Austerity

Your opinion at the start - stage 1/6

In September 2008, the collapse of Lehman Brothers, along with the US sub-prime housing market, sparked the biggest financial crisis since the Great Depression. In the years since, governments have sought to deal with its consequences either by both expanding public spending to stimulate growth or by cutting expenditure to limit national deficits. Having experienced five years of cuts (with more to come), the British economy is growing, but took six years to fully recover from the crash. Is austerity in the public interest, or should the government adopt a different approach?

Read background

Research: Chris Underwood; editing: Perry Walker

Drag these using the hand symbol () so that they are in order, most preferred at the top

  • Increase government spending to grow the economy and boost aggregate demand.
  • Cut the deficit more slowly than the government plans, and make more use of tax increases rather than spending cuts.
  • Eliminate the deficit by 2018, cutting welfare spending while reducing tax levels and increasing the basic rate of pay.
  • Aim to collect much more of the tax owed by clamping down on tax evasion.

What might be the problems with running a deficit?

A government runs a deficit when - roughly speaking - what it spends is more than it receives in taxation. Supporters of austerity typically cite three main threats from a deficit: the cost of interest on the debt; the threat of higher taxation which will be required to cover excessive spending; and thirdly the impact on investors who will become concerned if they see a country’s debt continuously rising. The more concerned investors are, the less willing they will be to buy government bonds and the more the UK will have to offer in interest to obtain foreign capital. According to the Conservatives, this was a spiral Britain had become locked into because of borrowing under the Labour government that was in power up to 2010, and so public spending had to be drastically reduced in order to prevent our debt growing to a point where it would become unsustainable.

Is the debt to GDP ratio more important than the deficit? [Terms like 'GDP' are explained in the definitions section at the end of this background]

Many economists argue that what matters is not the size of a country’s debt or deficit, but its debt to GDP ratio. For instance, the United States has a national debt far higher than Greece’s, but this does not matter because the American economy is so much bigger, and its debt thus represents a much smaller percentage of the country’s income. According to this view, borrowing is not inherently bad even if a country’s debt is large in absolute terms, and there is no need for the government to always run a budget surplus. This is partly because the cost of money varies. When the crash hit in 2008, banks stopped lending and interest rates plummeted. Even now they remain exceedingly low, which means governments can borrow for much less than they could before the crash, and invest in the economy. This is important because whether the cost of a country’s debt increases or decreases depends on its relationship to the country’s GDP and the level of interest the country pays on its debts. Even if government borrowing increases the amount a nation owes, its real cost could still fall, so long as the country’s GDP grows by a greater proportion than its debt, or a fall in interest rates reduces the size of payments needed to service its borrowings.

However, an alternative school of thought (that which supports austerity) would claim that such an expansionary economic model renders a country vulnerable; interest rates can go up as well as down. Economists have also suggested that there is a tipping point, whereby once the debt to GDP ratio reaches a certain level (around 90%), government spending cannot generate sufficient economic growth to compensate for further increases in borrowing. Proponents of this view would claim that the economic impact of running a budget deficit is different for an economy with a low debt to GDP to ratio than a high debt to GDP level.

The position in Britain

Britain’s national debt currently stands at over £1.5trn, with its debt to GDP ratio estimated to be between 82% and 90%. In relative terms, this is significantly lower than other developed nations (Japan’s debt to GDP ratio is three times as large). It is also relatively modest by historic standards. In 2010, when the coalition embarked on their programme of fiscal consolidation, the amount the UK owed as a percentage of GDP had been higher for 200 of the previous 250 years. Indeed, Britain built the NHS, welfare state, industrialised and ruled much of the world when it had higher levels of relative debt.

The claim that future generations would be overwhelmed by public debt has been around since the country first undertook such borrowings in the 18th century, yet has consistently failed to come to pass. Britain is also fortunate in who it owes; foreign investors make up just a third of the country’s creditors, while the bank of England (effectively the government) accounts for another third. This is because under the policy of quantitative easing, the Bank of England injected around £375bn into the economy through the purchase of assets from hedge funds and banks, including government bonds (thus government debts were transferred from private ownership to a public institution). This public ownership of UK debt further reduces the pressure it is likely to come under from a loss of investor confidence.

While Britain’s debt may be relatively low, the country’s deficit is about £85bn per annum. This is down from the £171bn a year it stood at when Labour left office, a peacetime record.

Although Britain has owed substantially larger sums in the past, the circumstances in which it did so were far more advantageous. Because of its global domination, 18th and 19th century British government bonds were not subject to the same competition from foreign regimes as they are today. Nor was Britain’s domestic capital market so accessible to investors. Thus in previous centuries, investors had little choice but to opt for British government bonds, which is no longer the case. This means that Britain has much less capacity to control the interest it pays on its loans.

