In a recession, the government’s budget will go into cyclical deficit as tax revenue falls and government spending on unemployment and other benefits rises. Provided the deficit is purely cyclical, it can be seen as desirable since it acts as an automatic fiscal stabiliser, boosting aggregate demand and helping to pull the economy out of recession. Once the economy returns to potential national income (i.e. a zero output gap), the deficit would disappear. At potential national income (Yp), government expenditure (including benefits) will equal tax revenue. The budget is in balance.
Again, provided that the deficit is only cyclical, discretionary expansionary fiscal policy that further deepens the deficit will not be a problem for public finances in the future. Once the economy pulls out of recession, the discretionary policy can be relaxed and the higher national income will eliminate the cyclical deficit.
But the problem the Chancellor of the Exchequer faced in the Budget (on 22/4/09) was not just one of tackling the recession. The UK economy has seen a massive growth in the structural deficit. His forecast is for the total deficit to be £175bn in 2009. But, according to calculations by the Institute for Fiscal Studies, even when the recession is over and the output gap has been closed, there will still be an annual deficit of around £140bn. This is not cyclical; it’s structural.
So why is there this huge structural deficit? And what is the solution? Will the solution slow down recovery? The following articles look at the issues.
Budget 2009: Tightening the Squeeze? Institute for Fiscal Studies (23/4/09)
We should start by admitting we’ve failed as an economy: Hamish McRae Independent (22/4/09)
Budget 2009: Experts cast long shadow over Darling’s sunny outlook Guardian (23/4/09)
Budget 2009: Economist warns of spending cuts and tax rises Guardian (23/4/09)
The chancellor’s Budget dilemma: Stephanie Flanders BBC News (23/4/09)
For a global perspective on structural deficits, see:
Why the ‘green shoots’ of recovery could yet wither Financial Times (22/4/09)
Outlines of the main Budget measures can be found at:
Budget 2009: Need to know Times Online (23/4/09)
At-a-glance: Budget 2009 BBC News (22/4/09)
Full details for the Budget can be found from the Treasury’s Budget site
Questions
- Explain the terms ‘cyclical deficit’ and ‘structural deficit’.
- Draw a diagram showing how government expenditure (including benefits) and tax revenue vary with national income. The diagram should show the sitation with no structural deficit: i.e. the two lines should cross at potential national income. Illustrate (a) a cyclical deficit where actual national income is below potential national income (a negative output gap) and (b) a cyclical surplus where actual national income is above potential income (a positive output gap).
- Now, on the same diagram, shift the two lines to illustrate a situation of structural deficit.
- Consider whether the government should attempt to increase or reduce the budget deficit at a time of recession.
- Why has the structural deficit become so severe over the past year?
- How quickly should the government set about tackling the structural deficit?
On 7 April, Brian Lenihan, Ireland’s Finance Minister, introduced an emergency Budget. He forecast that Irish real GDP would decline by some 8 per cent in 2009, that consumer prices would fall by 4 per cent (i.e. substantial negative inflation) and that unemployment, already at 11 per cent, would rise further. So what was his solution? Was it a massive fiscal stimulus to boost aggregate demand and turn the economy around? No: it was precisely the opposite. He announced substantial tax increases and cuts in government expenditure? Was this economic madness, or was there economic sense in the measures? The following articles explore the arguments.
Ireland’s shock therapy has got its merits Independent (9/4/09)
Ireland Faces ‘Challenge of Its Life’ BusinessWeek (8/4/09)
Few crumbs of comfort as incomes take severe hammering Irishtimes.com (10/4/09)
Republic’s Budget cuts ‘for the common good’ Belfast Telegraph (8/4/09)
Ireland unveils budget ‘challenge’ Financial Times (8/4/09)
Ireland unveils emergency budget BBC News (7/4/09)
When fiscal stimulus isn’t stimulating: Stephanie Flanders blog BBC News (7/4/09)
Ireland imposes emergency cuts Telegraph (8/4/09)
Questions
- Consider the arguments for and against the fiscal tightening measures adopted by the Irish government.
- Should the UK government also adopt a tighter fiscal stance?
- How important is investor confidence in determining the success of a Budget?
Every six months the OECD publishes its Economic Outlook. This gives annual (and some quarterly) macroeconomic data for each of the 30 OECD countries, for all 30 countries together and for the eurozone. There are 63 tables covering most of the major macroeconomic indicators, most going back 13 years with forecasts for the next two years. OECD Economic Outlook is normally published in June and December.
Similarly, every six months the European Commission’s Economic and Financial Affairs Directorate publishes its European Economy Statistical Annex. This gives annual data for 76 macroeconomic variables for each of the EU countries, plus the USA and Japan. Most of the tables go back to 1970 and forecast ahead for two years. There is also a separate publication, Economic Forecasts. The statistical appendix to this publication has 62 tables, again covering a range of macroeconomic data. The tables go back to 1992 and again forecast ahead for two years. There is a lot of useful commentary about the individual economies of the EU and other major economies, such as the USA, Japan, China and Russia. Both publications normally appear in May and November.
