Recently, The Independent ran a tabloid-style headline warning that the true UK net debt-GDP ratio was not 60% but a colossal 285%, a figure that includes new ONS estimates of future state pension and off-balance PFI obligations. Why is this misleading? Because if we count a stream of future obligations in the stock of current debt, we should compare it not to one year’s GDP but to the stream of future output. But these sorts of tricks, commonly used by deficit hawks, go largely unchallenged.
Basically, there are three schools of thought about deficit reduction. The first says that government deficits are always a bad thing—they fully ‘crowd out’ private investment and/or cause consumers to increase their savings. The second says that running a deficit may be required to counteract a downturn, but that as soon as things get ‘back to normal’, government should aim to balance the books over the business cycle as a whole. The third says that running a deficit is never a bad thing— except in the unlikely event of its leading to hyperinflation.
I’ve simplified the first school of thought somewhat, but readers can refer to various pieces on this subject.[1. An excellent explanation of this point appears in a recent Policy Brief published by the Levy Economics Institute; see http://www.levyinstitute.org/publications/?docid=1258; also see Robert Skidelsky’s ‘Deficit disorder: the Keynes solution’ at http://www.skidelskyr.com/site/view/new-statesman/; my own piece at: http://www.social-europe.eu/2010/07/method-in-our-budget-madness/ and an excellent piece by Paul Segal at http://www.guardian.co.uk/commentisfree/2010/jun/17/fiscal-deficit-threat] The real debate is between the second and third positions: between those who favour balancing the budget over the cycle as a whole, and those who think that running a deficit in ‘normal times’ is hardly ever a problem. A variant of this debate — whether governments can go broke — is to be found in the recent exchange between Paul Krugman and James Galbraith. I should add at the outset that I favour running a small(ish) structural deficit over the cycle as a whole and accepting a 60-80% debt-GDP ratio as the price for doing so!
Let us assume that—like the US and the UK—there’s a Central Bank. (Of course, if you live in a currency union like the Eurozone and your country has no central bank, the story changes completely.) The importance of having a central bank is quite simply that you can never go broke. Even if fiscal receipts and bond emissions are constrained, you can always print money. That is the first lesson of economics: governments, unlike individuals and firms, cannot go broke. We should learn this at school.
There is, of course, a limit to printing money—it comes when resources are fully employed and the economy is approaching what Keynesians call the ‘inflation barrier’. Monetarists disagree; for them, monetisation can only proceed at the growth rate of the economy; anything higher pushes us into inflation and thus fuels inflationary expectations leading to runaway inflation.
During the current slump, though, the argument between Keynesians and Monetarists has been academic since the danger last year was banking collapse and debt-deflation. Both agreed that money needed to be poured into the economy. In Washington, Ben Bernanke, an admirer of Milton Friedman, happily operated the printing presses when he engaged in quantitative easing (QE). Indeed, if there’s a double dip—which now looks likely—we may need more QE.
The IMF has concluded that 50% of current budget deficits around the world are explained by collapsing tax receipts, not by ‘excessive public spending’. This amounts to saying that the cyclical component of the deficit becomes increasingly important in a downturn—nothing new here! Still, the question is whether to run a budget deficit ‘over the cycle as a whole’. Even a monetarist would agree that (broadly) as long as the cost of debt service (basically, the interest rate) does not exceed the underlying trend growth rate for some very prolonged period, all is well and the stock of debt need not grow unmanageably. The non-economist reader should note that this ‘rule’ is more lax than the structure to run a zero deficit.
Does it matter whether (at the margin) the deficit is financed by raising new taxes, by issuing new bonds or monetised? Of course it does. But in normal times, tax receipts (on which see below) generally fall short of total expenditure — giving rise to the deficit — so some ‘topping up’ is required. Mr Brown’s rule was that only public spending on investment should be bond-financed. With the exception of borrowing for government investment, Messrs Brown and Darling favoured a balanced budget over the cycle.
This was a very conservative rule for two reasons. First, assuming the underlying growth rate to be greater than (or equal to) the interest rate, targeting a zero current deficit over the cycle will eventually lead to a zero stock of debt.[2. This follows from the relationship between the deficit and debt ratios for any assumed nominal growth rate of GDP (gr) greater than the rate of interest; ie, d = (gr - ir) * b, where d = the warranted deficit as % of GDP, gr = the long term growth rate of GDP, ir = the long term interest rate, and b = the debt as % of GDP. Thanks to Paul Segal for clarification on this point.] Since this involves a decision by the current generation to pass on no gilts, T-bills or whatever to our children (ie, which reduces their scope for portfolio diversification), it is unclear whether such a goal is desirable. Secondly, because when government borrows, it does so by selling paper to the general public. Like any sale, the public settles by drawing down money balances in the private sector, so it cannot be inflationary (other than by operating on expectations).
More generally, we accept that firms can have permanent debt, provided it is sustainable. This is so because private companies make productive investments that profit present and future shareholders, and it is therefore reasonable to let future shareholders share in the burden of the debt. In the same way, government, which invests in physical and human capital, raises the productive capacity of the country benefiting present and future generations. It is therefore quite reasonable to allow both present and future taxpayers share in the cost of these investments. Issuing debt is the way to achieve this inter-temporal cost sharing.
