Why Cuts and What Cuts?

Why Cuts and What Cuts?
 

 

 

Introduction

 

'Cuts' have become the mainstay of political debate currently. The leaders of both main Opposition parties, David Cameron for the Tories and Nick Clegg for the Liberal Democrats, made the reduction of Britain's national debt the centrepiece of their party conference speeches in the autumn of 2009.

 

Even Gordon Brown, who for most of his time as Chancellor of the Exchequer and Prime Minister made the distinction between 'Labour investment' and 'Conservative cuts' the defining choice in British politics, has conceded that reductions in public expenditure are now required. So much for ‘No more Boom and Bust’.

 

The purpose of this paper is twofold. First, it will attempt to explain by reference to economic theory rather than by recourse to specific details concerning ‘the recession’ why cuts in public spending are currently deemed to be necessary. Then it will try to identify those areas of public spending likely to be cut the most in the aftermath of the recession.

 

The Business Cycle

  

Capitalist economies like ours go through continuous cycles of upturns (i.e. periods of rapid growth of production to meet demand) and downturns (i.e. periods of sharp decrease of production as demand falls). A prolonged period of growth for a country’s economy is called a ‘boom’ but when the opposite occurs (i.e. economic output for a country experiences negative growth for at least two consecutive quarters or six months) it is called a ‘recession’. 

 

Recessions tend to be short lived and if any recession lasts more than two years then it is termed an economic ‘depression’.

In a boom period, some industries, encouraged by the prospect of high profits, supply more than can be profitably sold. A crisis then occurs and if the combined effect is large enough, it is followed by a recession as other dependent industries get sucked into the downward spiral of unsold commodities (due to a combination of over-supply and falling demand), diminishing profits, losses, layoffs, redundancies and business failures.

 

Eventually, however, the equilibrium between supply and demand is re-established and the conditions for profitable production are restored, at least for those firms that have survived the recession. In this way a new business cycle of boom, crisis and recession is created.

Recessions

  

In recessions, government borrowing will tend to increase. This is because:

 

• Higher unemployment means less people will be paying income tax.
• Lower consumption levels mean lower VAT and excise duties.
• Lower company profits mean lower corporation tax.
• Higher unemployment increases cost of social security payments - unemployment benefit, income support, housing benefit etc.
• Falling house and asset prices reduce stamp duties.
• Furthermore, in a recession, governments often try to stimulate the economy using expansionary fiscal policy. This could involve:
• Cutting taxes so people (hopefully) spend more
• Increasing public sector spending to stimulate aggregate demand

 

In a recession, not only will national debt increase, but as percentage of Gross Domestic Product (GDP), national debt will become higher. This is because the government is borrowing more, at a time when GDP is decreasing. For example, during times when economic growth is at 3%, the government can borrow 1% of GDP, and national debt as a percentage of GDP falls.

 

Apart from the most hard-line monetarist economists who have apparently not learned the lessons of History, most economists nowadays would agree that an increase in government borrowing in a recession is essential since to try to maintain a balanced budget would cause a much deeper recession. Past experience has shown that if the government during a recession tries to balance the budget through higher taxes and cuts in public spending it causes a bigger fall in GDP, a deeper recession and leads to even lower tax receipts.

 

For example, the National Government, led by Ramsay MacDonald in 1931, cut unemployment benefits and raised taxes on the advice of 'Treasury economists' in order to achieve a balanced budget thus helping to exacerbate the Great Depression. Also the Tories, under Margaret Thatcher, made the 1981 recession much deeper than it would otherwise have been by keeping to a balanced budget according to monetarist principles.

 

By borrowing more during a recession, the government is trying to increase aggregate demand and promote economic growth. The hope is by preventing a deep recession any budget deficit incurred should prove relatively small and short-lived and that government finances will soon be restored to health once the economy moves out of recession and resumes growth.

 

The Aftermath of a Recession

 

 

If the government has tried to stimulate the economy using expansionary fiscal policy during a recession by cutting taxes and increasing public sector spending, then, all things remaining equal, it needs to restore taxes to previous levels and cutback on public sector spending when the economy recovers and starts to grow again in order to keep national debt in check.

