Why run a deficit?

Unless you’ve been living under a rock (or living on a planet that makes sense), you will have no doubt heard repeated rhetoric over the last few years from politicians of all shades, stating that “tough decisions” must be taken to close the deficit and balance the budget.

Without prior knowledge, all these claims make sense, but all these claims do is propagate myths built on the misunderstanding that the government finances are comparable to a household, politically constraining the government’s ability to support the private sector’s ability to net save, and in turn subduing the consumer demand required to keep the economy growing.

In my previous post I covered national accounting and the zero-sum relationship between the government, private and foreign sectors. As stated there, an attempt by one or two sector to spend less than its income (i.e. save) is balanced by the remaining sector(s) spending more than it income, resulting in a deficit. On average, the private sector is a net saver, and its desire to save can be met either by a government deficit, a trade surplus, or a combination of the two. A strong trade surplus provides an alternative source of earnings for the private sector (as well as more taxes for the government) which can be saved, reducing the need for a government deficit. An example of a country like this is Germany, which has a history of running a trade surplus that helps sustain its budget surplus.

In countries with a trade deficit (typically developed countries where it is generally cheaper to import goods from abroad due to lower manufacturing costs), the ‘burden’ falls on the government to provide a source of earnings to support saving (the alternative is an increase in private debt, which increases the susceptibility of the economy to shocks), and run a deficit. A simplified illustration of the flow of money between the government and non-government sectors is shown below (note that there are other sources of income  other than taxation, but this is the primary one).

national accounts arrangement

Government spending provides a safe financial asset for the non-government sector to use as payment for goods, services, debt and taxes, as well as an asset to hold as a form of savings. The national debt simply represents the cumulative sum of all government deficits, and the sum of all financial assets (denominated in £s) held by the non-government sector. Deficit spending increases the supply of these assets in aggregate, increasing the amount that can be held for the purpose of saving. During downturns, deficit spending (this typically occurs in the form of welfare payments, which increase as more people become unemployed during a downturn) helps reverse the fall in aggregate demand by meeting the non-government sector’s desire to save, without lowering its level of spending.

So deficits, not so scary right?

I will (probably) touch on why the government can sustain its deficits, and why the size of the deficit on its own is irrelevant to the health of the economy in the next post.

Austerity rhetoric has chained the Conservatives

The ONS recently released their initial Q3 GDP growth rates for the UK, showing a fall of 0.2% from Q2 to 0.5%. The third consecutive quarter of declining growth serves to highlight the risk posed to the growth of the UK economy by Osborne’s insistence on cutting public spending in order to reach a fiscal surplus, an idea increasingly seeming to be founded on politcal, rather than economic principles.

The somewhat shaky recovery from the Great Recession makes the Chancellor’s stance on tax credits perplexing, though the bill was (fortunately) rejected by the House of Lords. In all fairness I agree that the state should not be topping up private sector wages and the increase in minimum wage (it is nowhere near the living wage, and so refuse Osborne’s rebranding) is a welcome change, but does not change the reality that the cuts are still too deep and disproportionally affect the most vulnerable.

The cutting of tax credits would remove income from low and mid-wage earners, the opposite of what is required to support consumer spending, which is vital in aiding the recovery of the economy. If consumers are able to spend more, company profits increase, promoting business growth and consequently, the hire of new employees and/or wage increases. This in turn simultaneously reduces reliance on social welfare, further increases consumer spending and bolsters government tax receipts from both individuals and businesses.

The US applied this Keynesian approach through several fiscal stimulus packages, the first under Bush immediately after the crash in 2008. The stimulus  provides for tax rebates to low- and middle-income taxpayers, as well as tax incentives to encourage business investment. The American Recovery and Reinvestment Act of 2009 followed and brought $831 billion in investment in a variety of areas including education, health, and social welfare. Met initially with criticism, there is good evidence that government investment had an overall positive (albeit imperfect) effect (1,2) on the US economy. This should have provided assurance to the British government that fiscal spending (provided it was targeted to useful infrastructure) was not as irresponsible as they might have us believe.

Nevertheless austerity is still the path we currently tread, despite evidence of the contractionary effects of austerity, and even IMF warnings about excessive austerity. These views have been echoed by Office of Budget Responsibility, whose research Bill Mitchell looks over to discuss the effects of fiscal stimulus. As a quick summary, the post makes the case for fiscal stimulus based on OBR analysis that suggests the fiscal austerity enacted by the coalition government early in their term was detrimental to growth.

At the end of all this, the Conservatives are somewhat stuck. After unexpectedly winning an election on the mandate of austerity as the fiscally responsible choice (and the Chancellor’s aim of a surplus), any talk of borrowing for a fiscal stimulus package (despite rock-bottom interest rates and oil prices) is politically incompatible with their agenda.

In demonising Labour as the party of overspending and the source of the nation’s financial woes, the Conservatives have politically blocked themselves from a vital tool that could sure up the growth of the UK economy, leaving it exposed to the global economy, and so too (somewhat ironically) his chances of becoming prime minister in 2020.