Will public sector spending cuts push the UK back into recession?
Tue, Jul 13 2010, 05:00 GMT
by Trevor Williams
The austerity package announced in the emergency Budget has raised concerns that the degree of public spending restraint could tip the UK back into recession. On the face of it, these concerns are understandable. With total spending cuts amounting to £99bn (or 5.2% of GDP) and tax increases of £29bn (2% of GDP) planned by 2015-2016, the fiscal squeeze is the most aggressive since the Geoffrey Howe Budget in 1981. In this weekly, we examine the size of the spending cuts put forward by the Chancellor and assess the implications for the economy as a whole.
How aggressive are the spending cuts?
Since 1997, the share of the economy accounted for by public spending has risen from 38% to 48% - its highest since 1984. Over the next five years, public spending is projected to fall in real terms by 4%. If realised, this would reduce the share of the economy devoted to the public sector to 40% over this period (given the anticipated growth in the economy).
This decline is far from insignificant, particularly when measured against previous assumptions. Moreover, the total cuts in department spending will be far higher than this, as a large proportion of public spending either falls outside the government’s control or is very difficult to change. This includes, amongst other things, the costs of servicing public sector debt, social security payments and public sector pension obligations.
With limited headroom to cut these categories, It falls to government departments to bear the main burden of the structural spending cuts. Full details of where the departmental axe will fall will not be published until 20 October when the government publishes its next Spending Review. Nevertheless, the totals were set out in the emergency Budget. Based on these, the Institute for Fiscal Studies (IFS) concludes that real spending cuts averaging 14% across all departments would be required for the Chancellor to deliver his objective of a balanced cyclically-adjusted current budget over the next five years. This equates to a structural reduction in department spending of around 5% of GDP in the period.
For most departments, however, the cuts are set to prove far more severe. Since the government has committed to protecting spending on the NHS and overseas aid, the average cut faced by ‘unprotected’ departments is estimated at 25- 33% over the next four years. Ahead of the Spending Review, the Treasury has asked departments to seek out potential cost savings of up to 40%.
The expectation is that efficiency savings will account for the bulk of the budget cuts although, given the scale, it seems possible that front-line services could be affected. Moreover, in its latest forecast, the Office of Budget Responsibility (OBR) estimates that as a result of the spending cuts, public sector job losses will total 600k by 2015- 2016.
Economic impact
The scale of the proposed spending squeeze has led to an intense debate about whether or not it will derail the nascent economic recovery. The cuts in public expenditure (both current and capital spending) will have a direct impact on GDP through reducing government consumption and public investment. There will also be a second order impact on consumer spending, savings, and investment as a result of the ensuing public sector job losses.
Balanced against this, however is that public sector borrowing will be lower than would otherwise be the case. This reduction could be expected to reduce the cost of capital in the private sector, and free up savings to finance business investment. This, in turn, could be expected to have positive benefits for employment and consumption and therefore GDP growth.
The net impact of a change in government spending on aggregate demand can assessed by looking at estimates of the fiscal multiplier. The OBR estimates that the fiscal multiplier applied to departmental spending is 0.6. – i.e. a cut in departmental expenditure equivalent to 1% of GDP would have the effect of reducing GDP by 0.6% in the short run. Over the long run, the implications for GDP are assumed to fade, as wages and prices ultimately adjust to bring the economy back to its long-run equilibrium.
Applying the fiscal multipliers to the timetable of proposed cuts in public spending show that the largest impact to GDP growth occurs in 2011- 2012 (see chart a). In that year, GDP growth is 1.5% lower than it would have been had the spending cuts not occurred. Thereafter, the impact of the fiscal multiplier on GDP growth steadily reduces.
It should be stressed that estimates of fiscal multipliers are highly uncertain. They depend on numerous factors, including the marginal propensity of businesses to invest, household’s marginal propensity to consume, the resulting monetary policy response, and prevailing inflation and credit conditions. Our own forecasts of the impact of the fiscal multiplier are slightly more cautious than those of the OBR, largely because we believe prevailing credit constraints and a lack of desire by businesses to invest in the current environment will act as an impediment to growth. Moreover, with interest rates already close to zero and term rates at historically low levels, it is unlikely that monetary conditions will loosen further.
Nevertheless, we are cautiously optimistic that the UK economy will be able to continue to recover, despite the scale of the fiscal tightening. We expect GDP growth to rise by around 1% this year, by 2% in 2011, before peaking at 2.7% in 2012. That GDP growth can rise amid such a sharp tightening in fiscal policy is not without precedent. Following Geoffrey Howe’s Budget in 1981, the share of government spending in the economy fell from 48% to 42% over six years. Over the same period, annual real GDP growth averaged 2.7%. Similarly, in the early 1990s, a substantial fiscal tightening under the Major government failed to prevent a strong economic recovery (see chart b).
It must be stressed that given the scale of the structural credit shock, we doubt the improvement over the coming years will be nearly as strong as the recoveries of the early 1980s and early 1990s. Nevertheless, we are cautiously optimistic that even with the scale of fiscal consolidation planned, low interest rates and a pick up in private sector demand should enable the UK to avoid a double dip recession.
