Category: Economics 10e: Ch 21

In a little over a decade economies around the world have experienced two ‘once-in-a-lifetime’ shocks. First, there was the global financial crisis of the late 2000s, which saw an unsustainable expansion of banks’ balance sheets that resulted in a global economic slowdown. Now in 2020, a global health emergency has meant unprecedented falls in economic activity. In both cases, the public sector has been the economy’s shock absorber but this has had dramatic effects on its financial wellbeing. We consider here the effect on the UK public finances and reflect on their sustainability in light of the recent Fiscal Sustainability Report published by the Office of Budget Responsibility (OBR).

The COVID-19 pandemic saw the government initiate a range of fiscal interventions to support people and businesses. Interventions directly affecting public-sector spending included a series of employment support measures. These included the Coronavirus Job Retention Scheme, commonly referred to as the furlough scheme, the Self-employed Income Support scheme, a ‘Kickstart Scheme’ of work placements for universal credit recipients aged between 16 and 24 and a ‘Job Retention Bonus’ whereby employers can receive a one-off payment of £1,000 for every furloughed employee continuously employed from the cessation of the Job Retention Scheme on 31 October through to 31 January 2021.

Further spending interventions have included small business grant schemes, such as the Coronavirus Small Business Grant Fund, the coronavirus Retail, Hospitality and Leisure Grant Fund and the Coronavirus Local Authority Discretionary Grants Fund.

Meanwhile, taxation relief measures have included a business rates holiday for retail, hospitality and leisure businesses and a reduced rate of VAT of 5 per cent for hospitality, accommodation and attractions until 12 January 2021.

OBR’s central scenario

The OBR in its Fiscal Stability Report in July 2020 attempts to assess the wellbeing of the public finances not just in the short term but in the medium and longer term too. This longer-term perspective allows it to assess the sustainability of the public finances.

Its analysis is based on some key assumptions, including population growth and future demands on public services, but, understandably, the timing of this report has necessitated some key assumptions around path of the economy, including the extent to which the economy will experience scarring effects, also known as hysteresis effects. While the analysis does not incorporate the Chancellor’s measures announced in its summer statement on the 8 July, including the kickstart scheme, job retention bonus and the reduced rate of VAT, which would have a material effect on this year’s numbers, the OBR concludes that there would be less significant impact on its medium-term analysis.

In what it describes as its ‘central scenario’ the OBR forecasts that national output (real GDP) will fall by 12 per cent in 2020 before growing by 9 per cent in 2021 and 4 per cent in 2022. National output therefore reaches its pre-virus peak at the end of 2022. However, 20 quarters on from the pandemic shock in Q1 2020 output is estimated to be 3.2 per cent less than it would otherwise have been, while the cumulative loss of output is expected to be 6.4 per cent over the period. The cumulative loss of output in the 20 quarters following the financial crisis (Q2 2008) is estimated to have been 9.3 per cent of actual cumulative output.

While national output is expected to be permanently lower because of the pandemic, consistent with hysteresis, the forecast assumes that the longer-term growth rate is unaffected. In other words, there is not expected to be what some now refer to as ‘super hysteresis’, whereby the scarring effects have persistent effects on rates of capital accumulation, innovation and productivity, which therefore depress structural economic growth rates.

Meanwhile, the unemployment rate is expected to peak at 11.9 per cent in the final quarter of this year, before falling to 8.8 per cent in Q4 2021 and 6.3 per cent in Q4 2022. By Q4 2025 the unemployment rate is forecast to be 5.1 per cent, one percentage point higher than the OBR was forecasting at the time of the Budget in March.

Spending and receipts

Chart 1 shows shows the predicted paths of (nominal) public-sector receipts and expenditures as a percentage of (nominal) GDP. Receipts are expected come in at £740 billion this financial year (excluding the impact of the summer statement measures), some £133 billion lower than was forecast at the time of the March budget. This will amount to a 10 per cent fall in receipts in the financial year, driven by a much-shrunken economy. However, the fact that nominal GDP falls somewhat more means that the receipts-to-GDP ratio ticks up slightly. (Click here for a PowerPoint of the chart.)

Public-sector spending is expected to be higher in 2020/21 than was forecast in the March by £135 million (excluding the summer statement measures) reflecting the COVID-19 interventions. This would result in spending rising to £1.06 trillion, a 20 per cent rise in the financial year. It would also mean that public-sector spending as a share of GDP rises to 54 per cent – its highest since 1945/46.

