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Transcript
Case K2 Trends in Public Expenditure And the crowding-out debate From 1900 to the mid 1970s, general government expenditure (GGE) as a percentage of GDP rose substantially. The rise, however, was not steady. On occasions, such as during the First and Second World Wars, the level of GGE rose dramatically (but without returning afterwards to previous levels). 50 48 Annual growth rate (%) 46 44 42 40 38 36 34 1970 1975 1980 1985 1990 1995 2000 2005 Figure 1 UK general government expenditure as % of GDP But after 1975, as Figure 1 shows, the trend turned downwards. In 1989 GGE as a percentage of GDP was 40.5 per cent – its lowest level for 22 years. However, the deep and protracted recession experienced by the UK in the early 1990s pushed expenditure rates back upwards again to reach 46.1 per cent by 1993. Nevertheless, with relatively rapid economic growth for the remainder of the 1990s, the rate progressively fell, to stand at 37.5 per cent in 2000. However, in absolute terms, GGE was still rising. It rose from £256.2 billion in 1981 to £339.9 billion in 2000, both in 2000 prices. Since 2000, with slowing economic growth, GGE as a percentage of GDP rose, to stand at 43.3 per cent in 2003. Despite more rapid economic growth since, it has continued to rise as government expenditure on health and education have increased significantly. By 2006 it had reached 45.6 per cent. Figure 2 shows that the five largest areas of GGE are social protection, health, education, law and order, and defence. Only defence has declined as a percentage of GGE (thanks to the ending of the ‘cold war’). Housing 1.8% Environment 1.7% Other 3.6% Recreation/Culture 2.3% Transport 3.7% Industry and Agriculture 3.8% Social protection 33.9% Debt interest 5.3% Law and order 6.0% Defence 6.2% Education 13.9% Health 17.8% Figure 2 Government spending by function: % of £488 billion (2005/6) Attempts to control public expenditure since 1979 As Chapter 31, section 2 shows, Conservative governments in the 1980s and 1990s adopted a number of tough measures to reduce the level of public expenditure (or to improve its efficiency). But despite the Conservative government’s desire to achieve savings in public expenditure, most of the cuts were only at the margin. In real terms, GGE continued to rise. Of all the government’s budgets, only housing, cut by 67 per cent between 1979 and 1990, was dramatically reduced. It is only by trimming the big four: social security, health, education and defence, which together account for 70 per cent of all spending, that GGE can be significantly reduced. If, at the same time, there is a desire to improve public services in both quantity and quality, a commitment of the Labour governments since 1997, any trimming becomes very difficult. All that can be done is to focus on improving efficiency. But the scope for efficiency gains, is limited, given the push to make such gains over the past 20 years. Why is controlling public expenditure seen as such an important economic goal? The answer lies in what is known as the ‘crowding-out debate’. The crowding out debate If increased government expenditure is used to stimulate output and employment, will the effect be neutralised by crowding out? Will, for example, a programme of public works to bring the economy out of recession merely lead to a reduction in private expenditure? To answer this, it is important to distinguish two types of crowding out: resource crowding out and financial crowding out. Resource crowding out This is when the government uses resources such as labour and raw materials that would otherwise be used by the private sector. This would clearly be possible if the economy were operating near full capacity. Workers cannot be in two places at once. If they work for the government, they cannot at the same time work for a private company. The argument is far less convincing, however, if there is slack in the economy. If the government merely mobilises otherwise idle resources, there need be no reduction in privatesector output. Quite the opposite: if there is a growth in public-sector output and employment, this will stimulate a demand for goods produced by the private sector too. If these privatesector firms have spare capacity, they will respond by producing more themselves. This is the argument put forward by Keynesians: extra aggregate demand will stimulate extra production. Financial crowding out This occurs when extra government spending diverts funds from private-sector firms and thus deprives them of the finance necessary for investment. If the government spends more (without raising taxes or printing more money) it will have to borrow more. In order to attract people to buy government securities or put their money in National Savings, the government will have to offer higher rates of interest. Private companies in turn will then have to offer higher rates of interest themselves in order to attract funds. Alternatively, if they borrow from banks, and banks have less funds, the banks will charge them higher interest rates. Higher interest rates will discourage firms from borrowing and hence discourage investment. In short, if the government spends more money, there will be less money for the private sector to spend. The weakness with this argument is that it assumes that the supply of money is fixed. If the government spends more but increases the amount of money in the economy, it need not deprive the private sector of finance. Interest rates will not be bid up. But would not that be inflationary? No, say Keynesians, not if there are idle resources and hence the extra money can be spent on extra output. Only if resource crowding out takes place would it be inflationary. What if the government reduces its expenditure: will this result in a release of resources and funds, and will this lead to extra private expenditure? This is an even more contentious claim, given that a successful reduction in government expenditure would lead to a direct reduction in aggregate demand, whereas any fall in interest rates, made possible by the reduction in government borrowing and the consequent release of funds to the private sector, would only stimulate private investment expenditure if there was confidence that the economy would expand. Question What is the connection between financial crowding out and resource crowding out?