Why We Need Government Intervention

Executive Summary

In this report, it will start by explaining how different level of government intervention lead to different economic system. Next, it will explore how the government intervention works in terms of fiscal and monetary policy. At the last part of introduction, we will then talk about the main idea of the report.

After the introduction, parts that we will cover in the main body are listed below.

Why we need government intervention?

Benefit of government intervention (China)

Threat of overspending in fiscal policy (UK)

How UK deal with the debt that caused by overspending?

What is the problem behind the rapid growth caused by fiscal and monetary policy in China?

Finally, we will conclude the information above and finish the report.

1.1 Three main types of economic systems

In an economic system, there are three sets of decisions need to be made. What to produce, how to produce, and how to allocate the product of the economy. In a free market economy, the answers of all these three sets of question are determined by buyers and sellers interacting with each other in a free market which is not controlled by the government or any authority. On the other hand, a planned economy which is on the opposite side of a free market economy gives the government total control over the allocation of resources, such as the government makes the major economic decisions. However, some economists have criticized these two economic systems for being too extreme and they can only be achieved in theory. People agree that we need something in between these two economic systems, which is a mixed economy. The government will have some role in regulating the market, but all other activity will be driven by the decisions of buyers and sellers.

1.2 Mixed economy – UK

In the UK we have a mixed economy. Most decisions are made by the market – e.g. customers choose what they want to buy with their money. However, some decisions are made by the government – e.g. infrastructure constructions, the supply of medicines in hospitals, etc. Generally speaking, in the UK the market make most decisions because of its high level of efficiency in responding to customer preferences. However, some decisions must be made by the government on behalf of society to ensure the social benefit, such as health service, education, etc.

1.3 Government interventionism

In this report, we will explore whether it is in the best interests of the business community for there to be constraints on a government’s discretion over fiscal and monetary policy by using real world examples. Since most of the countries in the world have certain level of government interventionism in the economy, and there are many ways in doing so, such as regulation, standard, tradable permits, taxation, subsidies, etc. However, we will investigate government intervention in terms of fiscal and monetary policy in particular.

2.1 Why is there a need for government intervention?

Most reasons for government to intervene in the economy can be categorized in three ways – correction of market failure; non-economic objectives; and redistribution of income.

First, we will look at how government intervention to correct market failure. Market failure occurs when the allocation of goods and services in a free market do not bring about economic efficiency. According to fiscal policy, government often uses government spending on infrastructure, education, health, subsidies, etc. to prevent market failure. However, the role of fiscal policy in developed countries and developing countries can be very different, fiscal policy in developed countries often is used to maintain full employment and stabilize growth whereas in developing countries it is used to stimulate fast economic growth.

2.2 Government Interventionism – China

A real world example of country that benefit from government intervention can be China. It is widely agreed that China used active fiscal policy in order to stimulate the economy in recent years to obtain their rapid economic growth. Chinese Vice Premier Li Keqiang said “The country’s fiscal policy will play an active role in maintaining steady and fast economic growth over the long run” (Jones, 2010) reported in Beijing, China. According to (BBC News, 2010), “The collapse in international export markets that accompanied the global financial crisis of 2009 initially hit China hard, but its economy was among the first in the world to rebound, quickly returning to growth.”

So, what did they do to gain the fast growing power in economy? One major move of the Chinese government in 2008 may be one of the answers. They have introduced some monetary and fiscal policies to stimulate their economy, such as loosen credit conditions, cut taxes and embark on a massive infrastructure spending program in a wide-ranging effort to offset adverse global economic conditions by boosting domestic demand. “A stimulus package estimated at 4 trillion yuan (about 360 billion British pounds) will be spent over the next two years to finance programs in 10 major areas, such as low-income housing, rural infrastructure, water, electricity, transportation, the environment and technological innovation. The policies include a comprehensive reform in value-added taxes, which would cut industry costs by 120 billion yuan (about 11.5 billion British pounds)” (Window of China, 2008).

