Labour’s Chancellor, Alistair Darling, delivered his last budget on the 24th March 2010. However, with the new Coalition government planning to make more substantial cuts and with George Osborne and other ministers claiming to find ‘black holes’ in the budgets left by Labour, an emergency budget will take place on the 22nd June 2010. The Coalition government has agreed to make £6 billion of spending cuts in the current year in a bid to reduce the UK’s substantial budget deficit, which stands at nearly 12% of GDP. Vince Cable told the Times:
I fear that a lot of bad news about the public finances has been hidden and stored up for the new government. The skeletons are starting to fall out of the cupboard.
There are plans to reform capital gains tax, possibly increase VAT to 20% and remove tax credits from some middle-income families. In Alistair Darling’s budget, it was middle-income families who were among the ‘losers’, with tax rises of around £19 billion, and it looks as though middle-income families may be hit again. Throughout the election all parties pledged to continue to help the poorest families, but there appears to be a lot of uncertainty ahead for middle-income families. They are likely to face reduced benefits and higher taxes as the Coalition government tackles the £163 billion deficit.
Despite critics of spending cuts arguing that it could cause a double-dip recession, the government is confident that cutting spending now is the right thing to do. As Osborne told GMTV:
I am pretty clear that the advice from the Governor of the Bank of England was that [cutting spending now] was a sensible thing to do, and if there is waste in Government that people at home are paying for with their taxes, let’s start tackling that now.
Chancellor launches audit of government spending Independent, Andrew Woodcock (17/5/10)
Osborne to give details of £6bn spending cuts next week (including video) BBC News (17/5/10)
Savings cuts to ‘hit middle class families’ BBC News (15/5/10)
Osborne to deliver emergency budget on June 22nd Times Online, Susan Thompson (17/5/10)
David Cameron declares war on public sector pay Telegraph, Rosa Prince (16/5/10)
All eyes on the emergency Budget Financial Times, Matthew Vincent (14/5/10)
Tax rises likely under Coaliation government, says Institute of Fiscal Studies Telegraph, Edmund Conway (13/5/10)
Questions
- What will be the likely impact on middle-income families if proposed spending cuts go ahead? How might this affect the recovery?
- What are the arguments for a) cutting spending now and b) cutting spending later?
- In the future, the Coalition government plans to limit bonus payments. How might this policy affect jobs and recruitment?
- What is the likely impact of the future increase in personal tax allowance? Who will it benefit the most?
- How are the proposals for corporation tax and capital gains tax likely to affect the economic recovery?
- Is a rise in VAT a good policy? Who will it affect the most? Will it reduce consumption and hence aggregate demand or is it likely simply to raise tax revenue? (Hint: Think about the type of tax that VAT is.)
The incoming coalition government in the UK has been spelling out its fiscal policy. It is sticking to the Conservative pledge of cutting £6bn from government spending this fiscal year (6 April 2010 to 5 April 2011). It hopes to make most of these by ‘efficiency savings’ – in other words, providing the same level of service for less money. It has, however, said that it will take advice from the Treasury and the Bank of England as to whether the cuts need to be delayed if the economy weakens substantially.
But the Bank of England is forecasting a continuation of the recovery (see its latest Inflation Report below), even assuming no further quantitative easing beyond the £200bn of assets purchased by the Bank. The Governor, Mervyn King, feels that the economy can indeed bear the proposed £6bn cut in government spending and that this will also send an important signal to the market that the government is committed to reducing the deficit.
The new government has also said that it will honour the Liberal Democrat pledge to raise the personal tax free allowance on income tax to £10,000. It has also backtracked somewhat on the Conservative pledge not to raise national insurance. Only employers will be spared the rise; employees will have to pay it.
So has there been a major change in fiscal policy? Has the focus moved from one of maintaining aggregate demand in order to avoid falling back into recession to one of making a start on tackling the deficit straight away? Or is the change in emphasis more one of presentation than substance? The following webcasts looks at the new fiscal policy emerging from number 11 and at the latest forecasts for growth and inflation.
