Unit 2 & 4: Fiscal Austerity Essay

Here is a really good example of a student essay that uses strong contextual evidence to build arguments on both sides of the fiscal austerity debate. First Year student Juhwan Sohn answered this question: 

"Evaluate the impact of the UK government’s fiscal austerity programme"

Fiscal austerity in the UK describes decisions made by the government with the aim of reducing the amount of government borrowing, or cutting the size of the fiscal deficit, over a time period adjusting for the effects of the economic cycle. This means that automatic stabilisers (fiscal changes as the economy moves through stages of the economic cycle of recessions and booms) result in the deficit rising and falling as the economy expands and contracts. Fiscal austerity is implemented by cuts in government spending such as welfare caps, “wage freezes” and defence cuts, and an increase in taxes such as the increase in VAT in 2011. 

A fiscal or budget deficit is when the government spending is greater than the tax revenue in a given time period. This means that during a period of economic growth, the cyclical deficit will fall, due to the decrease in spending on unemployment benefits and an increase in government tax revenues. The UK government fiscal austerity programme was introduced by the Conservative and Liberal Democrat coalition in 2010, and almost succeeded in halving the UK budget deficit by the end of 2015. George Osborne’s new fiscal rule (2015) stated a target for a budget surplus by 2019/20 and for all subsequent years in ‘Normal times’ (real annual growth is above 1%). 

Whilst it may make sense to cut the budget deficit and work towards a budget surplus, especially during periods of strong growth, cuts in spending and an increase in taxes are arguably counterproductive and potentially damaging to parts of the UK economy. The impacts of fiscal austerity in the UK has raised questions on whether the government has placed too much emphasis on deficit-cutting in recent years, and it could be argued that running a budget deficit is better than contractionary fiscal policies and there are better alternatives.

Although fiscal austerity has had some success in reducing the budget deficit, it has also resulted in negative impacts on the lower income families in the UK. Cuts in government spending since 2010 such as wage freezes and welfare caps, have had regressive effects in the UK, as it has affected lower income families the most. 

According to a UK case study by Oxfam, as a result of the austerity measures, the poorest two-tenths of the population “have seen greater cuts to their net income in percentage terms than every other group, except the very richest tenth.” Furthermore, according to the Institute for Fiscal Studies, the effect of the tax increases and welfare cuts will be to increase both absolute and relative poverty by 2020. It is estimated that an additional 800,000 children will be living in poverty, and an extra 1.5 million working age adults could slip into poverty. This therefore could lead to a worsening of inequality in the UK, which has risen faster among the working-age population than in any other OECD country. 

The unemployed portion of the UK population has also experienced significant impacts of the austerity programme. Following the cuts in welfare and small increases in taxes, unemployed people have seen a 7% loss of income, worsening their chances of climbing out of unemployment. This could contribute to the growth of long-term unemployment, whilst failing to address the problem of youth unemployment in the UK. Therefore, the regressive impacts of the fiscal austerity programme are damaging to the UK economy in the long term, and can be seen as being counterproductive. The Oxfam case study concludes that “the UK’s current austerity programme threatens to solidify the UK’s position as a country of growing inequality and poverty.”

The UK government’s fiscal austerity programme may not have significantly contributed to and have had a restrictive effect on the UK economic performance on its way to recovery since the 2008-9 crisis. Professor John Van Reenen of the LSE argues that the figures for the UK economic performance over recent years  gives a distorted view of reality, as fast population growth (net immigration is triple the government’s 100,000 target) contributed significantly to the GDP growth rate of 2.7% in 2014, and in comparison with “historic trends, GDP per capita was nearly 16% lower in 2014- a loss of about £4,500”. Further to this UK productivity measured by GDP per hour is approximately 16% below the trend and 17% below the G7 average. 

John Van Reenen has labeled the UK’s performance as “the worst recovery this century” and argues that plans for continued austerity would decrease the budget deficit but would also sacrifice investment, growth and employment, thus further affecting the already weak economic performance. The government’s contractionary fiscal policy and accelerated austerity such as increased in VAT to 20% in 2011, £32 billion of spending cuts by 2015 and an enormous 40% real cut in public investment during 2010-12, could have restricted the prospects of economic growth, especially following a recession and contributed to the UK’s poor economic performance due to factors such as the lack of multipliers (a change in one of the opponents of aggregate demand can lead to a multiplied final change in the equilibrium level of GDP) from investment. 

