Economics Weekly by Lloyds TSB

The austerity package announced in the emergency Budget has raised concerns that the degree of public spending restraint could tip the UK back into recession. On the face of it, these concerns are understandable. Will public sector spending cuts push the UK back into recession?

The austerity package announced in the emergency Budget has raised concerns that the degree of public spending restraint could tip the UK back into recession. On the face of it, these concerns are understandable. With total spending cuts amounting to £99bn (or 5.2% of GDP) and tax increases of £29bn (2% of GDP) planned by 2015-2016, the fiscal squeeze is the most aggressive since the Geoffrey Howe Budget in 1981. In this weekly, we examine the size of the spending cuts put forward by the Chancellor and assess the implications for the economy as a whole.

How aggressive are the spending cuts?

Since 1997, the share of the economy accounted for by public spending has risen from 38% to 48% – its highest since 1984. Over the next five years, public spending is projected to fall in real terms by 4%. If realised, this would reduce the share of the economy devoted to the public sector to 40% over this period (given the anticipated growth in the economy). This decline is far from insignificant, particularly when measured against previous assumptions.
Moreover, the total cuts in department spending will be far higher than this, as a large proportion of public spending either falls outside the government’s control or is very difficult to change. This includes, amongst other things, the costs of
servicing public sector debt, social security payments and public sector pension obligations. With limited headroom to cut these categories, It falls to government departments to bear the main burden of the structural spending cuts. Full details of where the departmental axe will fall will not be published until 20 October when the government publishes its next Spending Review. Nevertheless, the totals were set out in the emergency Budget. Based on these, the Institute for Fiscal Studies (IFS) concludes that real spending
cuts averaging 14% across all departments would be required for the Chancellor to deliver his objective of a balanced cyclically-adjusted current budget over the next five years. This equates to a structural reduction in department
spending of around 5% of GDP in the period.

For most departments, however, the cuts are set to prove far more severe. Since the government has committed to protecting spending on the NHS and overseas aid, the average cut faced by ‘unprotected’ departments is estimated at 25-33% over the next four years. Ahead of the Spending Review, the Treasury has asked departments to seek out potential cost savings of up to 40%.

The expectation is that efficiency savings will account for the bulk of the budget cuts although, given the scale, it seems possible that front-line services could be affected. Moreover, in its latest forecast, the Office of Budget Responsibility (OBR) estimates that as a result of the spending cuts, public sector job losses will total 600k by 2015-2016.

Economic impact

The scale of the proposed spending squeeze has led to an intense debate about whether or not it will derail the nascent economic recovery.
The cuts in public expenditure (both current and capital spending) will have a direct impact on GDP through reducing government consumption
and public investment. There will also be a second order impact on consumer spending, savings, and investment as a result of the
ensuing public sector job losses.

Balanced against this, however is that public sector borrowing will be lower than would otherwise be the case. This reduction could be expected to reduce the cost of capital in the private sector, and free up savings to finance business investment. This, in turn, could be expected to have positive benefits for
employment and consumption and therefore GDP growth.impact of the fiscal multiplier on GDP growth steadily reduces.