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Article 1: How could Philip Hammond ‘reset’ the UK's economic policy?

Britain’s Chancellor of the Exchequer, Philip Hammond, has declared that he is ready to ‘reset’
the government’s fiscal policy to respond to any slowdown caused by the UK’s decision to leave
the European Union. After six years of austerity, analysts believe that this is a further signal that
the Treasury will loosen the purse strings within months. The Chancellor has already outlined
his willingness to borrow ‘when the cost of money is cheap’, an indication that the government
could accept an increase in the budget deficit, in order to spend more on infrastructure and
public services. Many believe that the government is still maintaining fiscal prudence, even
though it has dropped its goal to balance the books by 2020. They still want a balanced budget.
Just not now.

Economic stimulus, in the form of tax cuts or government expenditure, ought to offset some of
the hit to growth that the Brexit vote could bring about. However, supporting the economy in this
way comes with a cost. If the additional borrowing does not boost growth sufficiently, it could
make the government more indebted, raising the national debt share.

The Organisation for Economic Co-operation and Development has calculated that raising
public investment in the world’s 34 advanced economies by 0.5% of their national output each
year over two years would pay for itself through higher growth in the UK, US, Eurozone and
Canada. However, large investment projects can also take time to get started. Instead, Danny
Blanchflower, a former Bank of England policymaker, says that cutting VAT from 20% to 15%,
would be something the Chancellor ‘can do tomorrow’, offering an immediate kick-start to
consumers and businesses.

Source: The Telegraph, 26 July 2016.

Article 2: UK Budget 2017, economic forecast and Brexit uncertainty

Philip Hammond has delivered his first budget since taking over the role of Chancellor of the
Exchequer after the UK’s Brexit vote. He has unveiled a brighter outlook for economic growth,
with an upgraded forecast for growth in 2017 from the Office for Budget Responsibility. He
spoke of job creation and wage growth. And, with public finances in better shape than expected,
he was also able to report lower borrowing forecasts.

But recent history shows us why we should not be so confident about all these healthy forecasts.
A look at the recent history of economic forecasting makes the upgraded expectations of 2%
growth in 2017 questionable. Deriving forecasts about the state of the UK economy and public
finances is a huge challenge – in general – but especially now that we do not know how the
UK’s relationship with Europe will shape up following Brexit. Indeed, forecasts in the past
usually turned out to be wrong. For example, during the 2008-2009 financial crisis, GDP fell
earlier and more sharply than policymakers thought at the time. Since 2015, provisional GDP
growth data seems to be sending the rather misleading signal that the economy is doing better
than it actually is. The Office for Budget Responsibility (OBR) – the UK’s fiscal watchdog – has
warned that ‘governments should expect nasty fiscal surprises from time to time – because
discretionary policy can only reduce risks, not eliminate them.’

Irrespective of what Mr. Hammond’s thinking might have been, the health of the UK public
finances critically depends on the country’s economic performance. This is hard to pin down.
Indeed, provisional published GDP data are often revised quite dramatically down the line. This
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is more the case in periods of increasing uncertainty – such as the recent financial crisis and the
present volatile economic climate following the recent Brexit vote.

Source: Newsweek, 9 March 2017.

(a) (i) What is your understanding of the term ‘discretionary fiscal policy’?
Fiscal policy refers to the action by the government to influence aggregate
demand by altering its level of taxation and expenditure.

(ii) How are tax cuts and a rise in government expenditure supposed to ‘offset some of
the hit to growth that the Brexit vote could bring about’ (Article 1)?
• Show the AD-AS diagram, with a rightward shift in AD curve, raising
aggregate price level and national output
• The Keynesian solution to a recession involves boosting aggregate
demand by raising government expenditure or cutting taxes, or both.
• Raising government expenditure may produce more direct impact on
aggregate demand, since all money gets spent.
o An increase in government expenditures by $x may have multiplier
effects in raising aggregate demand by more than $x.
o Additional government expenditures create additional income for
some people. Recipients of this income will in turn spend it, thereby
increasing aggregate demand further.
o Each dollar gets spent and respent several times.
• Reducing taxes increases may produce less direct impact on aggregate
demand. By reducing taxes, the public’s disposable income would rise.
This would encourage consumption and investment expenditure, thus
stimulating aggregate demand.
o However, tax cuts may produce smaller effects on aggregate
demand, since only part of the increase in disposable income would
be spent and part will be withdrawn into savings. They may simply
save the extra disposable income if they were pessimistic about
future macroeconomic outlook or perceive the tax cuts to be
temporary

(b) Using the concept of ‘automatic stabilisers’, explain why ‘the health of the UK public
finances critically depends on the country’s economic performance’ (Article 2).
As national income falls during the recession,
• More people would be pushed to lower tax brackets, thus reducing tax revenues
received by the government.
• More people would be unemployed, thus making the government to provide
more unemployment benefits. "

(c)
• The combination of these forces will enlarge the size of budget deficit.

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It is reported in Article 1 that the Treasury has been running years of fiscal austerity to
reduce growing national debt. However, it might now ‘loosen its purse string’ in response
to any slowdown caused by the UK’s decision to leave the European Union.

Critically evaluate whether this move makes good policy sense.

o The Keynesian school holds the view that fiscal policy should be actively
used as an instrument for stabilising macroeconomic fluctuations. As
such, budget deficits are desirable (or even necessary) during recessions
or slowdown, and should not be judged as fiscal recklessness. Prolonged
recessions, slowdowns or uncertainties would be damaging to
investment and hence long-term growth prospect.
o In addition, the Keynesian school believes that the economy is vulnerable
to shocks of all kinds. Fiscal policy should be administered in such a way
that the economic shock waves could be minimised, if not mitigated.
There are concerns that if discretionary fiscal deficit is not administered,
recession or slowdown would become worse and even more
destabilising.
o Increasing spending on infrastructure would raise the country’s
productivity and future economic performance. Spending on public
services would be necessary for ensuring that the welfare of those who
are less well-off is taken care of.
• The case against discretionary fiscal deficit
o Higher deficit-spending would cause the stock of debt to swell. If
investors cannot be convinced that the government would effectively
reform the fiscal procedure and reduce the size of public debt and deficit,
stronger
their confidence would be damaged, thus mane amplifying macroeconomic
instability. The danger of national insolvency and bankruptcy is real.
o Public sector consumes substantial resources, thus limiting the growth
of the private sector. If excessive government expenditure or budget
deficit is financed by non-bank private sector (i.e. does not rely on
monetary expansion), it would compete with the private sector for finance
and will have to offer higher interest rates. This would discourage firms
from investing.
o Larger stock of national debt must essentially be repaid. The burden of
national debt incurred by the current generation is likely to fall upon the
shoulders of the future generation.