4.5.4

• Fiscal austerity

  Fiscal austerity is the term used to describe policies designed to reduce the size of a government fiscal deficit and eventually control / lower the size of the outstanding national debt. In the UK, austerity policies were in place from 2010 in the aftermath of the Global Financial Crisis. Austerity has also been imposed in countries such as Greece and Italy as part of the bail-outs of national governments by the European Union and the International Monetary Fund.
• Arguments in favour of fiscal austerity

  1. Reducing the budget deficit and the national debt is in the long run interests of the economy - e.g. UK taxes lower and can avoid the problem of the state sector crowding-out investment and growth in the private sector
  2. Shrinking state encourages private sector growth in the long-run
  3. There is a high opportunity cost of the amount spent each year on debt interest
  4. Cutting the fiscal deficit can improve investor confidence and might attract more FDI into the UK
  5. The upturn of the economic cycle is time for government to borrow less
• Arguments against fiscal austerity

  1. Austerity is self-defeating especially if it leads to price deflation and lower employment, because this depresses employment and investment which are vital to sustain tax revenues in the future
  2. Government bond yields are low - the yield on ten-year government bonds is less than 2% - so this is an opportune time to invest more because infrastructure investment will increase AD and LRAS
  3. Wrong to cut state spending when economy is in a liquidity trap
  4. Economic growth is needed to pay back the debt and fiscal austerity makes this harder to achieve
• What are external shocks

  Shocks are unexpected changes in the economy that can affect variables such as inflation and the growth rate of GDP. In an inter-connected global economy, events in one part of the world can quickly affect many other countries. E.g. the Global Financial Crisis (GFC) brought about recession in many countries and financial distress in many regions. It also led to a fall in FDI flows into poorer countries and increased pressure on governments in rich nations to cut overseas aid budgets.
• Demand-side shocks

  • Economic downturn / recession in a major trading partner
  • Unexpected tax increases or cuts to government spending programmes
  • Financial crisis causing bank lending / credit to fall and which spreads to more than one country / region
  • Unexpected changes in monetary policy interest rates
  • Significant job losses announced in a major industry
• Supply-side shocks

  • Steep rise/fall in oil and gas prices or other commodities traded in the world economy
  • Political turmoil / strikes
  • Natural disasters causing a sharp fall in production and damage to infrastructure
  • Unexpected breakthroughs in production technologies which can lead to unexpected gains in productivity
  • Significant changes in levels of labour migration into/out of a country
• What is transfer pricing?

  Transfer pricing is also known as profit shifting and it happens when a TNC moves the profits they have made from subsidiaries in a high tax country to other subsidiaries in a lower tax nation. Usually this happens when a TNC sets up an internal trade - e.g. a royalty for using a trademark or a change for using component parts which then affects the costs of each subsidy and helps to ensure that lower profits are booked in the higher-tax economy.