The Discussion on Austerity Measures - Assignment Example

Government deficit indicates the excess of government expenditure over its total sources of revenue. Government usually raise its revenue by imposing taxes and when the overall taxes collected are less than the expenditure of the government, government deficit arises. Higher government deficit can be either negative or positive for the economy. The positive impacts of the government deficit may suggest that the government is investing into the infrastructure development in the economy which can be beneficial in the long run. However, consistently high government deficit can be detrimental for the economy in the short run owing to the fact that the government will have to borrow in order to finance government deficit. (Nellis & Parker, 1996). There are two methods through which the government can actually finance its deficit i.e. it can either impose more taxes or have to borrow domestically or from the international organizations such as IMF and World Bank. Similarly having the higher government debt would ultimately put pressure on the government because most of the government revenue would go towards the servicing of the debt. Further, a higher quantum of government debt creates crowding out effect thus reducing the amount of credit available for the private sector. The lack of credit available to the private sector will therefore ultimately increase the interest rates in the economy and therefore invariably affecting the level of investment into the economy. The lack of investment therefore can further result into the lack of capital formation and the economy may not be able to grow according to the estimates. The above laws therefore are critical owing to the fact that they outline the maximum limits to which economic variables such as government debt as well as the deficit can relate to the gross domestic product. Keeping both these economic variables therefore within a certain range will allow the governments to keep the detrimental affects of these economic variables under control. Data published recently indicate that the government deficit as a percentage of the GDP in EU area is 6.3% whereas the government debt is almost 80% of the GDP1. Countries with largest government deficits included Greece, Ireland, UK, Spain and almost all other major economies of the EU. Countries like Ireland and Greece received support from the EU whereas there is growing discussion about the Spain’s ability to repay its sovereign debt owing to higher government debt. Further, UK has initiated austerity measures in order to control the government expenditure so that the government debt can be rationalized. UK’s government deficit in almost 11.5% suggesting that the economy may not be in good shape and there is a greater need to implement economic strategies which can actually allow the country to remain within economic soundness. The higher ratios of the government debt as well as the government deficit therefore may suggest that the economies may require external support in order to keep themselves solvent. Thus the rules outlined clearly provide the best estimates for the countries to keep their debt and deficit within certain percentage to avoid such economic issues. 2) The circular flow of income suggests that there are three players in the economy i.e. the households, firms and the government. The national income which is generated in the economy therefore is generated with the interaction of these three economic entities. The exact relationship between these components therefore can be described in following equation: Y= AD= C + I + G The above relationship assumes that there is no external trade with other countries. However, if we introduce the trade with the external world, the above relationship will be : Y = AD= C+I+G+X X= Total exports – Total Imports The components of aggregate demand include the consumption, investment, government expenditure assuming that there is no foreign trade. The circular flow of income therefore suggests that the goods and services produced by the firms are consumed by either the households or the government. In return they pay for these goods and services which form the income of the firm. Similarly, the household supply their labor services to the firms or governments therefore the wages paid to them are their income. Government expenditure is incurred on the various expenses of the government and is sourced when government imposes taxation on the firms and households. 3) When an economy operates at full employment level, there is very little probability of further employment of resource. The austerity measures taken by UK and most of other EU countries may result into the decline in the economic activity. Economic theory suggests that the government spending has the multiplier effect thus increase in government expenditure G can actually increase the output level in the economy. As the above graph shows, the austerity measures can actually shift aggregate demand line downwards. The steps such as increase in VAT, reduction in government spending as well as the reduction in the social security benefits can therefore affect the output and employment level in the short run . If the government increases the VAT- which is a tax on what the consumers buy- thus actually increasing the cost of purchases. The increase in the prices will therefore force the consumers to reduce their consumption. A reduction in consumption can also result into the decline in the investment activity because of the lack of demand. Further a reduction in the social security benefits will further reduce the ability of the consumers to buy therefore further reducing the purchasing power of the consumers. Due to these austerity measures the level of output and aggregate demand will reduce and it will further create the unemployment within the economy. 4) In order to fully discuss the impact of the recent austerity measures and whether they were unavoidable or a mistake, need to be discussed from the perspective of the overall economic situation faced by the UK Economy. As discussed above that the UK’s government deficit was well over 11% whereas its debt as a percentage of the total GDP was in excess thus suggesting that the economy’s main economic indicators were not depicting favorable situation. It is also important to note that during recent past, UK has further developed into a welfare state thus systematically increasing the social security benefits for the citizens. Consistent and gradual increase in the social security benefit would ultimately increase the government expenditure and will lead to the further government borrowing in order to meet the government expenditure and fulfill the various obligations of the government. Austerity measures therefore aim to focus on the reduction of the government expenditure and the systematic withdrawal of the social security benefits in order to ensure that the reliance of the government on debt is lessened. Though a reduction in the government expenditure would have a multiplier effect and can lead to the reduction in the output in the short run however, a reduction in the government expenditure also allow the private sector to thrive. The reduction in the government borrowing will allow private sector to borrow more therefore re-channeling the funds into more productive use. A higher credit extension to the private sector always result into the higher investment activity thus its overall impact on the economy can be good in the long run. UK’ national debt as percentage of GDP was 68.1% in 2009 whereas its government deficit as a percentage of GDP was over 11%. (Pietras, 2010). These figures suggested that the UK was well ahead of the targeted rates set by EU and therefore the overall risk of the default was relatively high. In order to reduce the risk of being defaulted, it was therefore critically more important that the government must initialize a systematic process wherein it can control its expense and bring down the government debt to avoid the chances of going into default. In the short run, it is however, important to note that austerity measures can be termed as a mistake because the immediate impact of such measures can result into the decline into the output and employment level. History however, suggests that the more stringent austerity measures can be detrimental to the economy in the long run. The reduction in the government expenditure specially can result into the loss of employment as well as the decline in the output level. The measures taken by UK also included the reduction of the public sector workforce which would ultimately result into the increase in the unemployment level. Further, this could also create a conflict of interests between the trade unions as well as the public sector organizations thus further reducing the productivity and efficiency level. The famous strike by the British Air employees just provide a small picture of how the economic relationships between the public sector employees and their respective employers can get worse due to the austerity measures taken by the government. UK’s target is to bring the government expenditure within 1 percentage range of the GDP within next five years. Such drastic reduction in the government expenditure therefore can result into the withdrawal of the social security benefits as well as the lack of government investment into key areas of economic significance. Further an increase in the taxation such as VAT increase to 20% would certainly increase the cost of purchasing for the consumers and therefore it may result into the systematic decline into the aggregate demand into the economy. (Pimlott & Giles, 2010). Considering the above discussion, it may be sufficient to conclude that the austerity measures were unavoidable because of the increasing pressure on the public finance. However, deciding upon how much spending cuts to allow can be a debatable issue because consistently higher cuts can result into the dampening of economic activity. References 1. Nellis, J & Parker, D (1996). The Essence of the Economy. 2ne. ed. New York: Financial Times/ Prentice Hall. 2. Pietras, J (2010). Austerity Measures in the EU - - A Country by Country Table [online]. [Accessed 7th December 2010]. Available from: . 3. Pimlott, D & Giles, C (2010). UK?unveils dramatic austerity measures [online]. [Accessed 7th December 2010]. Available from: . Read More