Is there a limit to extra tax finance? Yes of course, but Britain is far from having reached it. As argued elsewhere, reform of the current tax system could raise billions.[3. See Irvin et al., In Place of Cuts: tax reform to build a fairer society, Compass 2009; http://www.compassonline.org.uk/news/item.asp?n=6164] It is in part because effective personal and corporate tax rates have fallen in Britain that, even in normal times, other forms of finance must be used so extensively.
As for there being an effective limit to bond finance, this has to do with debt service and interest rates. If interest payments (ie, debt service) eat up a growing proportion of GDP, public indebtedness must go up. At some very high level of debt, a country becomes vulnerable to interest rate shocks, and the only way to service the debt will be printing money. Monetisation need not be inflationary when there are unemployed resources. The key point is this; as long as the economy’s growth rate exceeds the growth rate of government’s debt service obligation, the problem does not arise. Mr Brown’s original logic should now be clear; if public borrowing is used only for growth-promoting investment, the resulting growth will make debt service self-financing.
Finally, here is a most important point. In an advanced economy, public goods generally are what economists call ‘superior goods’; ie, as we get richer, we need proportionally more education, better public services, greater supplies of renewable energy, more ‘greening’ and so on. To meet such expenditure, a variety of alternatives are available as argued above. We can raise more taxes, or run a higher structural deficit by accepting a higher debt/GDP ceiling and/or—particularly under present circumstances—monetise.
Under current National Accounting conventions — which tell us that more military investment is ‘good’ but does not recognise that more pollution may be ‘bad’— not enough attention is given to public goods, which have external effects. The French centre-right government thinks this lack of attention so important that it set up a high-profile Commission on the subject which reported in 2009.[4. See http://www.stiglitz-sen-fitoussi.fr/documents/rapport_anglais.pdf]
Running a permanent deficit can be self-financing if it produces not just growth, but the sort of growth which has a social value. In other words, ‘wealth creation’ is not just about ‘making money ’— today, it’s about meeting social needs. And it’s meeting social needs that will create the growth which, in turn, keeps the deficit under control. Investment leads to extra income which generates extra savings — not the other way round. It’s a simple lesson, but one that bears repeating.
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George Irvin tries to justify deficits on what he concedes to be the “simple” grounds that where a deficit funds public sector (PS) investments, the deficit is self financing. The big flaw in this argument is that deficits are NOT required to fund PS investments: the latter can be, and to some extent ARE funded out of current income!
I.e. Irvin’s argument is like saying that driving round in an M1 Abrams tank is justified because it provides a form of transport. The RELEVANT question is whether a tank is a sensible form of personal transport, or whether something else might not be more cost effective and environmentally responsible. So let’s look at the idea that PS investment justifies PS debt.
The first big flaw in the latter idea is that the amount governments spend on PS investment is more or less constant year after year. It thus makes precious little difference whether all investment in each year is funded out of government income in that year, or whether the funding is done on a “borrow and slowly repay” basis.
Also Kersten Kellerman looked in detail at the idea that PS investment justifies PS debt and concluded with a negative. See http://www.sciencedirect.com/science/article/B6V97-4K7NHCT-1/2/c56ef74fa9694ad51af1aed465c8c2b3
Irvin also trots out the old myth that public sector borrowing enables the “burden” of PS investment to be shared across generations. This is actually a physical impossibility. Put another way, and to put it figuratively, that there is no way new born babies and the as yet unborn in 2010 can supply the concrete, steel and labour needed to build roads and bridges in 2010.
As R.A.Musgrave pointed out in his American Economic Review paper “The Nature of Budgetary Balance and the Case for the Capital Budget” (1939) (p.269), the only way of achieving the above “share across generations” objective is to borrow the money for each capital project from abroad. But then if every country does this, the thing descends to farce.
Finally, there IS a justification for a constant deficit. In fact a constant deficit is inescapable assuming the monetary base and national debt are to remain constant as a proportion of GDP given the standard 2% inflation: the latter inflation necessitates a constant topping up of the ND and MB.
@Ralph Musgrave
Well, at least you've got some serious points to make. Yes, if PS current reciepts are sufficient, there is no reason to use deficit finance to fund PS investment. But the point is of course that in a downturn, tax reciepts drop precipitously. Since the thrust of counter-cyclical policy should be to reverse the downturn in investment (far more volatile than consumption), PS borrowing is almost certainly required. (Nowhere do I claim that PS investment will be constant year on year). As for the 'myth' of financing investment over current and future Y-streams, I wonder why corporations and households regularly do so. Of course in 'real terms' a baby born today cannot provide today's bricks and mortar, but that's not quite the point. In a downtunr with unemployed resources (particularly labour) available, the effective constraint is finance. The private sector is not going to invest enough in a downturn by deficinition, so the PS must step in.
In any event, I am grateful for your thoughtful and non-abusive comment—rare on the Internet these days.