Fiscal austerity is when the government of a country decides to raise taxes or cut government spending in order to reduce a government budget deficit.
It has advantages as well as disadvantages, one being that it reduces the welfare of citizens both in the short-run and in the long-run. For example, a rise in taxes means that consumers have less disposable income. Government spending includes transfer payments which is welfare benefits, so a cut in government spending effects those gaining benefits who are likely to be those on low-incomes. This leads to income inequalities.
Cutting spending on infrastructure and education will reduce the supply of physical and human capital in the future, this will then lead to lower economic growth. Austerity will lead to a fall in GDP, in the short-run – the more severe the rise in taxes are or the more severe the cut in government spending is, the more negative the impact on GDP is. If the economy is in a recession, austerity will only cause the recession to worsen. If the economy is in the recovery phase of the trade cycle, it will slow down the rate of recovery. However, Canada pursued austerity in 1993-1996 and maintained strong economic growth; their exchange rate depreciated as a result of this.
Unemployment will rise when there are cuts in government spending, this is because cuts in public spending or rises in taxes reduces aggregate demand which means there will be more spare capacity in the economy. This leads to welfare benefits for those unemployed or on low incomes rising while tax revenues will fall.
The main advantage of austerity is that it reduces the budget deficit, which overtime reduces the national debt. Austerity can cause interest rates to decrease, because there is low domestic demand,
and can cause the current account of the balance of payments to improve. This is because interest rates decrease which means that exports are cheaper so they increase and imports decrease as they are more expensive, the exchange rate depreciates which helps to restore a country’s competitiveness.
Spending cuts will lead to lower inflation, this is due to the fall in aggregate demand and if the government decreases public sector wages, public sectors workers will have less disposable income so consumption decreases, lowering aggregate demand which leads to a fall in inflation.
Some economists say that austerity is self-defeating – government spending cuts and higher taxes fail to reduce budget deficits. They come to this conclusion due to the large negative impact on real GDP. As explained above, government spending cuts lead to lower aggregate demand which leads to lower real GDP. The fall in GDP causes tax revenues to fall and spending on transfer payments (i.e. benefits) to increase. Although the original aim is to reduce budget deficit, there is no real improvement in the deficit as the spending cuts are outweighed by the increase in government spending that follows.
The current account is a component of the balance of payments. The balance of payments account is a record of all financial dealings over a period of time between economic agents of one country and all other countries. The current account records the trade in goods and services, as well as transfers and income flows. We say that the current account is in deficit when imports are greater than exports. The UK has been in a current account deficit since 2000 of an average 2.4% of GDP. This means that what is flowing out of the UK from trade in goods and services are more than what is flowing into the country.
The UK currently has an inflation rate of 2.3% and has generally been quite low in the UK economy. However, before the financial crisis of 2008 – resulted by deregulation of banks in the US – the inflation rate was 2% and this then increased to 5.2% during the crisis. The first bank to go bankrupt was Lehman Brothers, which was then followed by many other banks that became bankrupt. This resulted in crashes in other economies around the world. So, what is the link between inflation rate and the current account deficit? Well, an increase in the inflation rate, increases the prices of commodities (a raw material that can be bought or sold) which means that the costs of production for firms increase too (as commodities are needed in order to make products). As well as this, as the inflation rate rises, real wages (nominal wages adjusted for inflation) begins to fall so trade unions (a supply-side policy) may negotiate for higher wages as their aim is to maximise their welfare at their work. This will also lead to an increase in costs of production for firms as wages are one of the biggest parts of a firms’ costs of production. Firms will then increase the price of the good or service in order to maximise their own utility (profit). So higher prices makes UK goods less competitive internationally, and demand for UK exports decrease relatively to imports. Therefore, as imports increase and exports decrease relative to each other, the current account deficit worsens. As the inflation rate has constantly been changing (increasing and then decreasing and then increasing again) in the UK, it means that our economy is constantly in a deficit.
