Why cuts in real spending could be double the projections


8:09 am - October 21st 2010

by Chris Dillow    


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By how much will public spending fall in real terms?

The Treasury puts the fall in departmental and administration budgets at 8.3% in real terms between 2010-11 and 2014-15: see table A5 here (pdf). This could be too optimistic.

It implies that prices rise by 9% in the next four years – 2.2% a year.

However, in their Budget forecast, the OBR predicted the GDP deflator rising by 9.8% cumulatively; table C5 here (pdf).

What’s more, there’s a long-run tendency for general government prices to rise faster than inflation generally – that’s the Baumol effect.

In the last 20 years, the general government consumption deflator has risen 1.5 percentage points a year faster than the CPI – by 3.9% against 2.4%*.
If this continues, and if the Bank of England hits its inflation target, then the government deflator will rise by 14.8 per cent over the next four years, implying a fall in real departmental budgets of just over 14% – almost 6 percentage points more than the Treasury expects.

The real squeeze on spending could be tighter than Osborne claims.

* I’m dividing code identifier NMRP by NMRY from table A2 here.

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About the author
Chris Dillow is a regular contributor and former City economist, now an economics writer. He is also the author of The End of Politics: New Labour and the Folly of Managerialism. Also at: Stumbling and Mumbling
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Reader comments


Though aren’t public sector wages being held down so that public sector inflation will likely – at least over this period – be below general inflation?

Hooray!

The biggest driver of the ‘ Baumol effect ‘ are wages. It would be a pretty heroic assumption to imagine wages will outstrip inflation over the next few years. Moreover, suppliers will have very little pricing power.

I don’t think you can average it like that over the 2010/11 – 2014/15 period. Mainly because they have front-loaded the retrenchment with tax rises in the early years. For example, using Simon Ward’s figures, total managed expenditure is only projected to fall between 2009/10 and 2011/12 by £2 billion and tax receipts increase by £45 billion. Therefore, if you express it in constant 2011/12 prices, tax rises are actually taking 96% of the burden until 2011/12. So averaging the GDP deflator will not give an accurate real terms number for the first two years or indeed for the whole period. In a weak economy, front-loading tax increases in a consolidation is Mr Osborne’s big gamble. It is reckless in my opinion.

4. Luis Enrique

Isn’t the biggest driver of the Baumol effect productivity improvements in manufactured goods? It’s about relative (real) prices. If you hold wages constant but make T-shirts cheaper, you get the Baumol effect.

but while the above is probably technically correct, we’ll probably not get cheaper T-shirts over next few years either (weaker pound, domestic inflation in China)

Stiglitz has made his opinion known, and he thinks the cuts are wrong: http://www.guardian.co.uk/commentisfree/cifamerica/2010/oct/19/no-confidence-fairy-for-austerity-britain

Yes productivity in the industrial sector is key, Luis. However, the way the BE impacts the public sector is the public sector are labour intensive and have to compete with the industrial sector who have the productivity gains for labour. Therefore, being labour intensive pushes up their costs. I think there is a public sector wage freeze at the moment and I can’t see how there will be a BE over the next few years.

but while the above is probably technically correct, we’ll probably not get cheaper T-shirts over next few years either (weaker pound, domestic inflation in China)

Also this year’s cotton havest is buggered and prices have gone up accordingly.

Martin Wolf is as oft-quoted as Stiglitz.

He was on R4 this morning with Rogoff (Harvard).

Though I doubt the left will be quoting his view that Plan B (poss his own Plan A) should be tax cuts to offset the spending cuts. Indeed he believes the spending cuts are absolutely necessary to get govt back to a more reasonable 40% of GDP.

cjcjc, Martin Wolf is right if the coalition had their minds set on a consolidation in this timescale then they should have cut taxes. What they are actually doing makes no sense. The Treasury forecast that the consolidation will be 76% from spending and 24% from tax between 2009/10 and 2014/15. But the spending cuts are phased and the tax rises are front-loaded. Tax rises are just about the worst thing you can do to a weak economy and that is why they should come in later years of a consolidation. Some of the tax rises are inherited from the last government, but the Tories criticised them but they are keeping them and have added their own. Next year will be like a rise in interest rates for the economy.

If they were not prepared to go slower with the consolidation, it made more sense to cut spending more and offset with tax cuts. What we have is a classic fudge cobbled together by the two factions of the coalition. Let’s be clear they are gambling and next year will be crucial.


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