Going forward, in cash terms receipts are permanently lower than forecast because GDP is lower, though as a share of GDP cash receipts increase very slightly, but remain below what was expected at the time of the March budget. Spending in cash terms is expected to fall back by close to 8 per cent next financial year before increasing by 3 per cent per year up to 2024/25. This means that the spending-to-GDP ratio falls back to around 43 per cent by 2024/25, a couple of percentage points higher than was forecast back in March.

Deficits and debt

The difference between spending and receipts is known as public-sector net borrowing. While the extent of borrowing can be inferred by inspection of Chart 1, it can be seen more readily in Chart 2 which plots the path of public-sector net borrowing as a share of GDP.

The OBR is now forecasting a budget deficit of £322 billion (excluding the summer statement measures) in 2020/21 compared to £55 billion at the time of the March Budget. This would be equivalent to over 16 per cent of GDP, the highest since the Second World War. In a follow-up presentation on the Fiscal Stability Report on the 14 July the OBR suggested that the inclusion of summer statement measures could mean the deficit being as high as £375 billion, implying a deficit-to-GDP ratio of just shy of 19 per cent. (Click here for a PowerPoint of the chart.)

Deficits represent borrowing and are therefore a flow concept. The accumulated deficits over the years (minus any surpluses) gives total debt, which is a stock concept. The public-sector’s net debt is its gross debt less its liquid assets, principally deposits held with financial institutions and holdings of international reserves. This is also affected by Bank of England interventions, such as the Term Funding Scheme which enables banks and building societies to borrow funds at close to Bank Rate for up to four years. Nonetheless, the key driver of net debt-to-GDP ratio going forward is the persistence of deficits.

Chart 3 shows the expected path of the net debt-to-GDP ratio. The OBR expects this to exceed 100 per cent in 2020/21 for the first time since 1960/61. This reflects an increase in cash terms of the stock of net debt to £2.2 trillion, up from £1.8 trillion at the end of 2019/20, as well as a fall in GDP. By 2024/25 the net debt stock is expected to have risen to £2.6 trillion, £600 billion more than expected at the time of the March budget, with the net debt-to-GDP ratio still above 100 per cent at 102.1 per cent. (Click herefor a PowerPoint of the chart.)


The higher debt-to-GDP ratio raises longer-term questions about the sustainability of the public finances. The government is currently reviewing its fiscal rules and is expected to report back in time for the autumn budget. A key question is what debt-stabilising level might be considered appropriate. Is it the 102 per cent that the OBR is predicting at the end of 2024/25 (the medium-term horizon)? Or is it the 75 per cent that was being forecast for this point back in the March budget? This has profound implications for the fiscal arithmetic and, specifically, for the primary balance (the difference between non-interest spending and receipts) that the public sector needs to run.

If the government accepts a higher debt-to-GDP ratio as a ‘new norm’ that eases the fiscal arithmetic somewhat. However, some economists would be concerned about the economic consequences of larger public-sector debts, most notably so-called potential crowding-out effects on private-sector investment if upward pressure on interest rates was to materialise (see the news item MMT – a Magic Money Tree or Modern Monetary Theory?).

Even if the higher stabilising debt level was deemed appropriate, the OBR’s report analysis suggests problems in the government meeting this because it could still be running a primary deficit of 3.7 per cent of GDP by 2024/25. Therefore, even with interest rates expected to be lower than economic growth rates in 2024/25 (a negative growth-corrected interest rate) that enable governments to run primary deficits and yet maintain debt-to-GDP ratios, the debt-stabilising primary deficit for 2024/25 is estimated at only 3.2 per cent. All in all, this points to difficult fiscal choices ahead.



  1. What do you understand by the term financial wellbeing? What might this mean in respect of the government?
  2. What is meant by the fiscal arithmetic of government debt? Explain the factors that determine the fiscal arithmetic and the path of government debt?
  3. What is the difference between an increase in the size of a government deficit and an increase in the stock of government debt?
  4. Discuss the economic argument that, following the COVID-19 pandemic, government should avoid a return to an agenda of fiscal austerity ?
  5. What is the difference between the budget deficit, the primary deficit and the structural deficit?
  6. What are hysteresis effects? Discuss their relevancy in the design of the UK’s COVID-19 interventions.

Is there a ‘magic money tree’? Is it desirable for central banks to create money to finance government deficits?

The standard thinking of conservative governments around the world is that creating money to finance deficits will be inflationary. Rather, governments should attempt to reduce deficits. This will reduce the problem of government expenditure crowding out private expenditure and reduce the burden placed on future generations of having to finance higher government debt.

