Qn: Assess both views (in favour and against austerity policy) for the UK economy and illustrate how monetary and fiscal policy interacted in the UK economy in the period after the financial crisis.
AASHISH TANNA STUDENT ID: 1706966 TUTOR: DR PEDRO SERODIO
APRIL 3, 2018
EC 108: MACROECONOMICS SUMMATIVE ESSAY
Classical economics suggests ‘unemployment would be cured by the self-adjustment of the labour market to a balanced real wage’. However, Keynesian economics triumphed with government intervention; providing bank bailouts with fiscal and monetary stimuli during the 2008 financial crisis. These measures played a pivotal role in stabilising the economy and confidence levels before austerity measures were adopted in 2010. This essay aims to illustrate how demand-side policies (DSP) complemented each other whilst assessing the different views on austerity.
Bank of England (BoE) is responsible to ensure monetary and financial stability through monetary policy. Therefore, after Northern Rock’s bank run (an event that had not occurred for almost 150 years) (Elliot, 2015), the aim was to prevent a banking system crash, as had happened in the 1930s. Identifying the problem as liquidity and not insolvency, BoE bailed out Bank of Scotland, Lloyds TSB and Royal Bank of Scotland, using £850bn worth of taxpayer’s revenue (Elliot, 2015). As banks had provided poor loans and collateralised debt obligations – giving the risk of their loans to investors, to fund more loans – other bank runs, due to interdependency, may have had domino effects and led to the collapse of the entire banking industry. The BoE thereby stabilised the banking system to restore confidence; assuring depositors that their savings are safe and encouraging them to gradually return to original consumption patterns.
The next step was minimising the adverse impacts of the banking system trauma to households’ and business’ credit flow. Therefore, BoE and its Monetary Policy Committee proceeded to progressively cut interest rates (IR) from 5.75% (2007) to 0.5% (2009).
Taylor’s rule, model suggesting ideal interest rates due to changing economic conditions, closely correlated to the BoE’s reaction:
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Figure 2 proves that – lowering the IR meant: i) decreased cost of borrowing, ii) decreased reward on saving – the demand for money increased.
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Having reached a zero-lower bound, i.e. no scope of further stimulating growth through IRs, the BoE resorted to quantitative easing (QE). The creation of electronic money to purchase government bonds and other assets from banks decreased the IR (yield) of these assets (whilst increasing asset prices). This decreased the cost of borrowing whilst increasing liquidity for banks, increasing availability of loans at better rates. The extent of QE is considerably shifted the LM curve outwards.
Fiscal policy was also immediately implemented. There was a £145 tax cut for those on incomes below £34,800 per annum along with a 2.5% cut in Value Added Tax. Figure 4 shows the effect of a decrease in taxes: increasing consumers’ disposable incomes, thus allowing for greater consumption.
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Correspondingly, government spending increased with £3bn worth of investment spending preponed from 2010 alongside £20bn Small Enterprise Loan Guarantee Scheme. The government managed to stimulate greater consumption and investment (same IS effect), through the multiplier effect and practical means of funding.
This DSP mix complimented each other, and both IS and LM curves shifted outwards. Figure 6 shows the total effect of extensive changes in each policy.
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Growth rates only became positive in 2009, Q4. However, the expansionary policies resulted in a deficit of £175bn (12.4% of GDP) with national debt at 80% of GDP; ‘the inevitable price of dealing with the financial crisis’ (BoE). Therefore, the Conservative-Liberal Democrat coalition implemented austerity measures to reduce the national deficit (2010). The chancellor, George Osbourne, immediately increased VAT from 17.5% to 20% whilst announcing large cuts in spending on schools, hospitals, and roads. Many commentators feared this would deepen the recession and slow recovery; but what is the main argument behind austerity?
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In 2010 itself, the budget deficit decreased from 11% to 9.3%. However, the national debt was teetering towards unsustainability due to low growth rates. With government borrowing at 9.9% of GDP, larger national debts meant that the government had to repay larger principal and interest amounts, sacrificing next generation’s funds. Therefore, the argument for austerity consists of avoiding a debt crisis (such as in Greece and Italy) and minimising the burden of present borrowing on future generations; hence the aim of sustainably converting the deficit into a surplus and contributing towards debt reduction.
