1. The UK budget deficit
Key terms:
Austerity A policy of reducing government spending to tackle a budget deficit.
Government The accumulated borrowing of the government. This has to be serviced
debt which means that part of government spending every year is made up of
interest payments on this debt.
The Government borrows by selling bonds – time-limited pieces of paper
which promise the bondholder an annual interest payment and the value of
the bond when it matures.
Budget deficit Structural deficit – what the Government borrows to make up for a
– is sometimes shortfall in revenue (when government spending exceeds tax revenue)
divided into Cyclical deficit – an automatic consequence of the business cycle which
two means that in a recession, tax revenues fall and government spending
increases
Stimulus A policy of maintaining AD using either expansionary fiscal or monetary
policy
Government strategy – austerity or stimulus?
View 1: the cyclical deficit will take care of View 2: the only way to reduce the structural
itself – it is vital to tackle the structural deficit is by generating growth. Austerity will
deficit. A large deficit will lead to higher not produce growth and will, therefore not
interest rates to fund the borrowing needed reduce the deficit.
and this will hamper growth.
This requires austerity. This requires stimulus.
Growth with smaller government strategy Grow out of debt strategy
Contractionary fiscal policy: Expansionary fiscal policy will generate higher
Cut the fiscal deficit by cutting government tax revenues and reduce the deficit.
spending and maintain the confidence of the
‘financial markets’. Effective fiscal expansion needs
– higher spending rather than tax cuts
A period of stagnation is necessary and – spending on infrastructure and social
wages and prices should be allowed to adjust. transfers
– any tax cuts should target lower income
groups (who have a higher propensity to
consume)
Growth from supply-side policies: Growth from supply-side policies:
Employment protection laws should be Government should invest in education,
repealed to provide incentives for firms to modern infrastructure and research in
take on more workers. emerging technologies.
Taxes should be cut to provide incentives for
entrepreneurs.

2. Estimates from the Autumn Financial Statement 2011
£ billion % of GDP
GDP 2011/2012 1521 100
Government spending 702 46
Government revenues 575 38
Budget deficit 127 8
Structural deficit - c4% of GDP Cyclical deficit - c4% of GDP
Causes: Cause: recession
- expansion of health and education after - lower tax revenues (e.g. from taxes on
1999 and a failure to raise taxes 2000-2007 spending, incomes and profits)
to pay for this expansion - higher government spending (e.g. on
- running budget deficits in a boom welfare payments)
- funding military campaigns in Iraq and
Afghanistan
Future liabilities: Future spending commitments:
Governments have made promises on These higher costs may require higher
pensions and health spending which will taxes and higher taxes may depress
cause problems as we have an ageing economic activity. We might face a future
population. of slow growth and high debts.
‘Reducing debt should be the priority’ view: ‘Growth more important than deficit’ view:
We must reduce debt so that future Governments should keep spending to
generations are not burdened. restore growth because growth will reduce
the deficit.
Government policy: Government policy:
To eliminate the structural deficit by cutting To promote growth (through expansionary
(the growth in) government spending and fiscal policy) as this would automatically
increasing taxes. increase tax revenues and reduce
government spending.
Credit rating argument: Cuts hurt growth argument:
Important to cut the deficit to persuade Cuts will further weaken aggregate demand
creditors that they stand a good chance of and reduce economic growth which will
getting their money back as this will keep make it harder to reduce the deficit.
interest rates low and make servicing the
debt cheaper.
Run a programme of austerity to try and get But an austerity programme risks creating
back to a structural budget surplus. a debt trap. [This is where cuts to
government spending push the economy
into recession, increasing the level of
government debt and leading potential
creditors to demand higher interest rates
making the deficit even worse and requiring
further austerity measures.]
Problem: Problem:
Cutting government spending hurts lower Disagreements about how best to stimulate
income groups more growth.
Boosting AD will only work if there is spare
capacity in the economy.
Supply side measures can take a long time
to have an impact.