If deficits rise because of government response to an emergency, such as supporting people and businesses during the Covid-19 pandemic, then, as soon as the problem begins to wane, governments should attempt to reduce the higher deficits by raising taxes or cutting government expenditure. This was the approach of many governments, including the Coalition and Conservative governments in the UK from 2010, as econommies began to recover from the 2007/8 financial crisis.

Modern Monetary Theory‘ challenges these arguments. Advocates of the theory support the use of higher deficits financed by monetary expansion if the money is spent on things that increase potential output as well as actual output. Examples include spending on R&D, education, infrastructure, health and housing.

Modern monetary theorists still accept that excess demand will lead to inflation. Governments should therefore avoid excessive deficits and central banks should avoid creating excessive amounts of money. But, they argue that inflation caused by excess demand has not been a problem for many years in most countries. Instead, we have a problem of too little investment and too little spending generally. There is plenty of scope, they maintain, for expanding demand. This, if carefully directed, can lead to productivity growth and an expansion of aggregate supply to match the rise in aggregate demand.

Government deficits, they argue, are not intrinsically bad. Government debt is someone else’s assets, whether in the form of government bonds, savings certificates, Treasury bills or other instruments. Provided the debt can be serviced at low interest rates, there is no problem for the government and the spending it generates can be managed to allow economies to function at near full capacity.

The following videos and articles look at modern monetary theory and assess its relevance. Not surprisingly, they differ in their support of the theory!




  1. Compare traditional Keynesian economics and modern monetary theory.
  2. Using the equation of exchange, MV = PY, what would a modern monetary theorist say about the effect of an expansion of M on the other variables?
  3. What is the role of fiscal policy in modern monetary theory?
  4. What evidence might suggest that money supply has been unduly restricted?
  5. When, according to modern monetary theory, is a rising government deficit (a) not a problem; (b) a problem?
  6. Is there any truth in the saying, ‘There’s no such thing as a magic money tree’?
  7. Provide a critique of modern monetary theory.

Boris Johnson gave a speech on 30 June outlining his government’s approach to recovery from the sharpest recession on record. With the slogan ‘Build, build, build’, he said that infrastructure projects were the key to stimulating the economy. Infrastructure spending is a classic Keynesian response to recession as it stimulates aggregate demand allowing slack to be taken up, while also boosting aggregate supply, thereby allowing recovery in output while increasing potential national income.

A new ‘New deal’

He likened his approach to that of President Franklin D Roosevelt’s New Deal. This was a huge stimulus between 1933 and 1939 in an attempt to lift the US economy out of the Great Depression. There was a massive programme of government spending on construction projects, such as hospitals, schools, roads, bridges and dams, including the Hoover Dam and completing the 113-mile Overseas Highway connecting mainland Florida to the Florida Keys. Altogether, there were 34 599 projects, many large-scale. In addition, support was provided for people on low incomes, the unemployed, the elderly and farmers. Money supply was expanded, made possible by leaving the Gold Standard in 1934.

There was some debate as to whether the New Deal could be classed as ‘Keynesian’. Officially, the administration was concerned to achieve a balanced budget. However, it had a separate ’emergency budget’, from which New Deal spending was financed. According to estimates by the Federal Reserve Bank of St Louis, the total extra spending amounted to nearly 40% of US GDP as it was in 1929.

By comparison with the New Deal, the proposals of the Johnson government are extremely modest. Mostly it amounts to bringing forward spending already committed. The total of £5 billion is just 0.2% of current UK GDP.

Focusing on jobs

A recent report published by the Resolution Foundation, titled ‘The Full Monty‘, argues that as the Job Retention Scheme, under which people have been furloughed on 80% pay, is withdrawn, so unemployment is set to rise dramatically. The claimant count has already risen from 1.2m to 2.8m between March and May with the furlough scheme in place.

Policy should thus focus on job creation, especially in those sectors likely to experience the largest rise in unemployment. Such sectors include non-food retail, hospitality (pubs, restaurants, hotels, etc.), public transport, the arts, entertainment and leisure and a range of industries servicing these sectors. What is more, many of the people working in these sectors are young and low paid. Many will find it difficult to move to jobs elsewhere – partly because of a lack of qualifications and partly because of a lack of alternative jobs. The rising unemployment will raise inequality.

The Resolution Foundation report argues that policy should be focused specifically on job creation.

