses of United States of America and United Kingdom to the recent economic crisis of 2008. The real world examples taken are time relevant (as they are much recent) and valid (as both the countries faced the same crisis and took steps to tackle the situation).

The Big Picture

In the United States, the government followed a two-pronged strategy to reverse the financial crisis: bail out distressed financial institutions (lest they transmit their failure to their creditors) and pump government money into the economy (to stimulate business activity when private loans were scarce). (Encyclopædia Britannica Inc., Web. 19 Jul. 2012) [2] . According to the American Recovery and Reinvestment Act (ARRA), the economy was provided with a stimulus of $787 billion - the single largest economic recovery effort in U.S. history. The American Recovery and Reinvestment Act of 2009 distributed funds in three ways. Since its enactment in February 2009, $763.1B has been paid out, the breakup of which is as follows:

United Kingdom also responded to the crisis in similar fashion. The Bank of England slashed UK interest rates by half a point to 4.5% in its first emergency rate cut (Guardian, Oct 2008) and a £500bn rescue scheme was sketched out.

Indicators

The indicators selected to evaluate the effectiveness of the strategy adopted by the UK and USA are GDP, PMI (purchase manager index), unemployment rate and debt to GDP ratio. A positive impact of the strategy would suggest a rise in the GDP, PMI and unemployment rates for the two countries.

GDP

Data from World Bank [3] 

As is evident from the graph, USA experienced a dip in its GDP in the year 2009 but the fiscal stimulus jump started the economy again and the economy continues to grow out of recession; slowly but gradually.

On the other hand, UK has found itself dipping again into the recession. This can be attributed to the to-and-fro policy of UK government from fiscal stimulation to austerity measures. David Cameron passed radical cut-backs in public spending in 2010 and the outcome was predictable; the economic recovery stalled.

PMI

Purchase Managers Index serves as an important indicator as it reflects the acquisition of goods and services by the purchasing manager. A reading of above 50 for PMI means that the economy is expanding as there is more purchase and a reading of lower than 50 means that the economy is contracting.

Data from Markit [4] 

The PMI for USA shows a steady recovery since the crisis of 2009. The bounce-back in the PMI from 2009 to 2010 can be attributed to the American Recovery and Reinvestment Act. The UK PMI continues to falter barely keeping up with the 50 mark.

Unemployment

Data from TradingEconomics [5] 

The unemployment curve is coming down with time in contrast with the UK unemployment rate which is still growing at some pace.

Debt to GDP Ratio

The 2011 United States public debt-to-GDP ratio was about 69.4% whereas UK has public debt-to-GDP ratio of about 61%. USA has more debt-to-GDP ratio than UK and still decided to opt for government spending to help its economy out of crisis whereas the United Kingdom government forced austerity measures in 2010 which saw its economy plummet even further.

Conclusion

According to the IMF's chief economist it is essential that the country hit by financial crisis spends to get the long-term unemployed and young people back into the labour market (Olivier J. Blanchard, n.d.) [6] . Finally, fiscal stimulation in itself is not the answer to the problem. A number of policy actions need to be taken such as strengthening fiscal institutions and public health care systems and reforming pension entitlements which will mitigate the adverse effects of fiscal consolidation in the short term.

References

The Great Recession of 2008-09: Year In Review 2009. 2012. Encyclopædia Britannica Online. Retrieved 20 July, 2012, [online] Available at

http://www.britannica.com/EBchecked/topic/1661642/The-Great-Recession-of-2008-09-Year-In-Review-2009/286636/The-US-Response

The World Bank GDP data [online] Available at

http://data.worldbank.org/indicator/NY.GDP.MKTP.CD

Markit, 2012, Markit/CIPS UK Manufacturing PMI. Press Release 3 January 2012. [online] Available at http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8994

Trading Economics, Unemployment Rates. [online] Available at http://www.tradingeconomics.com/united-kingdom/unemployment-rate

Steve Schifferes, 2009. IMF praise for UK recession plan, [online] 20 May 2009. Available at http://news.bbc.co.uk/2/hi/business/8059861.stm

Investopedia, Definition of Contraction. [online] Available at http://www.investopedia.com/terms/c/contraction.asp#axzz212VQ2IHP

Wikipedia, Public Debt-to-GDP Ratio. [online] Available at

http://en.wikipedia.org/wiki/Debt-to-GDP_ratio

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