The Impact of Financial Crisis on UK Fiscal Policy and Government Debt - Essay Example

Area and Context of Research Where the global financial crisis has landed the biggest economies of the world into trouble, it has also offered themanother chance to look over their current economic and financial practices and what they have been doing wrong. Not only has the crunch changed the way development is judged but has also lead to change in the way development is perceived (Haddad, 2011). In a global village the inevitable result is that the global and collective interests of economies, like that of G8, G20 etc. outweigh the national interests of countries (Haddad, 2011). The current crisis is definitely more pronounced and prolonged than any other previous financial crisis, yet support from fiscal policy, monetary policy, use of guarantees on liabilities and purchase of assets has helped in reducing the direct fiscal costs (Laeven & Valencia, 2012). While such efforts might have led to minimizing the direct impact of the financial crisis yet it has been becoming a rising concern for fiscal sustainability in many countries, as the fiscal policy has led to increasing the public debt burden as well as the government contingent liabilities size (Laeven & Valencia, 2012). Fiscal policy holds great interest for policy makers as it has the ability to act as an instrumental tool for growth and development in the long run (Brahmbhatt & Otaviano, 2012). Fiscal policy is no business strategy, for a national economy is by no means a business, it does not earn; rather it implies how public is taxed and how the government spends the gathered money (debt bombshell, 2012). In UK the national debt is the amount that is owed to the private sector and UK gilts purchasers (Pettinger, 2013). The government spends more money than it can afford to tax, leading to selling bonds/gilts (debt bombshell, 2013). Research Question The research aims at studying that the fiscal policies that were established and followed as a result of the financial crisis lead to increasing the government debt in the UK. The Increased government debt leads to higher tax rates for the public. Theoretical Framework The case study is based in two economic theories and their fundamental aspects while addressing the research questions. 1. Political Economy Model Battaglini and Coate (2008) presented the political economy model. The model was meant to understand the influence of the fiscal policy that it has on the Business cycle (Barseghyan, Battaglini & Coate, 2013). The model is based on the predictive premise that the fiscal policy is counter-cyclical in nature and that debt tends to decrease in periods of economic boom while increases during the period of economic recession (Barseghyan, et. al., 2013). Tax rates increase during the period of recession while lowered significantly during the boom period and vice versa holds true for public spending (Barseghyan, et. al., 2013). Under general belief the stabalising effects generated by the counter-cyclical fiscal policies is generated through automatic stabalisers and discretionary actions; but the counter cyclical policies have led to an increase in the government debt and also obligated the government to debt services in the coming future (Gordon & Leeper, 2005). Counter cyclical policies can be counterproductive as they require their financing from high tax rates, low spending and elevated financial growth in the future; and also this tends to leave no space for any other business cycle other than itself (Gordon & Leeper, 2005). 2. Austerity Theory Austerity means to reduce the public sector expenditure to enable reduction in the debt (Konzelmann, Wilkinson & Davies, 2003). This is only effective if the economy has economic growth to speak of (Konzelmann, et. al., 2003). The government of the United Kingdom has implemented the austerity policy in wake of the financial crisis to give the failing economy a boost. Multiplier effects are exhibited when the national debt is high and the governments makes use of austerity and government spending (Konzelmann, et. al., 2003). During economic expansion, higher tax receipts result from growth and employment; leading to a reduced national debt ratio to GDP (Konzelmann, et. al., 2003). Subsequently, when expenditures are reduced while the economy is suffering from a recession, it can add to the downturn, which would lead to a further increase in unemployment and stall economic growth, thus inflicting heavy burden on the public services (Konzelmann, et. al., 2003). Where there are people like the head of Goldman Sachs, Lloyd Blankfein; who believe that Britain should stick to their austerity policy in terms of combating the crisis as it has no other choice (BBC, 2013). There are others who think that the policy is a fail and the government has failed