The Limits Of Government Policy

Government has 3 main policy tools that it can use to regulate the Economy. Fiscal Policy which uses taxation and spending to regulate aggregate demand. Monetary Policy which uses rates ( which is effectively the " price of money" to influence aggregate demand and Supply Side Policy which aims to promote the activity of factors of production, particularly labour and entrepreneurship.

The current problem that the Government has is that the first two tools cannot be used much further to stimulate growth. Government borrowing is at a record level and the size of public debt is continuing to grow to a level that will be very difficult to repay in the future. When lenders on international markets believe that the UK has reached this point they will demand higher interest rates on their loans which will make the interest costs unsustainable. This could lead to Government bankruptcy which has essentially been the case in Greece and is a serious risk in Spain,Portugal, Italy and Ireland. These countries are collectively known as the PIIGS. Now bankruptcy is not necessarily a bad thing, Iceland`s government went bankrupt due to the failure of it`s banking system and it is now growing rapidly again, Argentina has gone bankrupt on numerous occasions in the past, most recently after 2000 and yet it has enjoyed rapid growth in recent years. The problem is that bankruptcy by either Governments or commercial banks causes very severe problems in the short run. Because lenders will refuse to lend to a Government that is going bankrupt spending on public services must be significantly cut and this causes intense social disruption, look at the protests that have taken place in Greece. Any UK Government that went down the bankruptcy route would be unelectable for years. This is why the coalition is trying to reduce spending.

Monetary Policy has involved cutting the interest rate charged by the Bank of England to commercial banks to a 300 year record low of 0.5% and yet this is not stimulating growth in the economy. This is largely to the debt levels that were taken on prior to the banking crisis in 2008. Too much consumer debt got the economy into trouble in the first place with many people unable to repay what they borrowed. This has made banks much more cautious in their lending, consumers now need to offer much larger deposits if they want a mortgage, often 30% deposits if they want the best mortgage rates. Commercial banks have not passed on the very low interest rates charged by the Bank Of England as they try to restore profitablility on their lending. Quantitative Easing has involved the printing of more money which can then be effectively used to buy " bad debts" from commercial banks in exchange for cash. In theory this should encourage commercial banks to lend more but they have been cautious in making new loans because they fear incurring more bad debts if the economy returns to a serious recession. The velocity of money circulation has fallen.

The only remaining option is to encourage private sector growth through lower taxes on company profits,less regulation and more incentives to find employment. All of these are controversial, lower taxes on company profits are seen as rewarding " fat cats", less regulation may be seen as exploiting employees and encouraging people to find jobs may mean welfare reform to benefits.

For all of the above reasons it is difficult to see what further options this Government or any other has to promote further growth. It probably just has to wait for the private sector to create the jobs that the public sector is rapidly shedding