Furthermore, a current account deficit can also be caused by a rise in the exchange rate. At present, exchange rates have been falling but during the Financial Crisis of 2008 exchange rates rose by around 25%. This was because people started to want to sell stocks and highly liquid assets for dollars. This demand for cash appreciated the dollar, same as in other countries with their currency. A rise in the exchange rate means that the pound is strong. This means that imports would be cheaper to buy and exports would be more expensive to buy. So the demand for imports rises and the demand for exports decreases. This means that the size of the current account deficit worsens as imports are greater than exports. Similarly, a fall in incomes abroad means that incomes of foreign buyers fall due to a lack of economic growth in their economy (perhaps a recession). This means that they will demand less of UK exports. This also increases the size of the current account deficit as exports decrease. The effects of the financial crisis of 2008 still haven’t entirely been removed as we can see looking at the current account deficit as it was the biggest following 2008.
After the steep fall in the value of the sterling after the Brexit vote, expectations for inflation has risen. A fall in the value of the pound meant that goods brought into the UK are more expensive. This means that firms will past on their costs onto their consumers in the form of higher prices, which increases inflation. Sterling fell as much as 20% against the US dollar after the EU referendum in June. The Bank of England and many private economists say inflation is set to carry on increasing sharply in 2017. The quarterly survey, which was published on Friday, illustrated average public expectations for inflation over the next 12 months rose to 2.9% in February from 2.8% in the previous survey in November. And taking a five-year view, inflation is expected to be at 3.2% compared with 3.1% that was expected three months earlier.
The Bank’s Monetary Policy committee was divided on the decision about interest rates. Kristin Forbes is a member of the committee, who voted to raise interest rates as she felt that inflation was rising too quickly and that it could become a problem in the near future. Other members also indicated that they could join her in the future meetings if they began to feel the same. Ian McCafferty, who voted for an increase in the rate in early 2016, was the most likely member to join Forbes (according to analysts). Other members included Michael Saunders who came across as enthusiastic about the economy in a speech he made in January.
Forbes believes that inflation is likely to remain above the Bank’s 2.0% target for at least three years. She voted against the rest of the committee and wanted an increase in the base rate to 0.5% from 0.25%. The rest showed that the Bank of England did not want to follow the US Federal Reserve, which raised base rates on Wednesday. This was the first disagreement the committee faced since after the Brexit vote in July 2016 (when Jan Vlieghe voted for a cut in the costs of borrowing from 0.5% to 0.25% - the majority of the committee opposed him but in August 2016, they voted for a cut).
Last month, the Bank of England said it expected the economy to grow by a relatively strong 2.0% this year but was likely to slow down after the uncertainty with the country’s involvement with countries in the European Union, as they buy roughly half of Britain’s exports. This week, economists pointed out that wage growth was “notably slower” than they had thought even though the unemployment rate is now 4.7%, marking its lowest level since the summer of 2005 said the ONS, which economists say it nearly at full employment.
This week has been important for many business people, savers, students and families across the UK; this is because, the Budget was released and it is the annual financial statement that sets out the Government’s plans for spending and taxation for the coming year. As of Tuesday 8th of March, Chancellor Philip Hammond presented his first and last Spring Budget. It is his last because of the transition to a single fiscal event each year, an Autumn budget.
The Office for Budget Responsibility expects the economy would expand by 2% this year, which is an increase from their previous forecast of 1.4% economic growth. They judge that growth will moderate during 2017, as real incomes are affected by an increase in inflation due to sterling’s depreciation which leads to a slowdown in consumer demand growth. However, growth in the future years have been expected to be lower: in 2018-19, 1.6%; in 2019-20, 1.7% and in 2020-21, 2%. This means that the British economy will grow at a slower rate than before the Brexit referendum until the EU withdrawal and maybe even beyond. Higher levels of growth mean higher tax receipts and lower levels of borrowing; however, growth will be better in the short-run than in the long-run. Britain can, therefore, no longer claim to be the fastest-growing economy in the G7 group (which is a group consisting of Canada, France, Germany, Italy, Japan, the UK and the US – they are the major advanced economies as reported by the International Monetary Fund, together they represent more than 64% of the net global wealth).
