Contraction In Action

Reports out of the UK last week indicating that the GDP had contracted in the 4th quarter surprised just about no one who understands economics.  As promised during the campaign by the Conservatives (I'm not sure about the Liberal Democrats), the coalition's budget made significant cuts in government spending.  And as predicted, cutting government spending (demand) when there is insufficient private spending (demand) to make up for it led to a significant slowdown.  The Tories and their apologists in the UK financial press tried to blame it on the weather, but the only month affected by the unusual snows was December.  Either the snows were so bad that the economy contracted by a drastic 3-4% (they weren't) or the economy was very, very weak before the weather hit.  The latter seems much more likely, as the snows didn't result in widespread property damage or loss of life.

While it hasn't run its course, the spending cuts in the UK have created what is about as close to a single variable experiment as can be had in the field of macroeconomics.  The country is not much of an oil importer and so it was relatively unaffected by the recent prices increases.  The economies of the rest of Europe (overall, though not in some countries) and the US are growing, so export demand hasn't changed.   And there were no internal shocks such as a bank run or stock market crash.  The only major change was spending cuts.  Not all of them have hit, and there may be some scrambling to lessen the amounts of the upcoming cuts.  Still, the reduction in government spending will end up being significant.  We will be able to be certain about the result of the experiment after the first quarter of 2011.

Update 2011/2/26 (originally posted 1/30): It turns out that the numbers were even worse than initially reported - the UK economy shrunk by 0.6% in the fourth quarter.  That translates to an annualized rate of ~2.4%, which is how the numbers are reported in the US.