The OBR estimated that approximately 2% of GDP was lost due to austerity policies by the government. The fiscal austerity programme is arguably acting as a dragging force on the UK economy’s road to recovery. Having said all this, many other factors outside of the state’s control have also contributed towards “the worst recovery this century”. The eurozone crisis has had a drag on the UK economy and the decline of productivity in sectors such as oil and finances has played a role in the UK’s economic performance. However, the fiscal austerity measures undoubtedly forms a part of the reasons behind the poor performance.

Fiscal conservatives argue that a deficit reduction and balancing of budgets through a fiscal austerity programme will help maintain the UK’s international credit rating as well as improving confidence among domestic and foreign investors, encouraging an inflow of capital which could result in an increase in aggregate demand and aggregate supply (economic growth). The maintenance of a good credit rating should lower interest rates on bonds and this is shown by the fact that the yield on the UK government bond is 2%. The yield on a bond is calculated by coupon(annual interest)/market price x 100%. However, following the UK credit rating downgrade in 2013, the government was called to “ease the pace” of austerity. The UK still has a triple A rating from Standard & Poor, and a AA+ rating from Fitch, but in 2013 the UK lost Moody’s rating of AAA and was downgraded to AA1 due to the “continuing weakness in the UK’s medium-term growth outlook” according to Moody. Tristan Cooper, sovereign debt analyst at Fidelity Worldwide Investment stated that “now that the UK’s triple-A rating has been lost, it probably makes sense for the Chancellor to ease the pace of fiscal consolidation”. This shows that although fiscal austerity has not significantly harmed the UK’s credit rating or confidence among investors, its contractionary and restrictive nature could be a cause for concern. 

The concerns for the UK government’s fiscal austerity programme seems to be justifiable in numerous cases, as cutting the budget deficit does seem to be coming at a significant cost to other aspects of the UK economy. An alternative, and perhaps less harmful approach to cutting government spending to reduce the budget deficit may be to cut middle-class benefits to fund infrastructure spending in the UK. According to the Social Market Foundation (SMF), welfare and benefits for the relatively better-off families should be reduced and reinvested infrastructure projects. It estimates that £15 billion could be raised by cutting free bus passes and television licences for better-off pensioners, halving higher-rate pension tax relief (reduction in the amount of pension tax owed by an individual) and removing child benefits for the top 50% of income earners. This could lead to a significant cut in public spending and it would go towards a more expansionary policy. However, according to The Guardian, this alternative is unlikely to be taken up by a Conservative government, “as they will not want to cut pension tax relief for a core segment of their voters.” Another alternative to fiscal austerity, offered by Keynesians, is counter-cyclical fiscal policy. This means going against the economic cycle and during a recession, the government should send and borrow more to stimulate economic growth. This suggests that running a budget deficit is not very damaging to the economy and is better than paying the costs of correcting it through a fiscal austerity programme. Furthermore, Keynesians argue that running a budget deficit and borrowing more to stimulate growth could be partly self-financing. For example, when increased borrowing leads to an increase in incomes and tax revenues for the government. 

This approach is to allow economic growth through fiscal stimulus to bring the deficit down gradually through higher tax revenues and lower spending on benefits as the economy grows. Increased in spending especially on infrastructure projects, made possible by a rise in borrowing, could result in fiscal multipliers in the long run, as well as increases in the productive capacity of the economy. However, the Economist argues that “since [infrastructure] projects take time and money to construct, the argument for infrastructure spending having a positive impact on productivity in the short-term is difficult to quantify.” Therefore it could be said that running a budget deficit and borrowing more is likely to benefit the economy in the long run.

Overall, although the UK government’s fiscal austerity programme following the economic crisis of 2008-9 has significantly reduced the budget deficit, it has come at a significant cost and damage to other aspects of the economy, which could have long term implications. The austerity programme cannot be written off and branded as being completely damaging and useless, but an easing of or simply less austerity may be more effective in reducing the deficit without having serious implications for the economic performance. 

This reflects the views of economists such as Jonathan Portes, the director of the National Institute of Economic and Social Research and Ed Balls who blamed the economic performance since 2010 on the severe fiscal austerity programme. Jonathan Portes stated that “Fiscal consolidation has slowed, at least for the time being, and as a consequence it is playing a considerably smaller role in driving economic developments than it did two years ago”. A looser austerity measure may enable the government to rebalance the UK economy without doing further damage to the UK economy, and alternative measures that could work in tandem with a less severe austerity programme should also be considered.