Explain the rationale for austerity programmes to reduce sovereign debt and discuss how far these have been successful in Greece and the UK.
Introduction
Sovereign debt is a long to medium term accumulation of government borrowing through the issuing of bonds and Government Issued Long Term Stocks (GILTS) in order to stimulate economic activity. Whereas austerity programmes are the manipulation of one's contractionary or expansionary austerity programme, which directly relates to the rate of taxation and government expenditure. Sovereign debt and austerity programmes function in a cycle where the manipulation of government expenditure and taxation are used to stimulating an economy while indirectly increasing sovereign debt.
Carmen M. Reinhart Kenneth S. Rogoff. Reinhart and Rogoff (RR) and Thomas Herndon, Michael Ash, Robert Pollin (HAP) specialise in macroeconomics activity, international finance and public relations. Contextually, Greece and the United Kingdom have experienced challenges with their sovereign debt however faced two different levels of severity, due to factors such as financial position within economic and business cycles also the scale of the sovereign debt.
UK Austerity Programme
The United Kingdom uses austerity programmes that include the manipulation of government expenditure and taxation. Austerity programmes were used by the UK government to reduce sovereign debt with an expansionary programme. An expansionary programme would include an increase in the government spending and a decrease in the rate of taxation, which the UK has used following the recession in 2007.
Reductions on taxations such as income tax would impact consumption as the tax is direct and progressive. With this increase in disposable income with the decrease in income tax, the majority of people would increase their consumption, especially in the UK with their high propensity to consume, in contrast to saving. This increase in consumption would stimulate the economy by increasing aggregate demand from AD1 to AD2 as seen in figure 1.
With aggregate demand being the total planned expenditure on all goods and services produced within the economy, in a particular time period, the shift in aggregate demand would be significant as consumption holds a 60% weighting. This results in an increase in the real output from Y1 to Y2 as seen in figure 1, resulting in an increase in the national income. Increases in the national income would trigger an accelerator effect which is the relationship between an initial change in national income and the resulting usually larger change in investment; as the government is a public agency they would reinvest profits back into the public sector in areas such as infrastructure, healthcare as well as education.
Additionally, the reduction in taxation could be on corporate tax, which is a tax distributed to firms on their profits and dividends. The reduction in this tax would allow more scope of private investment as well as research and development with the additional retained profits. This would improve the long-term position and sustainability of the firms. The lower corporate tax also functions to attract foreign direct investment which would drive additional private investment into the host nation, which has other benefits in areas such as employment and trade.
However, the programme has short-term limitations, the increase in governments expenditure would increase the national deficit which leads to the increase in sovereign debt, therefore in short-term the expenditure has to be funded by increasing the national debt as the benefits from the public investment would only be seen in the medium and longer term future due to the transmission mechanism.
Increasing government expenditure can be increasing the budget for education and training, this method would assist in reducing the long-term sovereign debt. Education and training would lead to increases in productivity as well as increasing occupational mobility. Increasing productivity would increase the quality of goods and services therefore, increasing the global competitiveness by reducing the costs of production and directly relating to the theoretical decrease in the price level from PL1 to PL2, which is caused by the shift of the short-run aggregate supply curve from SRAS1 to SRAS2 as illustrated in figure 2a.
Investing in education and training, with funding towards higher education with promotional campaigns for apprenticeship schemes and increases in university funding would also improve the occupational mobility of the population, this would decrease the public deficit as a greater proportion of the population would be employed resulting in less of the population claiming benefits. Therefore, reducing the welfare benefit would have a significant effect on the reducing the national deficit, resulting in a fall in the rate of the sovereign debt. Additionally, the government expenditure would also have a secondary effect on reducing the increases in sovereign debt. This is with the multiplier effect which is the relationship between an initial change in aggregate demand and the resulting usually larger change in national income. The increase in the national income would reduce the national deficit resulting in a fall in the rate of increase in the sovereign debt.
The reductions in taxation also have negatives effects. This is with increasing levels of consumption and investment and the unfortunate influence on the general price level. This is as consumption increasing aggregate demand by 60% in the increase the general price level leading to demand-pull inflation. With low and stable inflation being an objective of most economies, the unintended consequence of inflation would have negative impacts on the overall economic performance and business cycle. A second negative of tax cuts is that in the real world the theoretical benefits may not be seen. An example of this would be that firms may not reinvest the additional profits from the fall in corporate tax, therefore the government would see no benefit in the pursuit to reduce their sovereign debt.
Greece Austerity Programs
The Great Recession in 2007 hit Greece, indirectly with a fall in the demand for the services that they held a comparative advantage. This led to Greece being perceived as unstable; which caused the interest on their government bonds to rise, to eventually be bailed out by the European troika on the basis of a loan. Therefore, Greece's bailout had left them in a position, where they have to seek means to reduce their sovereign debt; however, with them surrendering their monetary programme, Greece therefore had to enforce a contractionary austerity programme.
Following Greece's financial crisis in 2010, the Greece government put forward a contractionary austerity programme, in order to reduce their sovereign debt. This was executed by reducing their government spending and increase their rate of taxation as this would reduce their expenditure as well as increasing their revenue and therefore reducing the deficit and the rate of increase to their national debt.
