I believe this will be the first instance in a Great Depression-like scenario where the government of a developed nation will actually cut spending (if they follow through). Some like to say that federal spending was heavily cut in the U.S. during the early 1930s under the Hoover administration. This is false (it increased 10.8 percent in 1930, 3.4 percent in 1931, and 2.3 percent in 1932).
Assuming that the financial sector remains fairly stable in the U.K. (no explosive inflation or implosive deflation) this will be an interesting development to follow for two reasons:
We will get a better look at who was to blame for the Great Depression’s severity.
Was it the ignorant use of monetary policy or absence of proactive fiscal policy? If government spending declines don’t carry the UK into a massive depression, such an observation will take the earlier, more conservative fiscal policymakers of the 1930s off the list of culprits (except for the worldwide slice and dice of international trade and supporting nominal wage freezes). Such an outcome would also diminish the strength of future arguments for Keynesian-style government spending.
We will get to see which sector can better stimulate the economy: private enterprise or government.T
Conventional macroeconomic models suggest that cutting government spending is a bad idea. Doing so causes aggregate demand to fall and will put (more) deflationary pressure on prices and wages leading to lower output (and higher unemployment). It is argued that increasing government spending (holding taxes constant) will create a multiplier effect that increases subsequent output levels.
The crowding out theory holds that consumption and investment should increase one-for-one with the decrease in government deficit spending. If this holds, then the private sector will have more resources at its disposal and means private spending (personal consumption and business investment) will increase. What will be interesting to see is how strong the private sector multiplier is relative to the government expenditures multiplier.
Keep your eyes open on this development given its unprecedented importance.