The Budget: Tomorrow!

In the last few weeks we've considered the macroeconomic tools at the disposal of governments to try and influence the economy in a desirable direction.  The main tools are fiscal policy (the use of government spending and taxation) and monetary policy.

The UK government has now fobbed off monetary policy to the Bank of England (hence if inflation is announced to be high later today, it'll be the Bank's problem not Labour's), but fiscal policy remains its preserve, and tomorrow (Wednesday) the government will announce its budget for the forthcoming year.  That is, it will announce what government spending and taxation will be: It is announcing fiscal policy for the coming year.

We've seen that fiscal policy can often be ineffective, and the results of it hard to spot for a long time - these time lags between announcing a policy and that policy working its way through the system.  Hence, so close the the election, it's hard to imagine that any policy will have its effect in time to influence voters.

But that won't stop some electioneering going on, and the government will attempt to engineer some goodwill amongst voters with its intentions - things like pushing bankers more - forcing them to allow everyone to open a bank account, for example.

However, the government has also got to convey the impression it is getting on top of its deficit issue.  As mentioned in previous weeks, this is a contentious issue: Whether to cut now or cut later - because we've seen that government spending is an injection and taxation a withdrawal from the circular flow. 

Cutting spending and raising taxes will thus negatively affect the circular flow of income.  In order for the effect of this to be less noticed, then clearly other injections need to be significantly rising, and other withdrawals falling.  So if the economy is picking up from the recession and growing, then investment is likely to be increasing, and hence a gradual withdrawal of the government spending injections then might be less noticeable.

Regardless though, if the government is to retain the confidence of the people lending to it, it has to show it has a credible and thought-through plan for reducing the deficit substantially in the years to come - even if it doesn't start now.  If it doesn't, there will be negative consequences both for monetary and fiscal policy. 

Fiscal because more spending will be needed to pay interest on deficits and debt, and monetary policy because the increased money supply will lead to inflationary pressures requiring action via interest rates.