Still CuttingLast year the Cameron government announced that it would pursue an austerity drive in an effort to reduce the budget deficit, cutting government spending and increasing taxes by about £9bn in 2010, £41bn in 2011, and £66bn (about 4% of forecast GDP) in 2012. Because of this sharp and determined fiscal contraction, it forecast that the budget deficit would fall from about 10% of GDP in 2010 to around 3.5% of GDP in 2013.
YESTERDAY, we learned that British Chancellor George Osborne has a harder task ahead of him than he'd been envisioning. Inflation continues to come in ahead of forecasts; that's no surprise. But it also seems that the government is borrowing more than it had planned to, largely because tax revenues have come in lower than expected. That probably has something to do with the weakening British economy.
Mr Osborne's new budget makes no bones about the likely near-term trajectory for growth. Projected output growth for this year has been revised down to 1.7% from 2.1%, and growth next year may be just 2.5%. Even so, inflation projections are higher. Prices are expected to rise between 4% and 5% this year, though the government reckons the increase will drop to 2.5% in 2012.
That turns out to have been a bit optimistic. Unsurprisingly, raising taxes and cutting government spending by a couple of percentage points of GDP over the past year has contributed to a recent sharp slowdown in the British economy, as shown below.
This recent decline in economic activity in the UK is reflected in the forecasts on which the government's new budget is based. The next chart shows how the slowdown in the British economy has forced the Cameron government to lower its forecasts for GDP growth compared to 9 months ago.
Naturally, reduced economic activity in the UK means that the budget deficit will not fall by as much as hoped. The budget just released indicates that the sharp spending cuts and tax increases will lead to only about half the hoped-for deficit reduction in 2011 and 2012, thanks primarily to the slowdown in the economy caused in large part by... sharp spending cuts and tax increases.
All of this is unsurprising. But it bears keeping in mind as the fiscal clown show in Washington continues, because it provides yet another piece of evidence that mainstream new-Keynesian macroeconomic theory does an excellent job of explaining and predicting real economic events. Which is why we can be fairly sure that efforts to cut government spending during a tentative and rather delicate economic recovery will have a strong negative impact on the economy, and will probably end up failing to meet deficit reduction goals as a result.