Greece reduced their spending by privatising a proportion of their public owned companies. This had the effect of reducing the business costs for the government, they received revenue from the profit of the sale. Additionally, theoretically, the privatization allows the business to become more productively efficient as the business objectives shift from producing positive externalities and settling for normal profit at point B to profit maximisation at point A, as the business seeking new ways to cut cost to increase profits as seen in figure 3. The profits and dividends would be taxed due to corporation tax allowing the government to further increase their revenue from the privatization of government-owned companies further reducing their sovereign debt.
Greece also froze and capped the wages of government employees, as government wages was one of the government highest expenditures. This also had the consequence of reducing inequalities as public-sector wages were capped at €3,000 while lower-income employees' wages remained the same, reducing the gap between the higher and lower income owners. There were also reforms to pension schemes by capping pensions above a certain amount as well as increasing the retirement age for women from 60 to 65.
The negatives of reducing the government expenditure in order to reduce sovereign debt are that the privatising firms can lead to anti-competitive behaviour by the firms, who may drive up their price level to generate greater profits and therefore be excluding potential consumers by decreasing the consumer surplus and increasing their producer surplus. Also, the freezing and capping of wages for government employees can have negative effects on their performance this is due to the fall in the utility of their labour resulting in their indifference curve shifting outwards and therefore producing fewer units of output with a fixed amount of input.
Moreover, Greece also increased their rate of taxation specifically their VAT tax which is a proportional and indirect tax. The benefits of increasing the rate of VAT is that the tax is on all goods and services and therefore administratively it's relatively cheaper to control, but also the scale of the revenue that is large and will result in significantly large additional revenue to the government. Increasing income tax would have the effect of reducing disposable incomes. This has its benefits there will be less consumption which would increase the saving ratio by reducing the amount of consumption. This would help to reduce demand-pull inflation where inflation was as high as 5% in 2010.
An unintentional effect of increasing the income tax would be that workers may fall into the income trap where the utility of their labour decreases. At low levels of income, this may drive workers to become unemployed where the unemployment as the utility in the wages for their labour is less than the utility for the unemployment benefit, leading to increasing classical unemployment which can drive up sovereign debt. Also, increasing VAT can cause the tax into becoming regressive as consuming the good or service would take a greater proportion of their income for lower income earners than higher income earners.
Growth in a time of debt
RR's article is based on a longitudinal study over 200 years with over 44 countries, looking at the trends of GDP growth and the strains of increasing sovereign debt. RR's research displays a negative trend in the relationship of GDP growth rate and government debt. The negative correlation means that economies with high levels of debt exceeding a debt/GDP ratio of 90% will face limited growth rates. Figure 2 in RR's article illustrates this relationship between average median growth rates and government debt; where with an average government debt of below 30% yields the highest average growth rate at 3.8% and median growth rate at 3.9%, while with an average government debt above 90% the average growth rate is -0.1% and a median growth rate of 2.3%. Therefore, RR shows that there is a negative correlation amongst growth rates and government debt. Overall RR's article looks at the relationship how increased government debt would limit the economy's ability to grow. However, RR also state "external debt levels in advanced countries now average about 200 percent of GDP." (Reinhart and Rogoff, 2010) This can be interpreted to show that it is necessary to encounter significant debt to grow into an established economy.
Does High Public Debt Consistently Stifle Economic Growth?
Herndon, Ash, and Pollin (HAP) replicated the findings of RR, discovering a variety of systematic errors, causing the main point of RR's thesis to be unfaithfully represented. HAP states that "RR excluded: 5 years for Australia; 5 years for Canada; and 4 years of New Zealand." (Herndon, Ash and Pollin, 2013) this has the impact of having the combined effect of reducing the average for real GDP growth, where the figure given from RR fell by 1.9 percentage points
HAP states that the errors in RR's calculations, specifically in the calculations of the relationships between GDP growth rates and government debt is filled with systematic errors to the degree that HAP rejects RR's conclusions. HAP argued that the "Ratio of over 90 percent is actually 2.2 percent, not -0.1 percent" (Herndon, Ash and Pollin, 2013) this figure is significant as it shows that there is a less significant difference between the figures in the relationship of average median growth rates and government debt in figure 2 from RR's report.
A critique of HAP's research is they focus on the average in appose to the median. This holds significant as without removing outliers as extreme figures can distort the mean. Whereas the median discounts extreme figures. "Their findings have provided significant support for the austerity agenda that has been ascendant in Europe and the United States since 2010." (Herndon, Ash and Pollin, 2013) shows an application of the HAP's report to the impact the effectiveness of austerity programmes on reducing sovereign debt.
Conclusion
In light of the analysis, austerity programmes have been used to reduce sovereign debt, however, the success of these programmes is dependent on a variety of external and internal influences. Influences such as the size and scale of the austerity programmes, such as the amount government expenditure is increased or decrease and the rate at which the level of taxation has been increased or decreased. The confounding difference in the success of the UK's attempt to reduce sovereign debt with austerity programmes in comparison to Greece's is that the UK's monetary policy committee could manipulate their monetary policy to support their austerity programme to stimulate the economy.
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