Another organisation to publish 6-monthly forecasts is the International Monetary Fund. The Statistical Appendix of the Word Economic Outlook (after clicking on this, go to link on right), normally published in April and October, gives macroeconomic data for most economies and regions of the world. Forecasts are made ahead for two years and for five years.
The state of the world economy was so severe in early 2009 and was deteriorating so rapidly that earlier forecasts proved far too optimistic. In early 2009, all three organisations published interim forecasts – the European Commission and the IMF in January and the OECD at the end of March. They painted a much bleaker picture than the forecasts published at the end of 2008. What will the next set of forecasts look like? Will they be even bleaker?
The following links take you to these interim forecasts and to articles commenting on them.
EU interim forecasts for 2009–2010: sharp downturn in growth European Commission, Directorate-General for Economic and Financial Affairs (19/1/09)
World Economic Outlook Update IMF (28/1/09)
OECD Interim Economic Outlook, March 2009 OECD (31/3/09)
Global economy set for worst fall since WWII Times Online (31/3/09)
UK economy: We still need to take our medicine Times Online (1/4/09)
OECD predicts 4.3% contraction in richest economies this year Irish Times (1/4/09)
Global Slump Seen Deepening The Wall Street Journal (1/4/09)
Glimmers of hope, forecasts of gloom The Economist (2/4/09)
Questions
- Compare the forecasts for GDP growth, unemployment, inflation and output gaps for some of the major economies made by the OECD at the end of March with those made by the European Commission and the IMF in January and with those made by all three organisations in the autumn of 2008. Why, do you think, are there such large divergences in the forecasts?
- For what reasons might the OECD March forecasts turn out to be (a) much too pessimistic; (b) much too optimistic?
- In the light of the forecasts, should countries adopt further strongly expansionary fiscal policies – something rejected at the G20 summit in Early April (see news item Saving the world)?
The G20 countries meet each year. Normally their meetings are full of fine words resulting in little action. But at a summit in London on 2 April 2009, the fear of a deepening global recession focused minds and a package of measures worth over $1 trillion was agreed to stimulate trade and growth. This included $750 billion for the IMF to help economies in severe difficulties, $250 billion for financing world trade and $100 to multilateral development banks (such as the Asian Development Bank) to provide extra aid to the poorest countries.
The extra money for the IMF would include $500 billion of loans from member countries and £250 billion in new money – a form of international quantitative easing. This new money would be in the form of ‘special drawing rights’. These are denominated in dollars and are created by the IMF to be drawn on by countries in difficulties.
There was also agreement to tighten financial regulation and to resist protectionism. A ‘Financial Stability Board’ would be set up and work with the IMF to design a strengthened regulatory system for banks and other financial institutions and for financial markets and instruments.
The following articles look at the agreement and its likely effects.
‘This is the day the world came together to fight back’ Independent (2/4/09)
G20 communiqué: Point by point analysis Telegraph (2/4/09)
G20 summit – leaders’ statement. Full text of the communiqué Guardian (2/4/09)
G20: Economic summit snapshot BBC News Online (2/4/09)
G20 leaders seal $1tn global deal BBC News Online (2/4/09)
G-force The Economist (2/4/09)
World leaders declare war on risk Sydney Morning Herald (3/4/09)
Postscript (Sept 2009)
G20: What progress has been made? BBC News (23/9/09)
G20: Pledge by pledge BBC News (25/9/09)
Questions
- What will determine the success or failure of the G20 agreement to revive the world economy?
- Identify any multiplier effects from the agreed measures.
- Why did the French and German governments object to any further fiscal stimulus packages?
The term hyperinflation is almost an understatement when it comes to describing the level of inflation in Zimbabwe. In July 2008, inflation was estimated to be 231 million per cent. In January 2009, two estimates were made: one of 5 sextillion per cent (5 and 21 zeros); the other of 6.5 quindecillion novemdecillion per cent (65 and 107 zeros). These figures are simply mind-boggling for most people living in low-inflation economies.
Commentators say that prices can double in a single day and this can render banknotes useless very quickly. In fact, local banknotes are scarcely used as people turn to overseas currencies that offer more stability. Recognising this, in late January 2009 the government officially allowed foreign currencies to be used in Zimbabwe as well as the Zimbabwe dollar.
In an attempt to stabilise the currency the Zimbabwean central bank on more than one occasion has tried dropping several zeros from the currency. But this has had little effect and in January 2009 a new series of banknotes was issued, including a Z$100 trillion note. This is unlikely to be the last issue though, but what comes after a trillion?
Zimbabwe rolls out Z$100tr note BBC News Online (16/1/09)
ZIMBABWE: Inflation at 6.5 quindecillion novemdecillion percent IRIN News (United Nations) (21/1/09)
Questions
- Define the term hyperinflation.
- Analyse the main causes of hyperinflation.
- Discuss policies that the Zimbabwean government could adopt to try to reduce the level of inflation in the economy.
- Assess the impact of hyperinflation on the other major macro-economic targets.
- Research another instance of hyperinflation and write a brief summary of the cause(s) and the solution(s). You may find the Wikipedia entry on hyperinflation a good starting point.