Webcasts
What kind of medicine is the economy going to be fed? BBC Newsnight, Paul Mason (13/5/10)
Policy breakdown for Lib Dem-Conservative coalition BBC News, James Landale (12/5/10)
Savings cuts to ‘hit middle class families’ BBC News, Keith Doyle (15/5/10)
Inflation Report, May 2010 Bank of England (click on Watch Webcast) (12/5/10)
Documents and data
Coalition Agreement published (see here for text of agreement) Conservative Party (11/5/10)
Conservative – Liberal Democrat coalition negotiations agreements Liberal Democrats (11/5/10)
Inflation Report, May 2010 (portal) Bank of England, see in particular:
Articles
Department by department, what the new Government plans to do Independent (13/5/10)
VAT rise looms as coalition deal adds estimated £10bn to debt Guardian, Katie Allen and Julia Kollewe (13/5/10)
Some initial reaction to the Tory / Lib Dem coalition agreement Institute for Fiscal Studies Press Release, Robert Chote and Mike Brewery (12/5/10)
Tax rises likely under coalition government, says Institute for Fiscal Studies Telegraph, Edmund Conway (13/5/10)
Give and take BBC News blogs, Stephanomics, Stephanie Flanders (12/5/10)
Questions
- What ground has been given by (a) the Conservatives; (b) the Liberal Democrats in terms of their proposed economic policies (see Looking at the manifestos for details of their proposed policies).
- What will be the implications of a £6bn cut in government spending on aggregate demand? What other determinants of aggregate demand need to be taken into account in order to assess the likely growth in GDP over the coming months?
- What are the distributional consequences of (a) a rise in the personal income tax allowance to £10,000; (b) a rise in VAT?
- Has there been a major change in fiscal policy?
In the past few days, the euro has been under immense speculative pressure. The trigger for this has been the growing concern about whether Greece would be able to force through austerity measures and cut its huge deficit and debt. Also there has been the concern that much of Greece’s debt is in the form of relatively short-term bonds, many of which are coming up for maturity and thus have to be replaced by new bonds. For example, on 19 May, Greece needs to repay €8.5 billion of maturing bonds. But with Greek bonds having been given a ‘junk’ status by one of the three global rating agencies, Standard and Poor’s, Greece would find it difficult to raise the finance and would have to pay very high interest on bonds it did manage to sell – all of which would compound the problem of the deficit.
Also there have been deep concerns about a possible domino effect. If Greece’s debt is perceived to be unsustainable at 13.5% of GDP (in 2009), then speculators are likely to turn their attention to other countries in the eurozone with large deficits: countries such as Portugal (9.4%), Ireland (14.3%) and Spain (11.2%). With such worries, people were asking whether the euro would survive without massive international support, both from within and outside the eurozone. At the beginning of 2010, the euro was trading at $1.444. By 7 May, it was trading at $1.265, a depreciation of 12.4% (see the Bank of England’s Statistical Interactive Database – interest & exchange rates data
If the euro were in trouble, then shock waves would go around the world. Worries about such contagion have already been seen in plummeting stock markets. Between 16 April and 7 May, the FTSE100 index in London fell from 5834 to 5045 (a fall of 13.5%). In New York, the Dow Jones index fell by 8.6% over the same period and in Tokyo, the Nikkei fell by 7.6%. By 5 May, these declines were gathering pace as worries mounted.
Crisis talks took place over the weekend of the 8/9 May between European finance ministers and, to the surprise of many, a major package of measures was announced. This involves setting aside €750bn to support the eurozone. The package had two major elements: (a) €60bn from EU funds (to which all 27 EU countries contribute) to be used for loans to eurozone countries in trouble; (b) a European Financial Stabilisation Mechanism (a ‘Special Purpose Vehicle (SPV)’), which would be funded partly by eurozone countries which would provide €440bn and partly by the IMF which would provide a further €250bn. The SPV would be used to give loans or loan guarantees to eurozone countries, such as Greece, which were having difficulty in raising finance because of worries by investors. The effect would also be to support the euro through a return of confidence in the single currency.
In addition to these measures, the European Central Bank announced that it would embark on a ‘Securities Markets Programme’ involving the purchase of government bonds issued by eurozone countries in difficulties. According to the ECB, it would be used to:
.. conduct interventions in the euro area public and private debt securities markets to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism.
Does this amount to quantitative easing, as conducted by the US Federal Reserve Bank and the Bank of England? The intention is that it would not do so, as the ECB would remove liquidity from other areas of the market to balance the increased liquidity provided to countries in difficulties. This would be achived by selling securities of stronger eurozone countries, such as Germany and France.
In order to sterilise the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme. This will ensure that the monetary policy stance will not be affected.
So will the measures solve the problems? Or are they merely a means of buying time while the much tougher problem is addressed: that of getting deficits down?