Policy makers should act now to minimise outflows from the hard-hit sectors – a wage subsidy scheme or a National Insurance cut in those sectors would reduce labour costs and discourage redundancies. Alongside this, the Government must pursue radical action to create jobs across the country, such as in social care and housing retrofitting, and ramp up support for the unemployed.

Dealing with hyteresis

The economy is set to recover somewhat as the lockdown is eased, but it is not expected to return to the situation before the pandemic. Many jobs will be lost permanently unless government support continues.

Even then, many firms will have closed and others will have reassessed how many workers they need to employ and whether less labour-intensive methods would be more profitable. They may take the opportunity to consider whether technology, such as AI, can replace labour; or they may prefer to employ cheap telecommuters from India or the Philippines rather than workers coming into the office.

Policies to stimulate recovery will need to take these hysteresis effects into account if unemployment is to fall back to pre-Covid rates.





  1. What are the arguments for and against substantial increased government expenditure on infrastructure projects?
  2. Should the UK government spend more or less on such projects than the amount already pledged? Justify your answer.
  3. What are the arguments for and against directing all extra government expenditure towards green projects?
  4. Look through the Resolution Foundation report and summarise the findings of each of its sections.
  5. What are the arguments for and against directing all extra government expenditure towards those sectors where there is the highest rate of job losses?
  6. What form could policies to protect employment take?
  7. How should the success of policies to generate employment be measured?
  8. What form does hysteresis play on the post-Covid-19 labour market? What four shocks mean that employment will not simply return to the pre-Covid situation?

With promises by the newly elected Conservative government to increase investment expenditure on health, education, innovation and infrastructure, it was expected that Rishi Sunak’s first Budget would be strongly expansionary. In fact, it turned out to be two Budgets in one – both giving a massive fiscal boost.

An emergency Budget

The first part of the Budget was a short-term emergency response to the explosive spread of the coronavirus. An extra £12 billion is to be spent on the NHS and other public services. Whether this will be anything like enough to cope with the effects of the pandemic as businesses fail and people lose their jobs remains to be seen. (See the blog A global supply-side shock: the impact of the coronavirus (COVID-19) outbreak.)

A key issue is just how quickly the money can be spent. How quickly can you train health professionals or produce more ventilators or provide extra hospital beds?

This emergency part of the Budget was co-ordinated with the Bank of England’s decision to cut Bank Rate from 0.75% to 0.25%.

This combined fiscal and monetary response to the crisis was further enhanced by the agreement of central banks on 15 March to boost world liquidity by increasing the supply of US dollars through large-scale quantitative easing. The US central bank, the Federal Reserve, also cut its main federal funds rate by one percentage point from 1–1.25% to 0–0.25%.

The planned Budget

The second part of the Budget is to raise government investment by 9% in real terms over the next four years, bringing overall government expenditure to 41% of GDP, financed largely by extra borrowing. As the IFS observes, “That is above its pre-crisis level and bigger than at any point between the mid 1980s and the start of the financial crisis.”

But despite this rise in the proportion of government spending to GDP, in other respects the spending plans are less expansionary than they may appear. Increases in current spending on health, education and defence had already been promised. This leaves other departments, such as social security, facing cuts, or at least no increase. And when compared with 2010/11 levels, if you exclude health, government current spending per head of the population will around 14% lower, or 19% lower once you account for spending that replaces EU funding.

The Chancellor’s hope is that, by focusing on investment, there will be a supply-side effect as well as a demand-side boost. If increases in aggregate demand are balanced by increases in aggregate supply, such a policy would not be inflationary in the long run. But in the light of the considerable uncertainty of the effects of the coronavirus, the plans may well require significant adjustment in the Autumn Budget – or earlier.


Podcasts and Videos

Official documentation


  1. To what extent is this Budget ‘Keynesian’?
  2. Is the extra government expenditure likely to crowd out private expenditure? Explain.
  3. Demonstrate the desired long-term economic effect of the infrastructure policy using either an AD/AS diagram or a DAD/DAS diagram.
  4. How is the coronavirus pandemic likely to affect potential GDP in (a) the short run (b) the long run?
  5. Why is public-sector debt likely to soar over the next four years while annual government debt interest payments are likely to continue their gentle decline?
  6. What is missing from the Budget that you feel ought to have been included? Explain why.