3. Austerity- a good idea?
Benefits of an austerity package Problems of an austerity package
UK facing unsustainable debt. Reducing the Reducing G lowers AD
deficit is an important part of reducing Lack of growth will increase the deficit.
government spending as a percentage of the Private sector cannot quickly create jobs to
economy. employ redundant public sector workers
UK has to maintain existing servicing costs Waste of human capital
Buyers of government bonds need Long-term unemployed permanently leave
reassurance the labour market
UK has benefited from the lower interest Scrapping EMA will reduce long-term
rates which have resulted from a convincing productivity growth
plan to reduce the deficit.
The austerity package is an economic The austerity package is a political choice, not
necessity to correct the political failure to an economic necessity. It is being used to
adhere to balanced budgets over the push through a right-wing ideology aiming to
economic cycle. reduce government involvement in society
A stimulus package is a political choice by [e.g. in health, education and welfare].
those who want bigger Government.
Fairness – between generations. It is unfair Fairness – between income groups. It is
to burden the young. unfair to burden the poor.
OBR forecasts made in June 2010 and November 2011
2011/12 2012/13 2013/14 2014/15 2015/16
Deficit in £billion
June 2010 forecast 116 89 60 37 20
Nov 2011 forecast 127 120 100 79 53
Deficit in % of GDP
June 2010 forecast 7.5 5.5 3.5 2.1 1.1
Nov 2011 forecast 8.4 7.6 6.0 4.5 2.9
Causes and consequences
If you believe that the problem is … it might be logical to argue for deficit
mainly a cyclical one and that financing to tackle recession with more
the deficit problem is due to a government spending…
collapse in tax revenues as the
economy went into recession…. BUT this could make the structural deficit
worse
If you believe that the major … it might be logical to argue for a balanced
problem is the structural budget and cuts to government spending…
deficit….
BUT this could make the recession worse
If you believe that the problem … it might be logical to argue for higher
was caused by excessively low interest rates and a period of stagnation to
interest rates which incentivized allow prices to adjust.
over-borrowing, and an asset
bubble….. BUT this might make it harder for debtors to
service interest payments and the sale of
assets would not cover their debts.

4. Policy options – encourage growth or balance the budget
View 1: View 2:
Focus on the structural deficit: - government Focus on the cyclical deficit: - government
should eliminate the structural deficit quickly should act to stimulate growth and this
and leave the cyclical deficit to take care of growth will help reduce the structural deficit.
itself - just avoid doing anything which might
hinder growth.
Encouraging growth - on the demand side
Policy Reservations
The main influence on consumer Rising unemployment and the fear of
spending is disposable income. If you unemployment mean that consumers are
C
cut disposable income in a recession reluctant to spend
you won’t get growth. Consumers may choose to use an
increase in real or disposable income to
So.. pay off their debts rather than spend
Falling asset values make people feel
Encourage consumer spending by worse off and less likely to want to spend
reducing spending taxes and/or Cutting taxes may not help balance the
income taxes budget (in the short run)
Some argue that government should
encourage investment with lower
The main influence on business
corporate taxes and/or tax breaks and
I
investment is expectations about
low interest rates.
future market opportunities.
Interest rates are set by the MPC and are
evidence that in the opinion of the MPC
So..
the economy is not growing
Firms are using extra cash to pay off
Boost consumer spending [see
debts and buy back shares.
above].
Firms will not invest if consumers are not
spending.
This will make the structural deficit worse
G
Use deficit financing to fund Multiplier effects might be weak
infrastructure projects such as HS2, a
third runway or new airport. Opposition from influential environmental
or ‘nimby’ lobby groups.
An export promotion strategy Relies on the strength of overseas
targeting growing markets in Asia demand. Recession in the Eurozone
X-M Import substitution via a policy of
protecting or subsidising domestic
would hurt exports.
Tariff protection not allowed in EU and
open to retaliation anyway. Protecting
industries national champions not efficient.

