When a saver deposit ￡100 in bank x, the money will not sit still in the bank. Instead, the bank will try to lend some of money, where amount only limited by the capital reserve requirement set by the central bank. If the bank decided to lend the 90% of the money to company A, company A will eventually deposit a fraction ( let say 90%) of the money into bank y, bank y will then try to lend 90% of the money to company B.
At the end, a ￡100 primary deposit will end up in total of ￡100 + ￡90 + ￡72.9 = ￡262.9 in the economy. This is how the economy expands in financial term.
What happened during financial crisis was, when the primary depositor trying to call back ￡50 of the money he deposited, bank x have to recall ￡45 of the money it lend.As company A withdraw deposit to pay back loan, bank y have to recall the loan it made with the same portion to the deposit withdraw by company A.
Hence, an initial withdrawal of ￡50 will reduced the amount of money available in the economy by ￡45 + ￡22.5 = ￡67.5 . (provided company A decided to hold same amount of cash)
However, during the financial meltdown, the bank tends to horde more cash reserve by recalling more loan. Company A will forced to liquidate some of its assets if the amount recalled by bank is more than the amount of liquidity company A have. The fire sell of assets ( such as house price or equities) will drive down the values , forcing more company to go into negative balance and hence had to withdraw more deposit to maintain liquidity. This vicious spiraling cycle is precisely what happened during global financial meltdown of 2008.
Even if somehow, the primary depositor feel safe to keep their money in their bank (because of deposit insurance), and the central bank is pumping more ￡100 into commercial bank, the multiplication effect of the money is determined by the willingness of the bank to lend, and the willingness of the company to borrow. If the bank is unwilling to make riskier loan to avoid worsening their own balance sheets, and creditworthy companies decided to borrow less amid by economy uncertainty, the bank might end up loaning less fraction of the money, creating less money in the economy. This is precisely what happening now when UK facing the potential threat of double dip recession.
The key here is restoring the confidence of the market, by restoring economic growth through increasing government spending throught keeping large budget deficit. Ie, when the government acted as the borrower of the last resort, absorbing the cash reserve save by the bank, to recycle the money back in the economy. However, as I will try to show, this action came with huge costs of inefficiency and increasing government debt.
If the government decided to pay off a public servant( or funding a project that hired worker) about ￡100, the immediate tax revenue that the government can generated back, is 20% ( including income tax and National insurance contribution).
Out of the ￡80 that the worker receive, some will be paid to local council, some will pay back to government when they spent on tobacco and fuel, some will be save by them/ or used to pay loan to finance purchased of house, some will pay as rent. Only a fraction of it(lets say 50%, will be spent on goods that incurred VAT.)
Hence, the government only receive about ￡30 of each ￡100 spent immediately. ( including income tax, NI, VAT and tax on income gained from financial assets
). Out of the ￡70 , only ￡40 will be recirculate at the economy for further taxation. An amount of ￡30 will be untaxable.
The idea is that if you put the total money in recirculation as a sum of infinite GP series, with r as the fraction of money recirculate, t is the tax rate. And imposing the condition, r+t <= 1 ( the sum of income taxed and income spent to be recirculate in economy could not be greater than 1) .
The total tax return that a government can get from what it spend is t*(￡100/1-r), which could only equal to ￡100 if r+ t = 100. ( extremely unlikely as people will save some of the money, or spent it on way that is taxed at lower rate/non taxable such as rent and interest on mortgage payment.)
Hence, the conclusion, the government can never taxed the money back from its own spending. It will have to eventually financed it by borrowing ( or deficit ). You can never grow an economy in sustainable path simply rely on government spending. The only benefits of increasing gov spending and keeping budget deficit, is to create a false hope/confidence/demand that stimulate the economy, so that the economy can start its own hope/confidence/demand that will be sustainable.
Furthermore, the only two reason developing can keep budget deficit without much trouble, is by selling government bond to foreign investor as a way to attract foreign capital into local economy, and glowing themselves out of debt burden. ( As long as GDP growth rate is higher than debt accumulation rate, a debt to GDP ratio of 100% with total debt growth at 5% per year, will down to debt to GDP ratio of 63% in 10 year as long as the GDP growth rate is 10% a year).
The reason that the developing country can growth out of their debt burden, are they have faster population growth and pyramid demographic structure which have growth in total demand, combined with untapped efficiency potential in current productivity practiced, coupled with the catch up effect due to the lack of their economy compared with the developed one.
However, developed countries won’t have these three growing factors, thus if their debt burden growing too fast, they will not be able to grow themselves out of the debt burden. The only reason, that the US, and UK are keeping large government deficit, is to prevent the economy from collapsing.
Hence, cutting spending might reduced tax revenue generated from the spending alone, but the overall effect will improve the government balance sheet. Increasing taxation will reduced disposable income in the economy, but depending on which tax is increased, the increased should have zero to positive impact on government balance sheet. The only costs of doing it, is by reducing the size of the government in economy, it will produce a false fear/lost in confidence/collapse in demand that might initiated a real one in the underlying economy.
The need to improve government balance sheet, stems from the costs bear by rising government debt burden. First, it competes with private sector for the same source of capital, driving up interest rate unless the central bank decided to finance it by printing more money (or quantitative easing ) . However, when central bank started printing money to finance government deficit, inflation started. Second, when government debt burden is too high, private sector will deemed the government to be insolvent and start demanding higher interest rate, which worsening the government balance sheet due to increasing interest payment for debt. Thus, forcing the government debt burden into unsustainable path that the government will be forced to default (Like what happening in Greece now).
The default could be less painful, if the debt is denominated in local currency brought by foreign investor, the government can simply deflated its currency( like the USA). However, whether the burden can be reduced or not, a sovereign default will have a devastating effect on the economy, which initiates recession for several years.
As mentioned before, given the UK economy can never grow rigorously like the developing country again ( at least not without a big recession), the danger of sovereign default, far exceed the danger of potential double dip recession caused by government austerity measures. The key is , you can’t avoid the pain after the labour badly managed the public finance during the boom year, the only thing you can do is making it less painful at a time, avoiding extra pain induced.
Hence, Ms largade would be right to comment that UK fiscal consolidation plan was appropriate,
. The Welsh economist would be wrong to urge the government stop austerity plan now, when using the “if …” clause of Ms Largade,
Martin Wolf article on FT argued that the market is begging the government to borrow more, but I will agree with Stephen King on FT, that the low bond yield cannot justify higher government borrowing.
The key question,whether you should accept the inevitable GDP stagnation/shrunk followed by government austerity measure is, whether the part of the role that the government play in economy, is justified or just a waste of resource to create a false demand.
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