Would cutting of public budget leads to the deeper recession

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This study highlights the fact of economist believes that they think cutting the public budget leads to the deeper recession. So study allows us to analyse the situati

History & Background

Timing of depression varied across the different nations, but in the world most of the countries faces a great depression in 1929 and it lasted in late 1930's or in 1940. The great depression has devastating effect on the nations like personal income, tax revenue, profits and prices dropped while the international trade plunged 1/2 to 2/3. Unemployment rose up to 33% in different countries.

Multiple causes for the first downturn in 1929, which includes structural weakness and specific event that turned into deeper recession, but historians emphasises that it was due to failure of massive banks and stock market crash. In contrast economist (Barry Eichengreen, Milton Freidman and peter Temin) point out the monetary factors such as US Federal Reserve contracted the money supply.

(Great Depression, Encyclopaedia Britannic)

The European economy is in the midst of the deepest recession since the 1930s, with real GDP projected to shrink by some 4% in 2009, the sharpest contraction in the history of the European Union. Although signs of improvement have appeared recently, recovery remains uncertain and fragile. The EU's response to the downturn has been swift and decisive. Aside from intervention to stabilize, restore and reform the banking sector, the European Economic Recovery Plan (EERP) was launched in December 2008. The objective of the EERP is to restore confidence and bolster demand through a coordinated injection of purchasing power into the economy complemented by strategic investments and measures to shore up business and labor markets. The overall fiscal stimulus, including the effects of automatic stabilizers, amounts to 5% of GDP in the EU.

(European Commission Directorate-General for Economic and Financial Affairs)

In this situation main three objectives have been performed to recover the depression and to raise the GDP. First, protracted spells of unemployment in the workforce tend to lead to a permanent loss of skills. Second, the stock of equipment and infrastructure will decrease and become obsolete due to lower investment. Third, innovation may be hampered as spending on research and development is one of the first outlays that businesses cut back on during a recession.

(Marco Buti) Director-General, DG Economic and Financial Affairs, European Commission

The financial crisis in 2008 is of such epic proportions that even astronomical amounts spent to address the problem have so far been insufficient to resolve it. Besides the well-publicized $700 billion approved by Congress, the Federal Reserve has attempted to bail out institutions and markets with about $1.3 trillion in investments in various risky assets, including loans to otherwise bankrupt institutions and collateralized debt obligations like those backed by subprime mortgages that are defaulting at rapid rates (Morris, 2008). A further $900 billion is being proposed in lending to large corporations (Aversa, 2008), making a total of nearly $3 trillion in bailout money so far, without even counting the massive sum of corporate debts guaranteed by the U.S. government in the last year.

Many blame defaulting mortgages for the current financial crisis, but this massive tragedy is only a component and symptom of the deeper problem. The pricing of credit default swaps, whose principal amount has been estimated to be $55 trillion by the Securities and Exchange Commission (SEC) and may actually exceed $60 trillion (or over 4 times the publicly traded corporate and mortgage U.S. debt they are supposed to insure), are totally unregulated, and have often been contracted over the phone without 3 documentation (Simon, 2008), is the primary fundamental issue from which all the other problems of the crisis emanate.

Austin Murphy, Professor of Finance, Oakland University, SBA, Rochester, MI


Components of Deficit

Capital Account Surpluses Current Account Deficit

Large public deficit needs to be financed and cannot be financed domestically because the deficit is too high compared to what is left of the domestic savings after all national investments. If the public deficit is not reduced, only incoming foreign investment can finance it.

The country consumes and imports beyond its means. Otherwise it would not have the public deficit or it would be able to finance it domestically. Belt tightening or an export miracle maybe driven by currency devaluation seems to be the only solution.

Instead of financing the public deficit by borrowing money from foreign investors, government and Central Bank could resort to "Printing Money". A more distinguished term for this is "Quantitative Easing". This refers to increasing the money supply by increasing the excess reserves of the banking system by:

Central Bank prints money and gets so more money on its account.

Central Bank purchases government bonds, corporate bonds etc. from banks and financial institutions.

