Is the juice worth the squeeze

Dougie Young considers the arguments for and against the huge fiscal stimulus introduced by the UK government which is shown by the rising budget deficit. Will it help the UK economy out of a recession?

A rising level of government borrowing must mean either an increase in government spending or a decrease in tax revenue. In the UK, I would say it is a result of both, each occurring due to both the government pursuing a fiscal policy and the consequence of entering a recession. Whether intended or not, an increased budget deficit must be financed and the effects of increasing the level of government borrowing must be evaluated. The BBC cites the £128 billion budget deficit we are estimated to have in 2009, which is 12% of the UK GDP, as the largest since 1970, and while this should stimulate aggregate demand and consequently output, one must ask: is the juice worth the squeeze?

Naturally, an increase in government borrowing must be conducive to an increase in government spending which, as a fiscal stimulus, boosts aggregate demand and causes the economy to expand. For example, higher government spending on infrastructure would boost both aggregate demand, from AD to AD1 and the capacity of the economy through long run aggregate supply. It should also create jobs within the economy and combat unemployment, all of which help the economy by shifting aggregate demand outwards. The increase in government borrowing would hopefully also have the effect of improving public services, such as healthcare and education, and general infrastructure. Thus, the more money the government has from borrowing, the more it can use to pursue a fiscal policy in a recession in accordance with the Keynesian approach, as it is doing now with Alistair Darling announcing plans to inject £20 billion into the economy until April 2010.

However, an expansionary fiscal policy, if over applied, carries with it the risk of inflation. If one increases the budget deficit with the intention of boosting aggregate demand, the general price level will rise with everything else remaining constant.

This is an inevitable risk with fiscal stimulus and one which the government must prevent; it occurs as a result of the net injection of demand into the economy, which increases the supply of money in the economy, thus diminishing the purchasing power of the economy. This decrease in purchasing power, however, could help the ever growing trade deficit the UK is facing as it would increase the UK’s competitiveness abroad and allow firms to compete better domestically against inflated imports. Thus, while inflation might increase, our trade balance would probably also improve, although the global recession might stunt such growth as global consumption decreases and nations tend to avoid purchasing imports.

Increasing taxes in a recession could merely deepen the downturn as it would decrease consumers’ personal disposable income and consequently their propensity to consume and government spending is inevitable as more people are unemployed and qualify for more welfare benefits; many people also fall down the progressive income tax system and thus a budget deficit is almost inevitable in a recession, both due to fiscal policy and the natural tendencies of the economy in an economic slump. And so, higher taxes and lower government spending as the UK enters a recession could be highly damaging to the economy.

However, the considerable rise in government borrowing inevitably causes a higher cost of servicing debt, the Chancellor announcing that he expects the public sector debt to rise from 41% to 57% by 2013. A lot of this is a result of the government not mending the roof while the sun was shining, namely continuing to run a budget deficit in times of economic prosperity (as one can see on the diagram, the government continued to borrow between 2-3% of their GDP in the early part of the decade). Their failure to raise taxes and cut government spending has the result that when the UK enters a recession, their National Debt is already beyond manageable. The IMF will naturally react to the accumulating debt Britain is taking on and banks will undoubtedly raise interest rates on UK loans. All of this makes increasing government loans seem more ill-advised and speculation that this fiscal package will not even be enough to significantly reduce the downturn will do nothing to soothe concerns.

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Running a budget deficit will hopefully battle increasing unemployment, which is estimated to hit 1.5 million next year, and generally improve living standards. Cuts in tax, while also encouraging consumption and boosting aggregate demand, also provide work incentives, particularly if income tax is cut. People will then be more encouraged to enter the labour market and stay-at-home parents might be forced to search for a job thus stimulating the supply of labour. The government will also probably try to restrict unemployment benefits to try and combat employment. However, it could also be argued that in a recession, it is a lack of demand for labour which increases unemployment as firms streamline and cutback to avoid liquidation and that therefore an increase in work incentives will have little or no effect on unemployment. Despite this, increased investment by the government, particularly in vocation retraining, could also improve the productivity of the labour force and boost long run aggregate supply. If the government continues to spend as highly through borrowing more, the money will help fund public sector projects such as hospitals and education, which will improve the standard of living for people.

In conclusion, I believe that a budget deficit is vital in combating recession, but that the rate at which the government is borrowing makes the economy too unstable. The government will have to spend a huge amount simply paying off interest on their loans and it runs the risk of losing its AAA credit rating which will make them less attractive as borrowers. In the long term future as well, taxes will inevitably have to be raised and/or government spending cut and depending on the length and severity of this recession, it might have to happen while the UK has yet to recover, which could deepen the economic downturn. While the benefits, such as an improved public sector, are highly desirable, the government must impose damage control and avoid further National Debt, with it already having broken many of its own self-imposed rules, such as the limit of 40% of GDP being national debt: the question remains, will Alistair Darling have the sense to throw in the towel and start to fight a budget deficit which is spiralling out of control.