Moreover, the UK has consistently struggled to control its finances since 1945. At the same time as it was constructing the NHS, Britain was simultaneously forced to borrow money from America and Canada to remain solvent. The country’s post-war decline was a reflection of its financial limitations and the weakness of the pound, as consecutive governments struggled to balance social spending with increasing defence costs. It was this pressure that led to Britain’s humiliation at Suez in 1956 and influenced decolonisation. Ultimately it forced the country to abandon its base in Singapore, in the wake of a humiliating devaluation of the pound in 1967, brought on by the haemorrhaging of currency reserves. In short, Britain’s post-war history has been of a country steadily abandoning overseas commitments in an attempt to live within its means.

The crash: its causes and how governments responded

Since the 1980s, Western governments (particularly Britain and the United States) have pursued policies of privatisation and deregulation, ultimately creating the conditions that sparked the credit crunch when Lehman Brothers collapsed in September 2008. Because the banking system was so loosely regulated, financial institutions were able to bypass restrictions limiting the amount they could lend in relation to their total reserves, becoming dangerously exposed. As the economy grew and profits rose, banks relaxed restrictions on mortgage access in order to tap into a new market; sub-prime housing (this comprised people who would not normally have qualified for loans). So long as house prices kept increasing, it didn’t matter if the people the bank lent the money to couldn’t pay it back because the bank could simply foreclose on the property and make a profit. By developing a complex series of insurance products which were then sold on to other corporations, banks succeeded, at least in theory, in outsourcing all the risk from these transactions, and thus had little incentive to deny credit to those who sought it. However as more and more people began defaulting on their mortgages the housing bubble burst, leaving banks unable to pay each other as the value of their assets plummeted.

As banks faced insolvency, Western governments embarked on a series of bailouts to prevent them from failing. The UK taxpayer funded a £500bn rescue package in October 2008, while the US Treasury pumped $700bn into the American banking system. Both packages aimed to provide banks with fresh capital to restart lending to each other, as well as purchasing some of their bad assets.

The approach of the Labour, Coalition and Conservative governments

These measures prevented economic meltdown, but failed to stave off recession. As the economy contradicted, the Labour government embarked on a programme of fiscal stimulus in November 2008. This comprised reductions in VAT, measures to support those on low income and other initiatives totalling £20bn, and was financed largely through a big increase in government borrowing. By the time of the 2010 election the need for spending cuts had been accepted by all major parties, and had been assumed as part of Labour’s plan.

On coming to power the Coalition ended Labour’s expansionary policy and embarked on an extensive range of public sector cuts, aimed at gradually bringing government expenditure into line with revenue. Following an initial VAT hike, a cut in public investment projects and a reduction in the top rate of tax, 2013 saw the first major round of welfare cuts. That April saw the implementation of the bedroom tax (where people had their benefit reduced if they were judged to have a spare bedroom), major reductions to legal aid with many family law cases rendered ineligible for funding, a reduction in the value of benefits by linking them to the consumer price index and the scrapping of the disability living allowance. Austerity measures undertaken during the course of that parliament are estimated to have saved around £38bn.

Following their election in 2015, the Conservatives announced that a further £30bn worth of savings were needed, which was to include an additional £12bn of welfare cuts. Measures announced so far include the ending of housing benefit for people aged below 21 and the limitation of child benefit to two children. The process of deficit reduction was supposed to have balanced the budget by 2015, but persistently low growth forced the coalition to revise this target to 2018, while George Osborne has now extended it to 2020.

Definitions

GDP – Sum of the goods and services produced in a country over a specified time period (typically a year).

GDP Per Capita – The sum of the goods and services produced within a country over a specified time period, divided by the country’s total population.

National Debt – The total amount a country owes its creditors at any given time.

Deficit – The amount by which a country’s debt increases over a given time period.

OECD – Organisation for Economic Co-operation and Development, comprising 34 countries and including many of the world’s richest nations.

G7 – The seven most economically advanced countries in the world, as determined by the International Monetary Fund

Keynesian/Fiscal Expansionism – Policies which increase public expenditure in order to stimulate growth. Such policies are often referred to as ‘Keynesian’ in reference to the economist John Maynard Keynes, who argued that governments should increase spending to stimulate demand in an economy at times when businesses and households are restricting their own spending.

Non-Domiciles – Tax status that only requires individuals to pay UK taxes on income which is transferred to or earned in the United Kingdom, rather than on earnings or investments that remain overseas.

Tax Gap – The difference between the total amount of tax owed to the UK government and the amount collected.

OBR – Office for Budgetary Responsibility