The Cuts!

So the Tories (helped by the Lib Dems) got into power in the end, and late last week were able to announce the first installment in their cuts, £6.25bn announced by George Osborne last week. As noted in the Times article flagged up in the last post on GDP growth, this fiscal tightening is likely to act as a "brake on growth".

That comes from the simple analysis from the circular flow of income and the multiplier effect. From there, government spending (G) was an injection of funds into the circular flow, and taxation (T) a withdrawal. If G rises, the money then goes round the cycle a few times, with withdrawals along the way. So if £6.25bn was injected into the economy, the overall effect would be greater than £6.25bn.

How much greater? This depends on how much is withdrawn each time, and of course everybody is different. But let's look into some rough and ready figures. The top band of income tax is currently 40%, but of course we're taxed in many ways less directly. So lets say half our income goes in taxes. Then there's savings. The data suggest that essentially we don't bother saving much these days - although that's changing at the moment with all the talk of austerity. So lets say we save 10% of our income. Then we import a lot too, so lets say perhaps we import goods amounting to about 20% of our income. That leaves just 20% of that £6.25bn still in the cycle next time round.

The overall multiplier then will be 1/0.8=1.25 and hence £6.25bn becomes only £7.8bn. So assuming the same works in reverse, then perhaps George's cuts won't be too bad.

But, of course, what if we don't import as much as 20%? What if we save a bit less? Say we save just 2% of our income, and import 10%, then the marginal propensity to withdraw (what we divided by a moment ago for the multipler) becomes 1/(1-0.5-0.02-0.1)=1/0.38 and £6.25bn becomes £16.4bn.

How much is the economy currently growing by? GDP in 2010Q1 was £360bn up from £349bn in 2009Q1 (see http://www.statistics.gov.uk/statbase/TSDdownload1.asp). So that appears to be a jump of just £11bn between 2009Q1 and 2010Q1.

We shall have to wait and see what the effect of Osborne's cuts are. At least one commentator acknowledges the effect of the multipler (see this FT article), but doesn't think it'll be big enough to tip us back into recession. It'll be interesting though (and painful for many I imagine).