5. QE – Quantitative Easing
The monetary policy of cutting the interest rate to boost growth cannot be used because
interest rates are as low as they can go. So, if the Bank of England can’t change the price of
debt it can act on the quantity.
The Bank of England creates money for itself and uses it to buy government bonds from
banks, pension funds and insurance companies. The hope is that these institutions will use
the money to increase lending to firms and individuals at attractive rates. [In theory, if the
Bank of England buys government bonds it makes them more expensive and a less attractive
investment for banks etc. which means that they are more willing to lend to firms.] The long
term aim is that when the economy recovers, the Bank of England will sell the government
bonds it has bought and destroy the cash it receives.
QE has helped the cash position [and the bonus pools] of the banks. It hasn’t led to higher
growth because firms do not want to borrow to invest because expectations of future growth
are so low. Banks are also scared to lend because they don’t believe that the economy will
grow.
An alternative suggestion has been that the government should set up a National Investment
Bank to offer ‘patient capital’ [i.e. not looking for fast returns] and thereby release funds for
long-term innovative investments – in particular ‘green’ investments.
The case of Japan: very low interest rates, QE and no recovery
A boom in the 1980s saw an expansion of debt secured against property. Come the
recession, asset prices fell which meant that for many [firms and households], the value of
their assets was lower than their debts. This made them disinclined to borrow more – the
priority was to reduce debt and low interest rates helped. An ageing population made the
problem worse – retirees are less likely to boost consumer spending than workers.
If UK firms and households behave in a similar way to Japan then QE may not work.
Low interest rates may not be a good idea
There is also an argument that low interest rates in the 2000s lead to unproductive
investment and were to blame for the speculative bubble which led to the financial crisis in
the first place.
Low interest rates made some projects appear viable that wouldn’t otherwise have been. This
meant that after a period of time, for example when teaser rates on mortgages came to end,
the rate people paid would rise, and those who were unable to pay the higher rate defaulted.
This resulted in the start of the downturn, as banks would no longer lend to other businesses
at such attractive low rates. Low interest in other words lead to poor investment decisions
and a misallocation of resources
Low interest rates also encouraged an unsustainable boom in the housing sector.
This argument would suggest that interest rates should be allowed to rise and prices and
wages should be allowed to adjust. Supporters of this view would be opposed to any
stimulus measures and would argue that the austerity package does not go far enough – it is
merely slowing the rate of growth of government spending, not actually reducing it.

6. Encouraging growth - on the supply side
Deregulation Aim Reservations
Cutting/abolishing the To encourage hiring and cut This increases the amount
minimum wage employer costs the taxpayer has to pay via
tax credits to make up the
shortfall between a low wage
and a living wage.
Weaker health and safety To reduce employer costs Killing and maiming workers
laws may not help the recovery
Weaker employment rights To encourage hiring by Reducing job security reduce
re. dismissals reducing risks of employment loyalty, motivation and
tribunal costs productivity
Education
Restore the EMA To encourage young people Takes a long time to have an
to stay in education and impact
increase their skill levels
Boost apprenticeships To encourage employers to Takes a long time to have an
train their staff and increase impact
general skill levels
Tax incentives
Reduce top rate taxes To encourage ‘trickle down’. Trickle down doesn’t happen -
this just increases inequality.
More likely to ‘trickle out’ to
tax havens.
To encourage enterprise. There needs to be a
distinction between enterprise
and rent-seeking.
Political Economy
Economics can provide us with a way of looking at things but cannot provide a ‘correct’
solution. Economic data can be found to support all of the competing views expressed above.
The reality is that different economic policies serve the purposes of different interest groups
(and are focused on different time frames), this means that policy decisions are made within
a political context.
Politicians interpret the economy for us [the general public] and tell us a simplified story to
explain how things are and what we should do. Studying economics can help us to question
the stories they tell us!
Possible questions
1. What is meant by the term budget deficit? [K]
2. Distinguish between a structural and cyclical deficit. [Ap]
3. Explain the arguments which might be used
a. by a supporter of an austerity strategy
b. by an opponent of an austerity strategy. [An]
4. Analyse the OBR forecasts and suggest reasons why forecasts might change.[An]
5. Assess the choices facing the UK government and comment on the policies which the
government has chosen to pursue. [Ev]

7. Acknowledgements
I would like to thank Professor David Myddleton of the Institute of Economic Affairs and Ian
Marcousé of the Institute of Education – the two speakers who presented their ideas to a
group of teachers at the Royal High School in Bath on February 21st 2012.
Ian Marcousé used this presentation to support his argument.
The data used above was prepared by and presented to teachers by Professor Myddleton and
I am grateful to the two speakers and the teachers who attended for their contributions and
ideas. I have included some of their ideas in the above. Any mistakes are mine.
Colin Leith