AQA ECON4 JANUARY 2012 CONTEXT 2
D Fiscal policy is government policy in relation to government spending and taxation. A requirement for all EU members states to balance their budgets would mean that all government spending would have to be financed by taxation revenue and no new government borrowing could occur. I One effect of such a requirement for the UK would be that it would lose the power to run a budget deficit in order to help counter downturn or recession. Ap As the extract identifies, governments including that of the UK were keen to use Keynesian policies to boost aggregate demand in the face of the recession in 2009. An Government spending is an injection into the circular flow of income, while taxation is a leakage. Accordingly, government borrowing results in a net injection of aggregate demand to the economy, helping to generate business for firms and support output. This can be boosted by multiplier effects as the injection creates incomes for firms and workers, allowing them to spend and create income for others. Jobs are also created because the demand for labour is derived from the demand for goods and services that labour produces. In this way, running a budget deficit can help the government to counter recession by preventing the gap between current and potential output becoming too great. An Diagram A balanced budget rule would reduce ability of UK to manage demand

I A second effect for the UK of being required to balance its budget would be that it might actually have to tighten its fiscal policy during a recession. An This is because government finances deteriorate automatically during a recession. Shrinking economic activity reduces the tax base and lowers government revenue, while transfer payments in the form of benefits are likely to increase. This may create a budget deficit which is contrary to the new balanced budget rule and necessitate that the government increases tax rates or cuts its spending. This may then make the recession worse. I The UK could also suffer as a result of other EU member states being required to balance their budgets. An This is because the rule would limit the ability of governments across the EU to stimulate demand and support growth in their economies. Lower income would then result in lower consumption, and this would serve to reduce demand for UK exports, in turn hitting growth in the UK. Evaluation/final judgement (s) I It is clear, then, that a new balanced budget requirement in the EU would prevent both the UK government and others from being able to use fiscal policy to manage the short to medium term performance of their economies. An The recession in 2009 has shown just how important this ability can be. The loss of this power could have particularly serious effects because of the large extent to which trade between EU countries contributes to the output of them all. Collectively, the EU countries are the UK’s largest trading partner by some distance and the UK could be badly damaged if the balanced budget requirement led to subdued growth in these countries. Kn/Ap/An This is especially important due in view of the UK’s current need for a rebalancing of its economy so that it relies less on domestic consumption and can enjoy more export-led growth. While it is possible that over time emerging economies may become important markets for UK exports, we are currently highly dependent on our trade with EU countries, so could be hit badly by the balanced budget requirement. I The effects of the balanced budget requirement may be more beneficial when considered in the long term, however. Ap As the extract suggests, “it cannot be denied that the best way forward is that which delivers macroeconomic stability across the EU”. The balanced budget requirement would help to prevent member states from accumulating unsustainable national debts. The example of Greece with its “budget deficit of 14% of GDP and national debt of 115% of GDP in 2009” demonstrates the impact that this can have. An Investors began to see it as being too risky to lend to the Greek government, with the effect that interest rates rose and Greece was effectively bankrupt, needing support from other EU member states. Greece is now experiencing rapidly falling incomes and savage cuts. It is possible to argue that had a balanced budget requirement been adhered to in earlier years, the long term effects would have been much better for Greece, for the EU, and by implication for the UK’s export markets.

I A straight forward balanced budget requirement would be too restrictive for EU and the UK, however. It would be better to require that budgets be balanced over the length of a business cycle. An This would allow governments to run deficits to counter recessions, so long as they ran a corresponding surplus later in the business cycle. Any budget deficit would then be cyclical rather than structural. The national debt would not increase over time, but the government could still smooth the business cycle. Further, it would be sensible to allow governments to borrow for investment purposes, as this allows the capacity of the economy to increase, generating sustainable economic growth and increased tax revenues in the future. An Both the UK government and other EU governments do need to ensure that their finances are well controlled. Without this, borrowing may become unsustainable or interest rates may increase, as investors demand a risk premium when lending to governments. Kn A number of European nations are now in this position, and even France has lost its AAA credit rating. An While a balanced budget requirement could help to produce macroeconomic stability, and in this way help to protect the UK’s interests, the requirement should be applied over the length of an economic cycle and borrowing should be allowed for investment purposes. These are the rules that applied in the UK prior to the global financial crisis. However, once rules are set they should be adhered to, otherwise their potential benefits are lost. It would be beneficial for the UK if these rules were adopted by the EU, but with measures in place to ensure that they cannot be flouted by governments. An Diagram Budgets should be balanced over the length of a cycle