Monday, 25 April 2011

The difficulties of reducing large public sector deficits such as those in Ireland, Italy and Greece

The EU says that its members can have a deficit of no more than 3% of GDP per year, and that total government  debt should not exceed 60% of GDP. These are seen now as more of guidelines than actual rules, as most of the member states have broken one or both of them (including Germany).

Currently, Italy, Ireland and Greece are running huge public sector deficits, due to their generous welfare systems along with highly-paid public sectors - not to mention the tax evasion that is rife in Greece - which are having to be financed by large amounts of borrowing, subsequently increasing total government debt. Because the EU sets out guidelines of the amount of borrowing that is acceptable, once an economy begins to exceed these, they are warned that if they cannot control their borrowing through either increases in taxation or reductions in public spending (austerity measures) then the central bank will take control of their fiscal policy and make the cuts for them, as well as potentially bailing them out. This happened in Portugal, where they were dangerously close to "defaulting" which is effectively a declaration of bankruptcy and saying that you are unable to repay your loans. Defaulting is best avoided.

While raising taxation and/or cutting public spending sounds like a relatively straightforward way of reducing the deficit, it is not. It is very difficult to increase taxation or reduce government spending without harming economic growth, and just after a global recession, this can be disastrous, as it could lead to a double-dip recession. Cutting government spending would harm economic growth in the short run as government spending is a component of AD, it would also affect long run potential growth as it may lead to schools having to close or public sector jobs being lost. Increasing taxation would also harm growth by reducing levels of investment by firms or reducing consumption as people have less disposable income (income after tax), both of these are also components of AD. In Spain, as it says in extract 3, they "feared the social consequences of high unemployment" which may be brought about through public sector cuts, this led to them increasing unemployment benefits which puts a further strain on the government budget.

Furthermore, if a government chooses to continue with high levels of public expenditure in order to grow out of the recession before deciding to make cuts, they may risk losing their credit rating, currently the UK has a AAA credit rating, and because the government is doing lots to reduce our deficit, it seems that we will keep it. Spain, however, recently had its rating reduced for the banking sector to AA. The effect of a lower credit rating means that you are considered less likely to re-pay the debt you owe, which means lenders will most probably increase the interest rates they ask for in order to outweigh the risk of lending.

In conclusion, it is the risk to economic growth, as well as the social consequences that make reducing large deficits very difficult. It is, however, necessary if a country wishes to continue to be able to borrow at low interest rates in the future.

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