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IF Insights: Can governments cut public spending to fight inflation?

IFM_Inflation
Demand-pull inflation arises when aggregate demand outpaces the supply of goods and services, increasing prices

Inflation poses a significant challenge to governments and economies. When faced with rising prices, policymakers often consider reducing public spending a potential solution.

However, the effectiveness of this strategy remains a subject of debate. Can governments cut public spending to fight inflation? By examining empirical data and case studies, we will evaluate the impact of reduced public expenditure on inflation rates and shed light on the potential downsides of this policy move.

According to the Bank of International Settlements, governments must either increase taxes or reduce expenditures after central banks keep interest rates too low for an extended period in the face of rising inflation, a phenomenon which started in 2022, coinciding with the Ukraine war.

According to the Basel-based organization, which provides advice to 63 central banks overseeing 95% of the world’s economic output, closing the gap between government income and expenditure would “calm down inflation.”

The institution stated that governments that are cutting down on spending or raising taxes would decrease business and consumer demand and be a crucial part of the “last leg” in the fight to tame inflation, which despite an intense run of interest rate rises by central banks around the world is far from over. To slow the rapid pace of price growth, however, this last push would also be the “hardest.”

The BIS took a firm stance amid worries that the United Kingdom’s economy is already entering a recession following abrupt interest rate increases, stating that increased taxes and less expenditure could “contain financial instability risks in multiple ways.”

It would lessen the need for further tightening of monetary policy, apart from providing “additional headroom” should public resources be called upon for crisis management in coordination with central banks.

“It would reduce the possibility that the sovereign becomes a source of financial instability,” BIS stated further.

Despite freezing personal income tax thresholds that will result in an increase of higher rate taxpayers over the next five years, Jeremy Hunt’s March 2023 budget somewhat relaxed the Rishi Sunak government’s purse constraints.

Conservative legislators are unlikely to approve increased taxes given that millions of working households are already dealing with rising mortgage payments and retail costs.

Relationship Between Public Spending & Inflation

Examining the underlying factors that drive inflation is crucial to understand the connection between public spending and inflation. Both demand-pull and cost-push factors can cause inflation.

Demand-pull inflation arises when aggregate demand outpaces the supply of goods and services, increasing prices. Cost-push inflation occurs when production costs rise, resulting in businesses passing higher costs to consumers.

Reducing public spending can directly impact aggregate demand by cutting government expenditure on goods, services, and welfare programs. This reduction in spending can help curb inflationary pressures stemming from excessive demand. However, the efficacy of this strategy depends on the extent to which public spending contributes to aggregate demand in a particular economy.

Amid concerns that the UK economy is already heading into a recession after a succession of sharp interest rate rises, the BIS took a tough line, saying higher taxes and lower spending could “contain financial instability risks in several ways.”

“It would reduce the need for monetary policy to tighten further. It would mitigate the risk that the sovereign itself becomes a source of financial instability,” it added, saying it would also “create more headroom should public resources be called upon for crisis management in concert with central banks.”

Jeremy Hunt’s budget loosened government purse strings slightly despite freezing income tax thresholds that will increase the number of higher-rate taxpayers by 2028.

The Taxpayers’ Alliance has called for further spending cuts but, in opposition to the argument by the BIS, said the funds generated should be used for tax cuts.

If efforts fail to reduce the inflation rate in the short term drastically, the impact on economies could be devastating, the Bank of International Settlements stated, warning that although inflation had come down from recent historic highs, there was still a serious risk posed by a prolonged crisis.

“The longer inflation is allowed to persist, the greater the likelihood that it becomes entrenched and the bigger the costs of quenching it,” the BIS said.

The United Kingdom hasn’t been able to follow the declining trend of European inflation and deservedly, now facing criticisms.

Recent calls for significant government interventions in areas such as financial support for British mortgage holders affected by higher monthly payments came after “decades of reliance on monetary and fiscal policy as de facto engines of growth,” according to the BIS report.

Case Studies On The Impact Of Spending Cuts

United Kingdom

In the early 2010s, the UK implemented austerity measures involving substantial cuts in public spending. Proponents argued that these measures would alleviate inflationary pressures.

However, the National Institute of Economic and Social Research (NIESR) found that austerity had a limited impact on inflation. The study revealed that while public spending reductions slightly lowered inflation in the short term, the long-term effects were negligible. Moreover, the cuts had adverse consequences, such as reduced public services and weakened economic growth.

Greece

During the sovereign debt crisis, Greece implemented severe austerity measures to tackle inflation and stabilize its economy. However, these measures had mixed results. While the move temporarily lowered inflation, the negative impacts on economic growth and social welfare were profound. GDP contracted, and unemployment rose, followed by social unrest, thus hampering the country’s recovery.

Downsides Of Cutting Public Spending

Drastic cuts in public spending can result in an economic downturn characterized by reduced consumer spending and business investments. This can further exacerbate the inflationary pressures arising from weakened economic activity.

Also, reductions in public spending often translate into reduced social welfare programs, healthcare services, and infrastructure investments. Such austerity measures disproportionately affect vulnerable populations, increasing social inequality and hardships for those relying on public assistance.

Public spending on education, research, development, and infrastructure can contribute to long-term productivity gains and creation. Cutting these expenditures can hamper the potential for future economic growth and reduce a country’s competitive edge in the global market.

Also, overly aggressive cuts in public spending can push an economy into a deflationary spiral. Deflation, characterized by a persistent price decline, can lead to decreased consumer spending and business investments, exacerbating economic stagnation.

Conclusion

While reducing public spending may offer short-term relief in curbing inflation, the long-term effectiveness of this strategy still needs to be investigated. Case studies in countries like the UK and Greece demonstrate the limited impact of such measures, coupled with significant social and economic costs. Governments must consider a balanced approach.

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