Tuesday, 15 May 2012

George versus George

George Chapman challenges George Osborne
image from: static.guim.co.uk

In principle, the remedy for our limping economy is simple. It is imperative that we cut the deficit (as much as we can) whilst stimulating growth at a sustainable level. However, the policies required for such macroeconomic engineering are not so easy to uncover, and unfortunately George Osborne is probably not our Sherlock Holmes.
The deficit hawk’s recent austerity measures were (and indeed still are) what this economy needs to begin to cut the UK deficit. That is however only half of the story. In practise, an emphasis on debt reduction through cutting government spending should act as a quick fix for our debt, reducing the deficit almost immediately but will also succeed in shrinking the UK economy.  One macroeconomic measurement of an economy’s performance is ‘aggregate demand’; equal to C + I + G + (X-M). We can see in this summation that any change in government spending G will have a direct impact on aggregate demand, where austerity leads to a fall in G and a subsequent fall in AD overall.  The diagram below illustrates one such contraction, through the inward shift of AD1 to AD2.
As any point on the aggregate demand curve represents GDP, we can diagrammatically appreciate this economic shrinkage through the shift of curve AD1 to AD2 and the intersection of the shifted aggregate demand curve with short run aggregate supply. The economy has reached a new equilibrium, where a fall in inflation and deficit reduction has occurred but where the economy is also feeling the effects of both austerity measures and unemployment.  In short, although this policy can be employed to remedy the deficit, it should not be used exclusively in order to be of optimal benefit to the UK economy. If possible, expansionary demand-side policies should also be used to boost growth so as to start to pay back some of the debt and to begin the long process of economic recovery in the UK.
Free-marketers would argue we need to spend or invest our way out of a recession, and boost growth as much as the economy will allow. Industry deregulation and corporation tax cuts in accordance with a reduction in government spending as above will encourage private sector investment I. Thinking back to the summation AD = C + I + G+ (X-M), an increase in investment I will hypothetically have an inverse effect to above, and there will be an expansion of the aggregate demand curve. Thus, the result is GDP, and colloquially economic, growth.
To summarise, when posed with two different macroeconomic problems, it is not possible to combat both with one individual policy. With the UK’s current economic conditions, we must reduce government spending immediately and simultaneously boost growth in order to start on a long road to recovery. Therefore, if I were Chancellor, policies to have sprung from my red briefcase on Budget-day this year would have focused on drastic cuts in government spending, but equally importantly industry deregulation and corporation tax cuts. However, each of these courses of action are demand-side, and in fact conflicting. Thus, it is crucial that a balance is instated between the two policies, adjusted accordingly once implemented, such that we do not end up with too much austerity at the expense of growth, or indeed vice versa.

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