Some countries like the U.S., U.K., Euro countries and Japan have the benefit that they can issue debt in their own currency. This does provide these countries with the advantage that they can devalue their currency without seeing their real debt and its cost ballooning as would be the case for countries that have to borrow in foreign currencies.

Thus these countries can devalue their currency without a penalty for their Current Account

Imports are much higher than exports

Due to under-developed, inefficient, too expensive, protected or old-fashioned production facilities for goods and services and/or artificial low kept currency exchange rates for trading partners.

Costs of large foreign funded public debt

Caused by foreign financing of historic deficits. The foreign financing of public deficits is a Capital Account component, but in later years the costs of this financing puts direct pressure on the Current Account. It is a self-reinforcing process.

(Van Beek on September 29, 2010)

Causes of recession in UK, Greece, Spain, Italy and France.....

lack of effective monitoring of government deficits

lack of enforcement of the rules

irresponsible budget behaviour

do not have the ability to use independent monetary policy

Non availability of devaluation and stimulating exports

Current Account deficit due to large public deficit, Imports are much higher than exports, Costs of large foreign funded public debt


To establish or bailout insurance fund

to measure debt loads accurately

To take short-term loan and credit

Giving up control of the domestic fiscal budget

To drop Euro and return to their own currency

As for preventing these problems from happening in the first place, one way to do this is to establish a bail out or insurance fund with the contributions for individual countries linked to their compliance with the rules regarding permissible debt loads (e.g. a debt to GDP ratio no larger than 60%).

A key factor here is the ability to measure debt loads accurately. Accounting tricks such as those used by Greece to hide its growing indebtedness should not be allowed. Thus, in addition to the need for penalties when countries are out of compliance, the reporting rules need to be strengthened so that compliance can be accurately assessed.

The insurance fund described above with contributions that are linked to a country's debt position is not the only way to dissuade countries from pursuing high debt strategies. But whatever strategy is chosen, countries must face penalties of some sort in order to change their behaviour. If they know they will be bailed out if things fall apart and that no penalties will be assessed, there's no reason to avoid risky high debt strategies. But, again, this requires a means to effectively monitor existing debt loads and the existence of a central authority with the powers to do something when countries endanger other countries through there sovereign debt choices.

What should be done if problems develop despite attempts to prevent them? One option is to do nothing and let the countries suffer a long period of high unemployment while they pay off their debt. The problem with this is that it allows the unemployed to suffer needlessly they could be helped but the choice is to turn away and the possibility of default remains which affects other countries through its impact on financial markets.

If, rather than doing nothing, the decision is to step in a help, there are several options available to help countries through their difficulties.

First, other countries could grant the countries having troubles short-term loans and credits, but this simply transfers debt from the present to the future and hence does not get at the underlying problem.

Second, there could be a direct bailout from other countries, i.e. the other countries pay off debts without asking for repayment in the future, but this sets up moral hazard problems. One way around this is to force countries to allow their budget to be controlled by a central authority in return for paying off the debts, but for many countries simply defaulting and leaving the EU would be a more attractive option. In any case, it's a bad idea to pay off the loans without penalty, so some sort of "conditionality" would be necessary. However, conditionality would be resisted by sovereign governments - it means giving up control of the domestic fiscal budget or other similar measures - and that is something countries do not want to do.

Another solution is to allow countries to temporarily drop the euro and adopt their own currency (in return for some conditions), devalue, and then return to the euro. However, the administrative problems with this proposal make it infeasible.

If the inability to devalue is the problem, is there some way for countries to devalue without temporarily going off the euro? Wage and price controls accomplished through a government decree to lower all wages and prices would work in theory, but the administrative and enforcement problems would be insurmountable, so this is impractical.

The final option is the one discussed above, an insurance fund of some sort that can be used to wind down countries in trouble. A fund of this type can also be used to blunt threats to default or leave the union that currently give countries in trouble leverage over other countries, so there are multiple advantages. The proposal to from a European Monetary Fund discussed here is a good starting point for the construction of an institution with these capabilities.