 

However, the government needs to be very careful about cutting spending when the economy moves out of recession. If consumer confidence is still low and if banks are still unwilling to lend then cuts in government spending could push the economy back into recession. This return to negative growth would force the government to increase borrowing again and cause the national debt to be increased further.

 

Cuts in Public Spending

 

The UK national debt has soared as a result of borrowing during the recession and the need to bail out the banks to prevent a collapse of the financial sector. Government forecasts suggest it will rise to an unprecedented level of £1.1 trillion by 2011.

 

To put that in perspective, when the then Labour Government had to go cap in hand to the International Monetary Fund to avoid a financial meltdown in 1976, Chancellor of the Exchequer, Denis Healey, was running a budget deficit of 6% of GDP. Under the present Labour Government the deficit is double that level.

 

There are various measures that can be taken by the Government to reduce its budget deficit. These include overall rises in tax and national insurance, pay freezes for public sector employees, increased deductions from public sector workers’ wages to put into their pensions, a cut in the public sector's overall workforce and most controversially cut backs on welfare benefits and public services.

 

Whatever options the Government decides to take as it tries to get to grips with the national debt it can be safely predicted that the public sector as a whole will have considerably less money in real terms to spend for several years to come. However, this does not necessarily mean that all areas of public spending will suffer uniformly.

 

At the UK level, both Labour and the Conservatives are pledging to safeguard spending on frontline health and education services. The Institute for Fiscal Studies has estimated that Labour’s pledge to protect not only health and education but also early years and overseas aid budgets in 2011/12 and 2012/13 would leave the rest of the public sector facing budget cuts of £25.5bn or in percentage terms real cuts of 6.7% year.

 

Be that as it may, none of the major parties are prepared in the run up to the General Election to be precise about where they believe the axe on public sector spending should fall. To do otherwise could harm their electoral prospects and, therefore, presently mainstream politicians are restricting themselves to vague pronouncements about cutting inefficiencies, cutting unnecessary programmes and cutting lower priority budgets which they maintain can be done without jeopardising vital front line services on which the public depends.

 

The first unequivocally clear sign of the cuts in the public sector will come from the Government in their comprehensive spending review. This sets three-year budgets for government departments but the Chancellor, Alistair Darling has said that will not happen until after the General Election by which time he and his party may not be the ones issuing the comprehensive spending review.

 

Notwithstanding the above, a clearer picture is beginning to emerge in Scotland as to what cuts are going to be made. Local councils have been setting their budgets for the next financial year and it would appear education has been targeted. Proposed education cuts range from 2% to 10% in some areas, with average savings of around 6%.

 

In total, Scottish councils will have to find savings of £270 million in the next financial year as they face their toughest cuts since devolution. A wide range of services will be adversely affected (e.g. sheltered housing wardens and support for drug addicts), while the majority of councils also plan to increase charges. Unions estimate around 3000 jobs, out of a total local council workforce of 275,000, will be cut in 2010/11 through natural turnover and non-replacement of posts.

 

 

 

Conclusion

 

Production of commodities in capitalist economies is subject to a business cycle of upturns and downturns and is never steady. Severe downturns are known as recessions and during a recessionary period, government revenues fall as many workers are laid off and no longer pay income tax. Also lower sales during a recession means less VAT and falling business profits leads to less corporation tax being paid.

 

Faced with a decline in revenues and budget deficits, governments, during a recession, borrow extensively to maintain public services and promote recovery by means of an ‘expansionary fiscal policy’. To do otherwise is to invite the wrath of the voting public and to preside over a worsening economy. The expectation is that public finances can be restored to health and national debt reduced once the economy picks and starts growing again.

 

However, following a recession, the Government has to act cautiously for fear of inducing a double dip recession. Only once the economy is fully into an upturn phase can the Government start taking measures to reduce national debt by cutting back on public sector expenditure and repaying what has been previously borrowed during the recession.

 

Cuts in public sector spending are always unpopular, at least with those members of the public most affected. In the run up to a General Election, political parties, vying for votes, are always going to be reluctant to be divulge where exactly they believe cuts in public expenditure should fall. This explains why currently the mainstream parties are vague about their policies to deal with the national debt.

Eddy Cornock
West Lothian SSP (Chair)