There has been an increase on duties for demerit goods, for example: a packet of 20 cigarettes will cost 35p more; while it will be 44p more for a packet of 30g of hand-rolled tobacco. This is another way of decreasing the amount of demerit goods consumed. This is an example of an increase in tax revenue, which the Government can use to pay back what they have borrowed or to pay their bill to the EU. This then has an effect on public sector net borrowing, this has been forecasted to decrease from 3.8% of GDP to 2.6% this year, and reaching 0.7% in 2022.
The government has announced that it is getting rid of the Class 2 National Insurance contributions (NICs) from April 2018. The self-employed also have access to the same pension scheme as employers. This leads to an increase in the main rate for the Class 4 NICs from 9% to 10% in April 2018 and to 11% in April 2019. This means that only self-employed individuals with profits above £16,250 will have to pay more NICs. This affects 5 million people (who are self-employed) and breaks the Tory’s manifesto promise of “no increase in National Insurance contributions” that was made during the elections of 2015.
These are just some examples of the key points that were written in the Budget 2017. There are many other changes (increases or decreases) in spending, for example: the additional £2 billion given to councils in England over the next 3 years for adult social care.
Monetary policy is the manipulation by the Bank of England’s monetary policy committee of monetary variables, such as interest rates, to control inflation and reach its objectives. The committee consists of 9 economists who meet every Thursday of every month. They have a target for CPI (Consumer Price Index) inflation, which is set by the chancellor of the exchequer of 2% ± 1%.
The committee have to consider different factors when making their decision:
o Domestic monetary developments
• Bank and building society lending figures
• High street consumer credit data
• UK share prices
• House prices
• Growth of money supply
o Exchange rate
o Demand and output figures
• Retail sales
• Consumer expenditure
• GDP figures
o Unemployment figures
So as house prices are just one factor that the economists consider when making their decisions, we can question how important it actually is. Across England, by February 2016, 64% of households own their home according to the Resolution Foundation. This has fallen to its lowest level in 30 years as the gap between earnings and property prices has increased creating a housing crisis. The proportion of people who own their own home has fallen across every part of the UK since their peak in the early 2000s. Although even though this figure has decreased, it is still over half. This means that households are very sensitive to changes in interest rates as it affects their disposable income. However, as Theresa May will announce as her second biggest housing pledge, to support people between the ages of 23 and 40 to buy their first home by helping 30 areas around the country to unlock land to build on; this will increase the sensitivity of interest rates on the housing market as more people will be affected. There are about 25 million homes in the UK, of which seven out of 10 are owner-occupied. The number of homeowners has risen by more than one million since 1997.
Although, it only affects those with tracker mortgages. Tracker mortgages are a type of variable rate mortgage which follows the base rate of interest set by the Bank of England plus a charge on top that would be pre-agreed for a set amount of time. For example, if your tracker mortgage is base rate plus 2%, and the base rate is 1%, you will pay 3%. If the base rate rises to 2%, you will pay 4%. As interest rates fall, discretionary income (income remaining after deduction of taxes) rises for those with tracker mortgages. This means those households start consuming more and as consumption is a component of aggregate demand [C + I +G + (X - M)], so aggregate demand shifts to the right.
Furthermore, as Bank of England increases interest rates, the demand for housing falls because of the decrease in the demand for mortgages. Banks’ supply of mortgage equity withdrawals begin to fall so consumers have less money so consumption decreases and aggregate demand shifts to the left. This is known as the wealth effect, which is when consumer spending is affected by a change in the value of an asset, in this case house prices.
However, we should consider whether the housing market is the most important factor that the Bank of England should consider?
Unemployment is defined as those without a job but who are actively seeking work at current wage rates. In the UK, there are two ways in which unemployment is calculated: the claimant count and the Labour Force Survey (LFS). The claimant count measures unemployment by counting the number of people claiming benefits for being unemployed (Jobseekers’ allowance). The claimant count is not an international measure so it cannot be used to compare UK unemployment levels with those in other countries. The labour force survey is an internationally agreed measure of unemployment, conducted by the International Labour Organisation (ILO). It is the number of people who have actively sought work in the last four weeks and are available to start work in the next two weeks.
