UK Deficit 101: Explaining the Malady and Medicine

Oh hearing those fateful words: “Wait, you’re an economist! So what’s the deal on…..”.  I shudder at the memories. This blog is in response to a couple of people who’ve recently asked me to explain the background to some of the current economic controversies. Its also a space for me to have a little ramble and vent. First up, the UK budget deficit.

Debt. Deficit. PSNBR. First things first, what do these terms even mean? When people talk about the deficit they are referring to the gap between what’s coming into the government coffers through taxes/other revenue sources and what’s being spent. However, arguably a more useful measure to look at is the public sector net borrowing (PSNBR) figures as this includes investment spending. Finally, the national debt gives the total amount we owe, so it’s the cumulative effect of all the past surpluses and deficits. (Note: if a figure put forward in this context looks impressively high it’s probably going to be the national debt figure).

The UK is currently racking up its largest budget deficit in the last 60 years and things don’t appear to be getting any better. Oh. dear. The financial crisis and recession have resulted in lower tax revenues (as national income’s been hit) and higher government spending (for example, on unemployment benefits), making for a widening in the deficit and thus growing national debt. The latest ONS figures for June 2011 show that (inc. the impact of all the financial sector interventions) the PSNBR stands at £12bn and the national debt at £2276bn or 149.3% of GDP. This is causing the UK to move up those unenvied IMF net debt league tables, going from 11th place in 2007 to 9th in 2010. It looks like we might be elbowing a few more countries out the way this year too.

Why is high debt categorically classed as a “BAD THING”?

There has been a lot of talk on reducing the deficit and slowing the rise in national debt. The worry is that the path the public finances seem to be heading down is unsustainable, i.e. the country will not be able to honour its debts if things continue in the same way. Oh, as the Tory politicians and love to proclaim: “We’ve become accustomed to living beyond our means”. This has led both the previous Labour government, and the current coalition, to mandate substantial fiscal tightening. The UK coalition is committed to reducing the deficit from 12% of GDP to 0% over the next 5 years.

The arguments against a large budget deficit and high national debt are often hard to relate to as a ‘normal person’. One that seems pretty obvious, is that borrowing comes at a cost. Interest has to be paid on the debt, which comes at the expense of funding for services we care about. In the 2011 Budget, it is estimated that debt interest repayments will rise from £30.9bn in 2009/10 to £66.8bn in 2015/15. This eats up more than the education budget. Clearly this is not ideal.

Another pressing concern at present is susceptibility to bond market attacks. Think about what’s been going on in Greece, Ireland and Portugal to get an idea of what this means in practise. Yikes. If a country with high debt runs into trouble so that its current level of debt is deemed unsustainable (yep, that we’re “living beyond our means”), it will need to reduce its debts by spending less than it takes in taxes. The problem is actually putting this into practise. It’s hard. Often more so for those countries which find themselves with high debt levels in the first place. Therefore, highly indebted countries are often perceived as more likely to default on their debt (go bankrupt in other words). To protect themselves, investors demand higher rates of interest. This exacerbates the situation as a given level of debt (which in the cases we are considering, is high) becomes harder to finance, creating a need for greater fiscal tightening and potentially leading to a self-fulfilling crisis. Not the best.

Relating this back to ‘The Taxpayer’. Higher interest rates on government bonds are likely to raise those charged on private loans and mortgages. Our financial security is related to the government’s. To move the budget into surplus, measures will have to be taken which ‘hurt’ households, thereby raising the potential for us to default on our loans. Thus, higher borrowing costs for us. And, a higher government interest rate implies a greater debt burden and thus a need for a larger overall tightening. In this way, bond market panic can create the need for harsher austerity measures.

The other term bandied about is crowding out. Government bonds compete with private assets for savings. Some economists argue that, given this, each £1 of additional government borrowing results in less private borrowing and therefore less investment in the machines and the like which we rely on to make Britain great. Thus, the argument goes, government borrowing has the potential to undermine growth in the economy, thereby reducing our future living standards.

However, not all economists buy this. Government borrowing may be used to fund projects which cannot be provided by the private sector (e.g. high-speed rail), not all private debt magically enhances the productive capacity of the economy and good old market failures could anyway result in permanent excess saving that governments can tap into without any form of crowding out.

Finally, it is argued, and has been by the coalition, that high debt is not fair to our children and others in the future who will face the burdens of this debt without necessarily feeling any of the benefit. And we care about our children, right?

So what’s to be done then?

Okay, so we don’t want to be like Greece, a debt-to-GDP ratio of 140% can’t go on for ever, but this alone doesn’t justify harsh austerity measures now and it doesn’t imply a fiscal tightening strategy which revolves around spending cuts over tax rises. The preferred austerity strategy must have as small an impact as possible on overall demand in the economy, while sending a clear signal to investors that we mean business. This leads us to two oft debated questions: 1) Cut now or cut later? 2) Cut how?  The coalition plans involve faster fiscal tightening, more heavily reliant on spending cuts than those proposed by the opposition. Can this be justified?

1)       We want our turkey cold? Not me. ‘Classical’ economists tend to plump for a PAIN NOW prescription. It is argued that the key concern is to reduce investor fear of default and through this the interest rate on public and private debt. Lower interest rates can then fuel higher demand and mitigate recession. However, Keynesians worry that over-zealous attempts to cut the deficit will be self-defeating. This is the so called “paradox of thrift”. Fierce austerity has the potential to exacerbate a recession, ultimately resulting in a HIGHER deficit, if private spending and tax receipts fall a lot with the onset of austerity. Further, a key problem with the classical argument in the current climate is that interest rates don’t really have anywhere to fall to! So where is this demand driver going to come from? Although the “cut later” camp has to deal with making their promises credible, the Chancellor’s new fiscal mandate and the creation of the Office for Budget Responsibility have helped in this respect and thus I feel a gradualist approach to deficit reduction is justified.

