John Dance

Austerity ? A necessary evil?

Politics has dominated the economic landscape in 2011, not just in the UK but in Europe and the US too. European government debt crises, job cuts, austerity and political indecision are probably all you feel like you’ve read about and heard this year, it certainly feels like they are all we have commented and mused on this year.

The UK is suffering from the effects austerity and worse is yet to come with government spending cut plans set to increase over the next two years. Jobs are being lost in the public sector and those fortunate enough to retain theirs are subject to diminishing future benefit packages. Unions, defending their members, have successfully organised strikes in protest, although the impact of them was less successful and disruptive than they may have hoped and expected.

Social welfare payments have been cut, as have regeneration projects and a variety of subsidies. The cost of studying and taxes, including VAT, have both risen as has the cost of living as inflation has stubbornly persisted at around 5% all year long. The spring saw mass demonstrations all over the country in protest at the government’s plans to tackle our fiscal position.

The impacts are not just direct though, they trickle through to additional weakness in the housing market, reduced consumer spending, a slowing service sector and stagnating growth in all industry sectors. Job losses elsewhere fuel the spiralling difficulties and whole UK economy suffers, not just the public sector, benefit claimants and students.

So why would the government inflict such pain on us, especially in the knowledge that upsetting the populous reduces their chances of re-election?

The coalition inherited national finances that were in a perilous state, the UK’s public debt as a percentage of GDP stood at around 70% and roughly double its annual income. More worryingly, it was increasing at a rate of approximately 8% of GDP per year, or almost a third of its annual revenue. Ballooning public sector wage growth over the last 12 years (public sector salaries increased on average by 80%, almost three times faster than the private sector) and soaring benefit payments were two of the biggest contributors to this as the government borrowed more money to facilitate such expenses. Bailing out the banks after the 2008 credit crunch also made a big dent in the nation’s balance sheet.

Keynesian economics suggests that you borrow in the hard times to make them softer and then pay it back when things are better. Unfortunately over the last decade or so, when times were good, we forgot to pay it back.

You only have to look at the issues in Europe right now to appreciate the importance of a prudent national fiscal policy. The Greeks effectively had a debt fuelled party for the last 15 years, it’s economy growing rapidly as a result of infrastructure developments and public sector employment growth. Unfortunately the Greek government’s revenues were not sufficient to service the ever expanding debt obligations, not helped by an archaic tax collection scheme that allowed many to avoid meaningful tax contributions.

Unfortunately, early in 2010 the Greek government confessed it was struggling to meet its liabilities, the cost of issuing new debt ballooned and its difficulties spiralled out of control. The nation has received a variety of bailouts and although it has had to make aggressive cuts, it still effectively got the Olympics for free.

Fast forward back to today and the ever growing difficulties in Spain and Italy. The ‘market’ has grown fearful that they too will be unable to fulfil their future obligations. Italy owes more than the value of its annual production, albeit with a small deficit, whilst Spain which does not owe much in total has a large annual deficit so its position worsens at a rapid rate. As a result of the market’s fear the yields (the annual income plus capital return) on existing Spanish and Italian bonds has increased substantially, at times more than triple that available from other Euro members such as Germany. As they redeem existing debt and reissue new, they are forced to pay an ever increasingly punitive rate of interest which actually worsens their position as their annual expenditure is forced upwards, a vicious circle of sorts.

The austerity being felt in the UK pails into insignificance against that being forced in Greece, Spain and Italy where the cuts have had to be deeper and more painful in an attempt to restore credibility.

The uncertainty has persisted all year as European politicians have failed to get to grips with the situation and come up with a credible solution. The global economy has arguably stalled somewhat as a result, partly due to the banking system being stifled by fears who owns what and who is going to suffer losses if Greece, Spain or Italy defaults. Furthermore if you are an expanding business now may not be the best time to gamble investment on expansion.

At the end of the day, if your nation’s balance sheet is financed by debt then you need to have the confidence of those that lend to you that you can pay them back, just like you or I would if we approached a bank. Uncontrolled spending and borrowing is just not sustainable.

The austerity the coalition are ‘inflicting’ upon the UK right now may well hurt, it effects everybody in every industry whether they appreciate it or not and we will have to suffer a few more years of hardship yet. At present the yield on UK ten year gilts is approximately 2.06%, that is effectively the interest rate it would pay when issuing new debt for the same period of time, whilst the equivalent Italian and Spanish versions are 6.9% and 5.5% respectively. Clearly the lenders to the UK, at present, have taken comfort from the austerity and that it will allow the nation to service our debt.

Looking at the problems escalating in Europe, it is hard to avoid the fact that unfortunately, austerity is a necessary evil.

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