The global economic impact of the coronavirus outbreak is uncertain but potentially very large. There has already been a massive effect on China, with large parts of the Chinese economy shut down. As the disease spreads to other countries, they too will experience supply shocks as schools and workplaces close down and travel restrictions are imposed. This has already happened in South Korea, Japan and Italy. The size of these effects is still unknown and will depend on the effectiveness of the containment measures that countries are putting in place and on the behaviour of people in self isolating if they have any symptoms or even possible exposure.

The OECD in its March 2020 interim Economic Assessment: Coronavirus: The world economy at risk estimates that global economic growth will be around half a percentage point lower than previously forecast – down from 2.9% to 2.4%. But this is based on the assumption that ‘the epidemic peaks in China in the first quarter of 2020 and outbreaks in other countries prove mild and contained.’ If the disease develops into a pandemic, as many health officials are predicting, the global economic effect could be much larger. In such cases, the OECD predicts a halving of global economic growth to 1.5%. But even this may be overoptimistic, with growing talk of a global recession.

Governments and central banks around the world are already planning measures to boost aggregate demand. The Federal Reserve, as an emergency measure on 3 March, reduced the Federal Funds rate by half a percentage point from the range of 1.5–1.75% to 1.0–1.25%. This was the first emergency rate cut since 2008.

Economic uncertainty

With considerable uncertainty about the spread of the disease and how effective containment measures will be, stock markets have fallen dramatically. The FTSE 100 fell by nearly 14% in the second half of February, before recovering slightly at the beginning of March. It then fell by a further 7.7% on 9 March – the biggest one-day fall since the 2008 financial crisis. This was specifically in response to a plunge in oil prices as Russia and Saudi Arabia engaged in a price war. But it also reflected growing pessimism about the economic impact of the coronavirus as the global spread of the epidemic accelerated and countries were contemplating more draconian lock-down measures.

Firms have been drawing up contingency plans to respond to panic buying of essential items and falling demand for other goods. Supply-chain managers are working out how to respond to these changes and to disruptions to supplies from China and other affected countries.

Firms are also having to plan for disruptions to labour supply. Large numbers of employees may fall sick or be advised/required to stay at home. Or they may have to stay at home to look after children whose schools are closed. For some firms, having their staff working from home will be easy; for others it will be impossible.

Some industries will be particularly badly hit, such as airlines, cruise lines and travel companies. Budget airlines have cancelled several flights and travel companies are beginning to offer substantial discounts. Manufacturing firms which are dependent on supplies from affected countries have also been badly hit. This is reflected in their share prices, which have seen large falls.

Longer-term effects

Uncertainty could have longer-term impacts on aggregate supply if firms decide to put investment on hold. This would also impact on the capital goods industries which supply machinery and equipment to investing firms. For the UK, already having suffered from Brexit uncertainty, this further uncertainty could prove very damaging for economic growth.

While aggregate supply is likely to fall, or at least to grow less quickly, what will happen to the balance of aggregate demand and supply is less clear. A temporary rise in demand, as people stock up, could see a surge in prices, unless supermarkets and other firms are keen to demonstrate that they are not profiting from the disease. In the longer term, if aggregate demand continues to grow at past rates, it will probably outstrip the growth in aggregate supply and result in rising inflation. If, however, demand is subdued, as uncertainty about their own economic situation leads people to cut back on spending, inflation and even the price level may fall.

How quickly the global economy will ‘bounce back’ depends on how long the outbreak lasts and whether it becomes a serious pandemic and on how much investment has been affected. At the current time, it is impossible to predict with any accuracy the timing and scale of any such bounce back.




  1. Using a supply and demand diagram, illustrate the fall in stock market prices caused by concerns over the effects of the coronavirus.
  2. Using either (i) an aggregate demand and supply diagram or (ii) a DAD/DAS diagram, illustrate how a fall in aggregate supply as a result of the economic effects of the coronavirus would lead to (a) a fall in real income and (i) a fall in the price level or (ii) a fall in inflation; (b) a fall in real income and (i) a rise in the price level or (ii) a rise in inflation.
  3. What would be the likely effects of central banks (a) cutting interest rates; (b) engaging in further quantitative easing?
  4. What would be the likely effects of governments running a larger budget deficit as a means of boosting the economy?
  5. Distinguish between stabilising and destabilising speculation. How would you characterise the speculation that has taken place on stock markets in response to the coronavirus?
  6. What are the implications of people being paid on zero-hour contracts of the government requiring workplaces to close?
  7. What long-term changes to working practices and government policy could result from short-term adjustments to the epidemic?
  8. Is the long-term macroeconomic impact of the coronavirus likely to be zero, as economies bounce back? Explain.