2)       Bringing down the deficit has to involve either raising tax revenues, reducing spending or some combination of the two. Unless you want to go down the prayer route. We want to balance these things such that there is the smallest impact on overall demand. The first thing to note is that any cut in spending is going to lower demand (this is true even if it is due to those allusive efficiency savings). This is especially so for those cuts which disproportionately target low income groups as their spending will fall back by a similar amount as their savings safety nets tend to be on the flimsy side and so the cuts cannot be offset. However, a temporary tax rate hike targeted at the better off is less likely to lead to large demand reductions as they can be partially smoothed via savings. Clearly in the long run, we need to worry about the other things which accompany tax rises but in the short term these look preferable. THINK raising capital gains tax and closing loopholes.

So, to sum up. The UK public finances aren’t looking great but front-loaded, cuts-reliant austerity measures are, in my opinion, not the optimal way to repair them. Even economics can lead you to this conclusion.

10 responses to “UK Deficit 101: Explaining the Malady and Medicine

  1. Pingback: The Cuts and The Riots: Not the Cause, Definitely Not Part of the Solution | Abi Adams

  2. Hey Abi,

    First of all, great blog, loving the first two articles! Keep it coming.

    I do have two points I want to pick on. First, I find your argument that cutting spending (may) result in a higher deficit to be the Keynesian equivalent to thinking that tax cuts pay for themselves. It’s undeniable that every pound of cuts reduces economic activity, but absent a really large spending mutliplier (around 3, not unheard of in the literature but definitely in the upper bound of estimates), it’s more probable that cuts today indeed do reduce the deficit.

    I also think that you’re underestimate the probability bond markets would have turned against the UK. Frontloading cuts is economically unadvisable, yes, but it does convince markets that there’s the political will to shoulder the pain of cuts. Markets appear to be skeptical of easily reversible promises to cut spending the the future;, witness the response to Italy’s troubles. Absent the undeniably important fact that Britain controls its own monetary policy, is Britain’s fiscal position any better than Italy’s or Spain’s?

  3. Lets see how convincing you find this response!

    1) At the moment there’s no where really for interest rates to fall, so it seems reasonable to assume that interest rates are fixed in the short run. Taking this and just considering the short run (so we don’t need to worry about price adjustment), each £1 reduction in government spending will reduce total national income by 1/(1- c), where ‘c’ is the marginal propensity to consume and that whole expression gives us the spending multiplier. In normal speak, ‘c’ tells us how much we spend and how much we save out of each £ we receive and the multiplier tells us, if you like, the total effect of putting a £ into the economy. Just quickly on the multiplier, if i give you a £1 and you go on and spend 80p, the person who receives that 80p with spend 64p, and the person who receives that….and so on! So basically, the effect of the £1 on total spending is greater than the £1. Sounds a bit wacko. So with c = 0.8, we get a multiplier of 5.

    Right so we have that reducing government spending by £1 will result in a fall in total income of 1/(1-c) and this will reduce tax revenues which are positively related to income. Just to illustrate, imagine we can express tax revenue as a percentage, t, of income. Then, cutting public spending will exacerbate the deficit if t/(1 – c) > 1 or c > 1- t. So if we have a large marginal propensity to consume (so austerity really hits private demand) and taxes on private income are high, so a fall in income has a big impact on tax revenues, austerity can make matters worse as this very stylised example helps to show.

    So do these conditions hold? Well potentially. Falls in government spending and services are going to disproportionately fall on low income groups who have the largest propensity to spend. Also, (this is more of an assertion i grant you- challenge me with the figures on this) those most at risk of redundancy and pay freezes in the public sector are unlikely to be in the upper echelons of the income distribution and thus also be the ones with relatively high marginal propensities to spend. So I’d say its by no means clear that austerity is necessarily going to make the situation better and this often isn’t made clear.

    2) Yeah, i was pretty blase about the probability of a bond market attack. A clear signal did need to be sent to the markets that the government was serious about getting the public finances under control. The government succeeded in doing that.

    However, I still think my points stand. We DO require discretion and flexibility in policy, things change. The supply side of the economy has been hit harder than expected and we face an increasingly challenging international economic environment so an export led expansion (which was pretty unlikely in the first place) doesn’t look like its going to turn up any time soon. A greater dose of gradulist, flexible thinking is required. The government succeeded in setting up the OBR and has set some ‘better’ fiscal rules to work under than those developed by Gordon Brown which i would hope should work to convince the markets that an alteration in plans now does not imply any reneging on commitments. Obviously i’m not a bond trader so don’t know what would convince me 🙂 Maybe in future, given we have the independent OBR for figures, plans could be made contingent on the economic performance of the economy at different stages of recession to create a climate more favorable to policy flexibility and those dreaded U-turns.

    Also, this is a slightly extreme comparison to make but look at what happened in the East Asia crisis in the later 90s. The IMF pushed for harsh austerity measures which others rightly did warn would be ultimately self defeating. The measures served only to temporarily put off the eventual chaos.

    Hmmm, this reply has gone on long enough and I don’t have the evidence at my finger tips right now (and am getting sleepy so am not going to go searching right now) to say if our fiscal position is objectively better than Italy’s or Spain’s. Thats going to involve an assessment of where they are now and where they are likely to be in the future which includes judgements on the likelihood of fiscal bailouts and integration in Europe, the sustainability of the euro and then things like their population and long term growth prospects. All i can say is, in my opinion, we have more credible political leadership than at least Italy. I LOVED The Economist headline a few months back “The man who screwed an entire country”.

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