Monday, October 25, 2010

Alternative To Spending Cuts

Readers Comment - From George Osbourne Economics - Personally- I accept your arguments, but what alternatives can you present? I certainly agree that we have to adapt any austerity package as the numbers change, but I also think that the sooner the deficit is (safely) dealt with, the better.

It's a fair comment. It is easy to say in a fragile recovery - don't cut spending and reduce demand. But, is there an alternative? Could the economy and bond markets tolerate another year of large budget deficits?

A budget deficit of £146bn, 11% of GDP is quite significant, and there are arguments that we cannot afford to wait. However, other economists suggest that the fears of the bond market are exaggerated and a more gradual reduction in spending would do less damage.

Cyclical v Structural

Firstly, a significant part of the current deficit is cyclical - the deficit reflects the collapse in tax revenues, and increase in unemployment benefits that occured after the great recession. In 2007-08, the budget deficit was less than 3% of GDP - hardly a huge structural deficit. (UK budget deficit) If the economy recovers, the cyclical aspect of the deficit will improve - even without raising tax rates and cutting spending.

Markets have taken a dislike to Greek and Irish debt partly because of high debt levels, but, also because of the dramatic decline in prospects for economic growth.

If spending cuts do cause a further economic downturn, the cyclical deficit won't improve. We have the pain of spending cuts, but, tax revenues won't recover.

However, it is also the case that the deficit is not just due to cyclical factors; there is an underlying structural deficit. Some of the tax revenues (stamp duty e.t.c) from the Credit bubble will not quickly return. Yet, the government have only talked of the big deficit as if it was due entirely to over zealous spending. This is not the case.

A strong recovery, will play a key role in reducing the size of the UK's budget deficit. A weak recovery will mean the cyclical deficit will persist.


One of the more curious arguments, which nevertheless had a certain credence, is the idea that cutting the budget deficit (i.e. spending cuts) would mythically restore 'public confidence'. I can't believe anyone in the real world would actually believe spending cuts will restore confidence. The new government and media have tried hard to accentuate how bad the situation is. The problem is this is in danger of becoming self-fulfilling - signs of falling consumer confidence are shown by the October fall in Consumer spending. (link- Telegraph)

An alternative would have been to stress the importance of restoring growth to help in a long term deficit reduction plan. The government have given the impression that their only real priority is cutting spending and dealing with budget deficit. Today, D.Cameron will try to stress he does actually hope growth will return from private sector. But, these will sound like empty words after policies they have implemented.

The Bond Market.

The big question, are the bond markets really on the verge of selling off UK bonds as they fear UK insolvency?

Deficit Hawks will point to the case of Ireland, Greece and Spain. They say that this year bond markets have become more unwilling to tolerate high levels of government borrowing. Since UK budget deficit is very high by EU standards, there is a fear that bond markets may fear UK default and UK interest rates may rise.

There are so many factors at play in bond market.
  • We could point to historical cases where higher UK public sector debt was sustainable without higher interest rates.
  • Rates on UK and US bonds have fallen, not increased, since start of credit crunch.
  • High demand for bonds is something you would expect in a liquidity trap. For example, at the moment, there is strong demand for government bonds as banks try to buy assets to improve liquidity.
  • The rise in government borrowing is offsetting the rise in private sector saving.
Yet, you could easily paint another view.
  • Bond yields have only fallen in UK, because they like the markets like the sound of harsh austerity package.
  • Bond markets are not comparable to 40s and 50s, as today there is greater fear of potential future inflation, inflating away value of bonds.

I do think that the government could definitely have made spending cuts less dramatic and pushed other spending cuts further into future. Rather than stressing the need for immediate cuts, they should have stressed the importance of economic recovery and reducing unemployment over cuts.

The fear of bond markets deserting UK is exaggerated. A credible long term plan combined with prospects of higher growth would reassure markets.

The government have made a mistake by pushing through an austerity package at this stage in the economic cycle (see also: Danger of listening to Pain Caucus - Brad DeLong)

From an economic point of view, they could have stressed some spending cuts which did least damage to economy - e.g. changes to retirement age, changes to welfare benefits. I would definitely have promoted some key infrastructure improvement spending. e.g. new rail links between Birmingham and London. Not only is this important for future productivity, it is important for boosting Aggregate Demand. Also maintaining a few high profile projects would help to maintain consumer confidence that the government does actually care about promoting growth.



Anonymous said...

n addition, Irish, Greek, UK and other government bonds crowd out the bond market.

Despite uncertainties, govnt bonds look much safer than corporate (so-called junk) bonds who are usually more risky.

This means that a private-sector led recovery seems more remote than ever.

This sad state of affair is further amplified by the fact that banks fail to lend enough to businesses and prefer government bonds....

Anonymous said...

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Contact: Jason Berg 239-841-0349

Setting up a capital market system by a government needs an initial investment made by that government for each citizen of the country in order to start seeing any return on the initial investment. In order to sustain and pay for the cost of running the government, and have economic growth for long periods of time.

We need to fix the gap flaw in the capital market system problem now!

The solution is having the US Government finish what it started 200+ years ago. The freedoms granted in the constitution were great, but it is time to finish setting up the capital market system.

When the country became a Republic, and the first president was elected, the US Government set up a capital market system, and issued money by the government recognized through the nation as the medium of exchange. They only forgot the most important part! In order to have a capital market system an initial investment must be made by the government in each citizen in the country in order to have a profitable return. The investor is the government in the initial setting up of the capital market system, and that same issuing government will provide the structure for the citizens to use the capital market by providing security, and law and order. All the citizens gain more freedom and increased standard of living over time using the capital market system. But, only after the investment is initially made in each citizen living in the capital market system, by the government who set up the system, will the gap flaw be fixed, and the market will crash if the investment is not made. it is just a matter of time.
They forgot to finish setting up the capital market system.

NO investment was ever made. Not for 200+ years!

Without finishing the capital market structure set up, they went as far as they could to give freedom to the people. Giving up control, and giving it to the people. Without the investment in the capital market in the long run will collapse and fail. The founding fathers did not finish setting up the structure for the capital market, but they did buy some time in the capital market. The founding fathers idea will not work until the initial investment is made. Granted the freedoms that were granted were great, and positive. Those limited freedoms bought some time in the capital market system. Making the USA the most powerful nation on earth today. The capital market idea is a great idea, but the founders of the country who came up with it, did not finish setting up the structure for the capital market system to work for the long run. One reason might have been some did not want to have the capital market system, or some did not want to give up the control, and power to the individual citizen. For what ever reason after 200+ years later it does not even matter. That long run back then is here now. It is time to finish the job!