From the Chinese business community point of view, the second part of the news will be in their best interests. However, the Chinese business community did not just benefit from tax cutting, but also subsidies. “In an effort to ease the pressure on its export sector, China is again increasing the export tax rebate for a wide range of products, including some plastic resins as well as finished products.” (Sun, 2009)

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Given the importance of exports in China’s economic growth, it is not unreasonable to assume that there might be a link between the policies that the Chinese government provides to the Chinese business community and China’s noteworthy export performance. In this case, the Chinese government intervention over fiscal and monetary policies is in favor of their business community, and there is no doubt that they have benefited from the intervention in terms of the profit they gained.

2.3 Side effect of fiscal policy?

In the UK, one of the main reasons of why we need to constrain fiscal policy will be the huge national debt. Especially after the financial crisis, enormous amount of government spending has led the nation to debt. From figures published September 2010 (Office for National Statistic, 2010), UK public sector net debt was £952.8 billion which is 64.6% of our National GDP. The graph below shows the public debt of UK from 1914 to 2014.

Source: http://publicdebts.org.uk/2010/06/06/new-site-on-the-uk-national-debt/

Since 2008, National Debt has increased sharply because of the economic recession, the UK government has lowered tax receipts and higher spending on unemployment benefits; financial crisis and the subsequent economic downturn, etc.

2.4 Constraints on fiscal policy – UK

In the UK, there are many moves to constrain fiscal policy over the past decade or more. We will focus on the Golden rule and the Sustainable investment rule in this report. These rules suggest that, over the cycle, government borrowing should not exceed government capital formation. The second concerns the case for attempting to construct a more comprehensive balance sheet of public sector assets and liabilities, including tangible public sector assets and certain contingent claims. However, these rules were suspended due to the extreme pressure on public budgets caused by the financial crisis in 2008, which we can refer back to the graph above.

The most up-to-date policy is the fiscal mandate. Chancellor George Osborne has introduced a new forward-looking fiscal mandate and a debt target to replace Gordon Brown’s golden rule. He suggests that the structural current deficit should be in balance in the final year of the five-year forecast period, which is 2015-16 in this Budget. However, Gemma Tetlow, senior research economist at the think-tank, said that the debt target was not a sufficiently constraining fiscal rule in the longer term and added that if the fiscal mandate is met then the debt target is also likely to be achieved. (Mead, 2010)

On the basis of business community interest, these policies might not be very welcoming to them. Since these policies generally lower the aggregate demand, it can potentially lower their sales.

2.5 Problem arising in China?

What comes after the rapid growth? In 2011, high inflation becomes a trouble. “Inflation in China accelerated to 5.1% in November from a year earlier, the fastest pace in 28 months, driven by higher food costs. China’s growth would ease partly because of the unwinding of fiscal stimulus, restrictions placed on overheating sectors, such as housing, and a tighter monetary policy. The Washington-based lender forecast China’s economy to grow 8.4% in 2012, down from 10% last year.” said by the World Bank. (Bloomberg, 2011)

However, to what extent it will affect the business community? In terms of theory, it depends on the price elasticity of demand. Since the inflation increase the general price level of goods, the business community may gain more profit from the inelastic demand or lose from the elastic demand.

3 Conclusion

We have looked at how government intervention can affect the economy and the business community. We can see how Chinese business community benefits from the government intervention, but we also see the slowly arising side effect. In the UK, the deficit-reduction plan perhaps may not be good news to the local business community since the fiscal tightening is likely to lower aggregate demand. However, the government may have no choice other than government spending cuts. Overall, it is very hard to generalize that whether it is in the best interests of the business community for there to be constraints on fiscal and monetary policy just by yes or no. It depends on many factors, for example, timing, during the subprime mortgage crisis, government just needs to step in and save the banks to prevent further disaster. In short, the more flexible the government intervention is, the more the business community can benefit from it.