to reach the targets and projected numbers, and is still behind its target of reducing government deficit (Matthew, 2013). The austerity policies in the UK lead to killing off investment, consumer spending and the growth of economy; which in turn increases the national debt, 30% since the crisis (Konzelmann, CBR, & DoM, 2012; scriptonite daily, 2013). Fiscal relaxation can lead to the slowing down or altogether stopping rebalancing of the economy (Matthew, 2013). The expenditure in the austerity policy makes, cuts to the government services and reforms to the benefit systems, in an attempt for deficit cut and economic efficiency (Matthew, 2013). But as the deficit increases the choice might be slipping away of replacing the austerity policy (BBC, 2013). Austerity is becoming more an issue of showing seriousness by the government than economic growth (Konzelmann, CBR, & DoM, 2012). Contextual Literature Review The government of the UK displayed a state of denial till the March of 2008 insisting that, ‘the economy is stable and resilient, and continuing to grow, and the government is meeting its strict fiscal rules for public finances’ (HM Treasury, 2008 A, p.1, cited in Sawyer, 2012); and also that rather improved resilience was being displayed by the economy lending the economy the ability to face not only the economic shocks but also with little cost to the economy (HM Treasury, 2008A cited in Sawyer, 2012). Sawyer (2012) applies the panel data approach to study the impacts of the financial crisis and the resulting fiscal austerity policy on the UK economic growth and its significance to the government. But after 2008 major changes were made to the public sector net borrowing by operation of automatic stabalisers; although the automatic stabaliser add to the budget deficit yet as the economy starts recovering the automatic stabalisers start working in the reverse and the deficit is also in turn made to fall back (Sawyer, 2012). The Labour Government under the ‘Code for Fiscal Stability’ set its fiscal rules, yet in wake of the crisis they were all suspended temporarily till the year 2015 – 16 (Sawyer, 2012). In place of the fiscal rules a ‘temporary operating rule’ was set up which was meant to annually improve the cyclically-adjusted current budget, to work the economy out of the crisis, balance it and the reduce the government debt in proportion to the GDP (HM Treasury, cited in Sawyer, 2012). Niesr warns that 2013 will see higher debt ratios due to austerity measures and that had such measures been not taken, not only would the economic growth had been higher but also the debt to GDP ratio would have been significantly lesser (Cited in Chan, 2012). Austerity policies might initially have been popular but that stance has changed in light of evidence that such policies might actually have been counterproductive (MCK, 2013). Renowned economists Carmen Reinhart and Kenneth Rogoff proposed in their paper ‘Growth in a time of Debt’, that when the government debt reaches 90% of GDP, the economic growth of the country will collapse (cited in Matthew, 2013). Reinhart and Rogoff (2010) employ a panel data approach in analyzing the government debt data from over two or three decades of 44 countries, to study the debt trends and their impact on economic growth. Reinhart and Rogoff (2010) argue that debt has a non-linear effect on growth, and perhaps results from the non-linear market interest rates as the countries approach their debt tolerance limit; at the same time the rise in interest rates leads to an increased tax rate, spending cuts or an outright default. Due to the increased market interest rates the fiscal policy at times requires painful to draconian adjustments (Reinhart & Rogoff, 2010) The government debt is being countered by large spending cuts; like in Canada and Sweden (Taylor, 2011). UK not only is advantaged but also disadvantaged because of having a reserve currency and being a financial center; where it can borrow more as GDP share, it also can’t default of the debt (Taylor, 2011). When the UK government borrows funds for its expenditures and consumption, the money does not pay for itself and can only result in high tax rates .In UK the productive expenditure between the years 2008 – 2011 is only 6%, debt interests was 38%, and the rest of the 56% is again being borrowed by the government for consumption (debt bombshell, 2012). As a result of the financial crisis and the resulting fiscal policy, the government debt rose at an alarming rate, in fact the fastest since 1946 (Conway & Porter, 2008). Such a fast rate of increase in debt resulted from borrowing £200 million a day, which will ultimately lead to low spending or higher taxes for future generations (Conway & Porter, 2008). Pettinger (2013) through a panel data approach explains how the current state of debt is over