Unemployment occurs for a variety of reasons:
o Frictional unemployment is when workers are unemployed for short lengths of time between jobs.
o Cyclical (or demand-deficient) unemployment is when a fall in AD, leads to a fall in economic output, therefore firms employ less workers. It is the idea that unemployment rises and falls with changes in the economic cycle.
o Seasonal unemployment is when workers are unemployed at certain times of the year, such as building workers in the winter.
o Real wage or classical unemployment is when workers are unemployed because real wages are too high and inflexible downwards, leading to insufficient demand for workers from employers.
o Structural unemployment is when the pattern of demand and production changes leaving workers unemployed in labour markets where demand has shrunk.
There are different policies which can be put into place by the government to reduce unemployment.
The fiscal policy can decrease unemployment. The expansionary fiscal policy must be put into action, this involves increasing government spending and decreasing taxes. This will increase aggregate demand and the rate of economic growth. Lower taxes mean an increase in disposable income and it will help to increase consumption, resulting in higher aggregate demand. As AD increases, real GDP also increases. So, firms produce more and so there will be an increase in demand for workers and therefore there will be lower cyclical unemployment. Furthermore, there will be stronger economic growth so there will be fewer job losses as fewer firms will go bankrupt.
Monetary policy would also reduce unemployment by cutting interest rates. This would involve cutting interest rates. Interest rates are the cost of borrowing so lower rates encourage people to spend and invest. This increases AD and so increases GDP. This is because there is an increase in demand for workers to help produce higher amounts of goods and services so reduces unemployment.
The policies states above are examples of demand-side policies. However, there are also supply-side policies which help reduce unemployment. These are:
Education and training can provide the long-term unemployed with new skills which enable them to find jobs in new industries. Although the unemployed may be unable or unwilling to learn new skills and this policy may take several years to affect unemployment.
Trade unions are organisations of workers that exist to promote the welfare of their members. By reducing the power of trade unions, it will help to reduce real wage unemployment because unions will not be able to bargain for wages above the market clearing level.
Furthermore, the government can provide employment subsidies. Firms could be given subsidies for employing those who have been unemployed for a long time. This helps give them new confidence and job training for them to increase their skills. However, it will be quite expensive and may encourage employers to replace their current employees with the long-term unemployed.
The aftermath of the US presidential election has cast a shadow on the economy, along with controversy. But how will America’s new president affect the global economy? The victory of Republican Donald Trump surprised the currency markets, with the plunge of the U.S dollar against other currencies, being a highlight. Despite the election results, the euro is also dealing with it’s own problem - uncertainty over upcoming elections in Eurozone countries. Alongside the euro, sterling grappling with the departure from the European Union. The pound rose 1.2 per cent against the dollar at 1.2529 and the euro was up 2.1 per cent at 1.1259.
Other than the fact the pound is rebounding from the referendum, Trump’s victory helps U.K economy. The republican has said the ‘UK will be at the front of queue for a new trade deal’. This would be be beneficial to Theresa May and the negotiations of ‘Brexit’. If she is able to show that she can do business with Trump, it will strengthen her negotiation powers with the other 27 members of the EU. However there are implications for Europe that may affect them economically and financially; the eurozone greatly reliant on exports as a source of growth. The exports could be affected by a more restrictive US trade network and also the volatility of the dollar.
Mexico is probably the most economically affected countries, with Trump's hatred towards America’s notorious neighbour. His first aim is to renegotiate the terms of the North American Free Trade Agreement. If he is not able to do this, he will pull out the deal altogether. On top of this he threatened to put a tax on some Mexican goods. Mexican workforce would be under pressure due to the retreat of many illegal immigrants in the US. Trade between US and Mexico would be very weaken, which may cause consumers in both countries see an increase in price of some goods.
We know for sure that ironically the future of the British economy is uncertain. Despite the Pound somewhat rebounding from its heavy fall since the flash crash, it is no longer regarded as the "safe haven" it was. Forecasts are bleak but in the long run the Pound is to recover back to the $1.60 it used to be at. Trump will no doubt help accelerate the recovery, but only time will tell what will happen.