This institution serves two purposes. By linking the contributions to the likelihood of default, countries are discouraged from pursuing high debt strategies. And if troubles develop anyway, the resources are available to effectively deal with the problem without creating a systemic threat. I'm not sure if the politics within the euro area would allow such an institution to be created, I doubt that they would, but that doesn't mean it isn't a good idea or that we shouldn't try to create such a facility.

Finally, the European Monetary Fund would be an effective means of addressing monetary and financial issues, but the problems posed by a currency union go beyond the monetary realm. As I explain in more detail here, effective institutions for redistributing resources across countries so as to stabilize and enhance economic activity do not exist within the euro area. If a central authority is to be created to deal with monetary issues, consideration should also be given to "fiscal federalism" that will allow taxes and transfers among countries to be used to stabilize individual economies. The political problems are difficult here as well, but this should still be part of discussions about what types of changes are needed going forward.

Mark Thoma  Feb 18, 2010

Impact of cutting Public Budget & Recession

Rising unemployment 

(often unemployment is a delayed factor) i.e. it takes time for unemployment to rise, but, even when the economy is recovering, it takes time for unemployment to fall.

Rising Government Borrowing.

A recession is bad news for the government budget. A recession leads to lower tax revenues (lower income tax and corporation tax revenues) and higher government spending on unemployment benefits. The UK is forecast to borrow £60 billion, a recession could make this borrowing even worse in 2009. This borrowing means higher taxes and higher interest payments in the future.

Falling Share Prices.

 Generally a recession leads to lower profitability and lower dividends. Therefore, shares are less attractive. Note share prices often fall in anticipation of a recession. e.g. the recent falls in share prices are largely because the market expects a recession soon. During the actual recession, share prices often increase in anticipation of the economy recovering. Note also, falling share prices don't always mean a recession, falling share prices can occur for many other reasons.

Lower Inflation.

 Typically a recession reduces demand and wage inflation. This should result in a lower inflation rate. However, this recession is complicated because of rising oil prices. Therefore, the forthcoming recession may actually occur simultaneously with higher inflation - a term known as stagflation. But, a recession will definitely reduce demand pull inflation pressures and encourages price wars on the high street as firms seek to retain consumers.

Falling investment. 

Investment is much more volatile than economic growth. Even a slowdown in the growth rate (economy expanding at a slower rate) can lead to a significant fall in investment.

All these factors are the indicators of recession, but cutting off the public budget is the derive these derivatives or factors of recession. Why it is so, if we cut the public budget mean there is no industry development and other facilities on which govt spend to generate revenue from it. But cost of living go to higher level , people will spend less because they will fear unemployment. As a result of this govt revenues goes down because production level also decrease which leads to less taxes from which govt generate a revenues and it cause the deeper recession in the long run.


I am quite agree with the statement the cutting of public budget leads to the deeper recession, as we analyze the whole situation above that cutting of public budget increases the inflation, unemployment, govt. Borrowings and falling of share prices (stock market crash).

So in order to avoid this kind of situation, instead of cutting the public budget govt should reduce its own expenditure, because If there is a fall in AD then according to Keynesian analysis there will be a fall in Real GDP. The effect on Real GDP depends upon the slope of the AS curve if the economy is close to full capacity lower AD would only cause a small fall in Real GDP.

AD is composed of C+I+G+X-M, therefore a fall in any of these components could cause a recession. For example, if the MPC increased interest rates sharply this would cause the cost of borrowing to increase and make saving more attractive. This would have the effect of reducing consumer spending.

So the problem is that these countries ran into large budget deficits because their governments had large spending and they fear large govt deficit means large debt which led to the financial crisis in these countries. Now to solve the situation these countries are cutting on government expenditure to reduce deficit and debt. This means that they will cut on jobs but the unemployment rate is also very high which can lead to deeper recession.

The argument is the reduction in deficit should be gradual and not so abrupt. Also govt should follow anti cyclical policies which means when the economy is already in a recession it should give a boost to the economy by increasing govt expenditure but the govt are doing the opposite.

There is no clear answer one side says we should not cut govt expenditure so much that it will lead to a deeper recession. The other group says no increase govt expenditure to avoid recession but it will lead to further increase in deficit and debt and so deeper recession in future.