bearing for the economic situation of the country. In UK the national debt is the amount that is owed to the private sector and UK gilts purchasers (Pettinger, 2013). The government spend more money than it can afford to tax, leading to selling bonds/gilts (debt bombshell, 2013). The public sector debt in February 2013 is £1,161.5 billion, which is 73.5% of the GDP; whereas the gross government debt for the year 2012 – 13 is estimated to be £1,412 billion or more simply an astounding 90.3% of the GDP (Pettinger, 2013). The national or the government debt lead to the government paying interest on the gilts and bonds that it sells; by 2012 the interest payments on the debt were estimated to be £48.6 billion, which is equal to 3% of the GDP (Pettinger, 2013). Forecasts based on the current economic growth and deficit, predict that the UK public sector debt will peak in 2015/16 at 79.9%, but this figure could be revised based on poor economic growth and less deficit reduction (Pettinger, 2013). Already for 2013 the debt to GDP is estimated to be 4.8% higher (Chan, 2012). The government is concentrating on issues that are not the problems in the crisis and do not exist; due to being the financial industry and the derivative market remaining unregulated, a massive $700trn represents the derivative debt, which equals to the GDP of the entire planet times ten, making it impossible to repay it (scriptonite daily, 2013). Konzelmann et. al. (2003), evaluate empirical panel data from UK’s economic history. They have analyzed economic data from the year 1914 (the First World War) to 2006 (before the recent financial crisis), and conclude that any attempts to reduce the national debt will only bear fruit when and if the economic growth of the country is significantly strong. Polices that are restrictive like austerity, can tend to be counter-productive and result in increasing the government debt further (Konzelmann, et. al., 2003). Thus, they have argued that the cuts in public sector spending should only be delayed and only implemented when the economy is showing significant growth (Konzelmann, et. al., 2003). Keynes also believed that cutting government spending during a recession or economic policy tends to be the wrong policy approach (BBC, 2011). Method and Data to be used The use of panel data approach for gathering data over the time period will be utilized to gain insight into the effect of the financial recession on the fiscal policy and the increasing government debt. When the same unit of observation is repeatedly measured at different points in time, it is referred to as panel data approach (Gravlee, Kennedy, Godoy & Leonard, 2009). Panel data is a longitudinal study and allows for studying change and continuity over longer periods of time; while in a causal analysis allowing to determine a temporal order and making the measured unit more reliable and accurate (Gravlee, et. al., 2009). The panel data is more apt than the cross-country regression, as it allows for the study of growth and development economics and enables to study aggregate production function across these economies (Islam, 1995). The data will be used from credible government sources like the national statistics, BBC, documents of HM Treasury, etc. gathering secondary data from government sources will allow for comparisons over longer periods of time and determine that implementing fiscal policies like austerity lead to increased government debt and indebt higher rate of taxation. Conclusion The government with its fiscal policies has led itself from a financial crisis into a debt crisis, and that indebtedness of a government hinders in its economic growth (Reinhart & Rogoff, 2011). The debt that has been mounting on top of the financial crisis will ultimately have to be paid by the future generations of the United Kingdom. Every new child who is born in the United Kingdom is born with the burden of debt on his shoulders with no visible and viable way to pay it off other than taxation. Also the fiscal policy that the UK adopted as a result f the crisis could lead to walking out of the crunch but might lead into an inflation crisis; which would be really devastating for public expenditures and defence budgeting (Braddon, 2012). According to the OECD 2010 report United Kingdom needs to play on its strengths by combining the right policies at the right time, like a low-carbon growth model; such growth will enable the United Kingdom to grow economically and reduce the debt while at the same time take the position of a world leader in such a model. References Aizenman, J. & Jinjark, Y. (2011). The role of fiscal policy in response to the financial crisis. World Economic Situation and Prospects. Background paper prepared for the UN Development Policy and Analysis Division. 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