Similarly, George Osbourne argued that austerity measures would strengthen the UK’s fiscal strength in case of another economic downturn; to warrant that the UK would be in a better position, as opposed to its current debt as a proportion of its GDP. Effectively, this would restore confidence in the economy’s budget management and allow easier access to external funds at lower costs in the future, whilst also freeing up internal funds to strengthen growth (relationship shown below).
Alternatively, austerity effects included: ‘2962 mental health practitioners left their practises’, ‘police workforce decreased by almost 19,000 people’, and ‘380 care home firms out of business’. By 2011, nearly 270,000 public jobs had been cut. (York, 2017)
Austerity and slow recovery meant that the government, banks, and households decided to deleverage (evident in figure 9) i.e. decrease the amount of debt in balance sheets, to reduce the risk of defaulting. With already low confidence levels and aggregate demand (AD), the government cut in spending only amplified the reduction in AD, rather than offsetting the fall in private sector spending. This led to a balance sheet recession, slowing growth, and a negative multiplier effect, reducing incomes and output levels, thereby driving the economy back into a recession.
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Additionally, austerity measures meant large cuts in health and educational sectors. Whilst affecting the whole society, the effects are regressive. This means that the poorer part of society – significantly dependent on government support – would be most disadvantaged. Research concludes that; ‘increased joblessness amongst youth meant average incomes plummeted, even those employed were considerably poorer than their parents’; ‘out of the public-sector job cuts, twice as many women made redundant’; and richest have seen their share of income rise (Oxfam: Para, 2011). Evidently, increased inequality has burdened professional opportunities and disposable income available to the economy, effectively decreasing labour mobility. It has also led to lower levels of trust between people, affecting the unity within societies. Thus, it is associated with increased levels of crime, falling health and education levels. Collectively, this dampens current and potential growth levels. Higher inequality may also lead to populist policies (and leaders), e.g. immigration policies, which do not correctly prioritise economic agenda and negatively affect growth. The rise in inequality due to austerity, therefore, has adverse effects on the recovery rate.
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Figure 10 shows that austerity measures led to a double-dip recession with the IMF chief economist stating that Osbourne was “playing with fire”. Instead, the fiscal stimulus would have been self-financing (Long, Summers, 2012). It would have allowed the economy to grow at faster and stable rates, making debt more sustainable; less government expenditure would be required, automatic stabilisers would raise tax revenues, and IRs could be increased to maintain inflation targets. The latter would be a crucial benefit, allowing the use of conventional monetary policy, if indeed another crisis occurred. However, there has been a paradox of thrift – austerity has led to greater saving – and a hysteresis; eight years after the crisis, growth is slow, and IRs are only at 0.5%. The budget deficit, £1.9bn, may be at its lowest since the downturn, however economic theory and evidence clearly suggests the wrong policy was implemented.
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References
Flanders, S. Damned if you do, and damned if you don't
Coggan, P. Too much austerity can be counterproductive
Wolfers, J. Repaying stimulus debt slows future growth
Basu, S. Ten years after the financial crisis: The long reach of austerity and its global impacts on health
Oxfam, A cautionary tale Fuentes, S. Financial Crises
https://www.theguardian.com/business/2015/jan/07/bank-of-england-minutes- financial-crisis-bank-bailouts
https://qualifications.pearson.com/content/dam/pdf/A%20Level/economics- a/2015/teaching-materials/case-study-the-great-depression-and-the-global- financial-crisis.pdf
https://www.economicshelp.org/blog/7707/economics/uk-policies-for-economic- recovery/
https://www.huffingtonpost.co.uk/entry/uk- austerity_uk_59366ad3e4b013c4816aaac2
https://www.tutor2u.net/economics/reference/monetary-policy-the-bank-of- england
https://thefinanser.com/2011/08/how-much-have-the-bank-bailouts-cost-uk- taxpayers.html/
https://en.wikipedia.org/wiki/National_fiscal_policy_response_to_the_Great_Rece ssion#United_Kingdom
https://www.economicshelp.org/blog/5366/economics/austerity-pros-and-cons/
https://www.theguardian.com/business/2016/may/27/austerity-policies-do- more-harm-than-good-imf-study-concludes
http://www.caixabankresearch.com/en/how-does-inequality-affect-economic- growth
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https://www.euractiv.com/section/elections/opinion/populist-economic-policy- and-how-to-respond-to-it/
https://www.thebalance.com/austerity-measures-definition-examples-do-they- work-3306285
http://lexicon.ft.com/Term?term=quantitative-easing
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