Webcasts and podcasts
Rescue plan bolsters the euro BBC News, Gavin Hewitt (10/5/10)
The EU rescue plan explained Financial Times, Chris Giles, Emily Cadman, Helen Warrell and Steve Bernard (10/5/10)
Peston: ‘Crisis is not over’ BBC Today Programme (10/5/10)
Greece ‘will get into even more deep water’ BBC Today Programme (11/5/10)
Articles
EU ministers offer 750bn-euro plan to support currency (including video) BBC News (10/5/10)
EU sets up crisis fund to protect euro from market ‘wolves’ Independent, Vanessa Mock (10/5/10)
Euro strikes back with biggest gamble in its 11-year history Guardian, Ian Traynor (10/5/10)
Debt crisis: £645bn rescue package for euro reassures markets … for now Guardian, Ian Traynor (10/5/10)
The E.U.’s $950 Billion Rescue: Just the Beginning Time, Leo Cendrowicz (10/5/10)
Eurozone bail-out (portal) Financial Times
Bailout does not address Europe’s deep-rooted woes: Experts moneycontrol.com (11/5/10)
An ever-closer Union? BBC News blogs: Stephanomics, Stephanie Flanders (10/5/10)
Eurozone crisis is ‘postponed’ BBC News blogs: Peston’s Picks, Robert Peston (10/5/10)
Multi-billion euro rescue buys time but no solution BBC News, Lucy Hooker (11/5/10)
No going back The Economist (13/5/10)
It is not Greece that worries EURO: It is China that teeters on a collapse Investing Contrarian, Shaily (11/5/10)
Data and official sources
For deficit and debt data see sections 16.3 and 18.1 in:
Ameco Online European Commision, Economic and Financial Affairs DG
For the ECB statement see:
10 May 2010 – ECB decides on measures to address severe tensions in financial markets ECB Press Release
Questions
- Why should the measures announced by the European finance ministers help to support the euro in the short term?
- Why should the ECB’s Securities Markets Programme not result in quantitative easing?
- Explain what is meant by sterlisation in the context of open market operations.
- What will determine whether the measures are a long-term success?
- Explain why there may be a moral hazard in coming to the rescue of ailing economies in the eurozone. How might such a moral hazard be minimised?
- Why should concerns about Greece lead to stock market declines around the world?
- What is the significance of China in the current context?
The final debate between the three party leaders was mainly on the economy. A key issue under debate was how each party would cut the huge budget deficit and how households and businesses would be affected. Something that we may see in the future is a banking levy and possibly new powers given to the Bank of England to ‘ration credit in boom years’. Spending cuts and tax rises are inevitable, but there were differences between the parties as to the extent of these changes and when they are likely to occur. The articles below consider these important issues, as the election entered the final 72 hours.
The broadcast debate
Prime Ministerial Debate: The Economy BBC Election 2010
Articles and podcasts
Economic debate: Banks and a balanced economy BBC News, Peston’s Picks (29/4/10)
General Election 2010: a fact checker for the leaders’ debate on the economy Telegraph (29/4/10)
Tim Harford on the truth behind leaders’ claims BBC Today Programme (30/4/10)
Questions
- It is not unusual for countries to have a budget deficit, so why is the UK’s receiving so much attention in the election?
- What is the difference between retail and investment banking?
- What do you think David Cameron meant by giving the Bank of England power ‘to call time on debt in the economy’?
- What is the difference between the budget deficit and national debt?
- What are the arguments for and against cutting the budget deficit now, as the Conservatives want to do and cutting it in the next financial year, as Labour is suggesting?
Public finances aren’t in a great state – that’s no secret. However, what is remaining a secret is exactly how and when the main political parties intend to reduce the budget deficit. The UK’s credit-rating is under pressure and with the election approaching, we can expect government finances to come under increasing scrutiny. Whichever party forms the government will face the unenviable task of having to pull Britain out of a recession, while trying to reduce: 1) a forecast budget deficit for 2009/10 of £167 billion (about 13% of GDP), 2) a government debt of 68.6% of GDP, with 3) £73.8 billion alone going on interest payments and 4) a trade deficit of £8 billion. Who would be a politician?!
Phoney deficit wars BBC News, Stephanomics (26/3/10)
Questions
- What is the structural deficit?
- A fall in government spending may improve public finances, but why may it adversely affect the UK’s recovery?
- Outline the main proposals by the Labour, Conservative and Liberal Democrat Parties to tackle public finances. Are any of their proposals viable?
- Why is the UK’s credit-rating under pressure? If the UK is down-graded, what could this mean?