British Age of Austerity and the Debt Essay

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British Age of Austerity and the Debt Crisis

Currently, the United Kingdom is going through a period of intense economic turmoil where the fundamental questions of monetary and fiscal policy are major political issues. As Europe finds it's way through the ongoing sovereign debt crisis, Britons find themselves on the cusp of a recession and their government is enacting unprecedented budgetary cuts to weather the storm. This paper will analyze the macroeconomic policies of the Cameron government in response to the sovereign debt crisis and the associated recession here in the United Kingdom.

Before we can analyze the current situation it is important to define terms. According to the Office for National Statistics (2011), the British government is in the midst of a recession. This is defined as a period of general economic decline, defined usually as a contraction in the GDP for six months (two consecutive quarters) or longer. Marked by high unemployment, stagnant wages, and fall in retail sales, a recession generally does not last longer than one year and is much milder than a depression. Although recessions are considered a normal part of a capitalist economy, there is no unanimity of economists on its causes (Gwartney, et al., 2005).

The cause of this recession is also far from clear. The European sovereign debt crisis has been created by a combination of complex factors such as: the globalization of finance; easy credit conditions during the 2002-2008 period that encouraged high-risk lending and borrowing practices; international trade imbalances; real-estate bubbles that have since burst; slow growth economic conditions 2008 and after; fiscal policy choices related to government revenues and expenses; and approaches used by nations to bailout troubled banking industries and private bondholders, assuming private debt burdens or socializing losses.

One narrative describing the causes of the crisis begins with the significant increase in savings available for investment during the 2000-2007 period. During this time, the global pool of fixed income securities increased from approximately $36 trillion in 2000 to $70 trillion by 2007. This "Giant Pool of Money" increased as savings from high-growth developing nations entered global capital markets. Investors searching for higher yields than those offered by U.S. Treasury bonds sought alternatives globally. The temptation offered by this readily available savings overwhelmed the policy and regulatory control mechanisms in country after country as global fixed income investors searched for yield, generating bubble after bubble across the globe. While these bubbles have burst causing asset prices (e.g., housing and commercial property) to decline, the liabilities owed to global investors remain at full price, generating questions regarding the solvency of governments and their banking systems (McCoy, 2006).

How each European country involved in this crisis borrowed and invested the money varies. For example, Ireland's banks lent the money to property developers, generating a massive property bubble. When the bubble burst, Ireland's government and taxpayers assumed private debts (Burnham, 2003). In Greece, the government increased its commitments to public workers in the form of extremely generous pay and pension benefits. Iceland's banking system grew enormously, creating debts to global investors ("external debts") several times larger than its national GDP. The interconnection in the global financial system means that if one nation defaults on its sovereign debt or enters into recession that places some of the external private debt at risk as well, the banking systems of creditor nations face losses. For example, in October 2011 Italian borrowers owed French banks $366 billion (net). Should Italy be unable to finance itself, the French banking system and economy could come under significant pressure, which in turn would affect France's creditors and so on. This is referred to as financial contagion (Mitchell, 2006). Further creating interconnection is the concept of debt protection. Financial institutions enter into contracts called credit default swaps (CDS) that result in payment or receipt of funds should default occur on a particular debt instrument or security, such as a government bond. Since multiple CDS can be purchased on the same security, the value of money changing hands can be many times larger than the amount of debt itself. It is unclear what exposure each country's banking system has to CDS, which creates another type of uncertainty.

Faced with these challenges and a growing recession in the U.K., the Cameron government decided to be proactive regarding the crisis. They envisaged drastic cuts to public spending with the goal of reducing the gigantic British public deficit to as close to zero as possible over the next four years. Ministerial budgets are to be cut by an average of 19% and 490,000 public sector jobs will disappear over the next four years. State expenditures will be slashed by 83 billion pounds and taxes increased by 29 billion pounds. According to opinion polls, the majority think the austerity measures are unavoidable (Stelzer, 2003).

Great Britain's deficit is the highest in Europe and ratings agencies have repeatedly warned of a downgrading of the country's credit rating. As it stands, Osborne's policy is nothing short of a massive political experiment, a high-stakes bet with an uncertain outcome. A senior official in the Treasury told the Financial Times that no one knows quite what will happen next. The Labour opposition has accused the Tories of using the debt crisis as a pretext to push through their vision of a smaller national government. There are reasons for concern. Early economic indicators are worse than they were just six months ago. Real estate prices are weak and consumption, both private and commercial, is cautious. Just how economically damaging drastic savings measures can be has been seen recently in the case of Britain's neighbor Ireland (Burnham, 2003).

In October 2010, Chancellor of the Exchequer George Osbourne announced the results of the Comprehensive Spending Review. The coalition believed that cuts of £49 billion to public expenditure is required to reduce the structural deficit in the United Kingdom. It claims the structural deficit will be solved in 2015 if the Comprehensive Spending Review cuts are made. The deficit spending problem, Osbourne and the government argued, had been exacerbated by the global economic crisis and such cuts were necessary.

Before the spending review results were announced, a number of announcements had already been made. Michael Gove, the Conservative education secretary, announced the scrapping of the Building Schools for the Future program, which was a fund for building and renovation of facilities in primary and secondary education. The government had also committed not to cut money from the National Health Service, and had suggested through the benefit reform work conducted by William Hague that major reforms to the benefits and social security payments, including the removal of universal child benefit from higher-rate tax payers. The government had also stated that no government department would be immune from spending cuts, and justified public sector spending cuts by stating that the private sector had suffered losses due to the worldwide economic crisis and the public sector would not be immune.

Fiscal policy, that is how government determines levels of taxation and spending, is at the core of any discussion of tax cuts. Therefore, consideration must be given to levels of government spending, given their considerable impact on the economy. Higher levels of government spending have been historically demonstrated to inhibit economic growth, particularly, when such spending is in the form of entitlements and other transfer payments (Sowell 2004, 2006). Even government spending as a consumer of goods and services has secondary effects that diminish the beneficial impact of said spending, therefore it is likely that over time the Cameron austerity cuts will be effective in righting the British deficit.

It is, however, helpful to contrast the economic impact of entitlement spending of the UK government with that of other governments. The current budgetary outlays of the U.S. federal government, measured as a share of national economic output, consume almost 21% of gross domestic product (Office of Management and Budget). According to figures provided by the Organization for Economic Cooperation and Development (OECD), Government spending consumes more than 50% of GDP in France and Sweden and more than 45% in Germany and Italy (Schettkat, 2003; Hauptmeier, et al., 2005). When government spends, it is draws from treasury receipts -- the majority of which is from collected taxes, or it must go into debt, typically by issuing bonds, to fund its expenditures (Bartlett, 2004). Thus, the government is presented with the choices of maintaining a balanced budget or issuing debt. Each of these alternatives has consequences that we will briefly examine. In order to operate a balanced budget, tax revenues to the government must match or exceed spending. if, however, tax rates are increased to the point that the tax burden is a disincentive to economic activity, economic growth slows, and tax revenues decrease (Laffer 1986; 2000). Deficit spending, as Keynes suggested might be desirable, has the consequence of creating a debt, which must be paid for, with interest, from future tax receipts (Moore, 2005). The challenge then, is to determine a fiscal policy, which…[continue]

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