Once again, why Britain’s cuts won’t work

As the Comprehensive Spending Review is unveiled in Britain, some of you will recall the recent Compass pamphlet, The £100bn gamble, of which I was a co-author.[1] I’ve just read an exceptionally good short piece by Malcolm Sawyer, Professor of Economics at Leeds, which made me realise that the pamphlet did not pay sufficient attention to Osborne’s highly unrealistic assumptions about just how much the private sector is assumed to expand as the public sector shrinks.[2] As the current plight of Greece and Ireland shows quite clearly, cutting public sector spending in the name of ‘sound finance’ could make things worse, not better.

To show how shaky the current budgetary assumptions are, Sawyer rightly starts with the basic national accounting identity for the ‘savings balance’:

Investment = domestic private savings plus domestic public savings minus the current account.

Why is the current account (CA) netted from the above? Because if a country is running an external current deficit (which is true for Britain just like the USA), it must be financed by a capital inflow from abroad; in economists’ jargon, such a capital inflow is known as ‘foreign savings’. So if you wish, you can replace the phrase ‘minus the current account’ in the above definition with the phrase ‘plus foreign savings’.

Table 1 below—which I’ve taken from Sawyer—shows the evolution of macroeconomic aggregates used by the Treasury to underpin Osborne’s position.[3] In particular, look at the bottom row which shows the percentage changes implied.

Britain’s problem at the moment can be characterised thus. While domestic private savings is (once again) positive, domestic public savings is negative (the budget is in deficit) while foreign savings (the current account deficit) is high. So if both the government and current accounts are to move to zero, export growth must recover strongly and private investment must shoot up by 2015 to match the pool of domestic private savings.

Table 1: Key Macroeconomic aggregates 2009-2015 (figures in £bn at constant prices)

First, consider the current account. By 2015, it is forecast that the overseas trade deficit will have shrunk to near zero (ie, foreign savings will be negligible). For the period from the beginning of 2011 to the end of 2015, exports are assumed to growth 33% and imports by only 18%. The forecast for the current account in 2015 is the most favourable since 1983. This is totally at odds with the current trend. In the past decade, imports have grown faster than exports. Moreover, despite a nominal devaluation of 23% since 2008, export growth in 2010 was still negligible.

Next consider domestic savings. With the budget assumed to be in balance by 2015, government savings is zero. Household savings decline somewhat as a percentage of GDP. Although corporate savings do not appear explicitly, these can be calculated and their GDP share is seen to fall by about 10%. Such a result is important since corporate savings are such a large proportion of total domestic savings. But corporations have been busy ‘deleveraging’; ie, rebuilding savings. In reality, it is difficult to see why corporate savings would fall for the period in question.

Crucially, it will be seen that investment is assumed to rise by 44% between 2011 and 2015. UK gross Investment (including public investment) at present in slightly less that 14% of GDP: the Treasury assumed that it will reach over 19% of GDP by 2015. This is higher than at any time in the past decade, and is to be achieved despite cuts in public sector investment. The resulting annual GDP growth rate forecast for the period 2011-2015 is 2.7%, higher than the underlying trend growth rate in the past decade.

In summary, if private investment does not growth as rapidly as forecast, if export growth does not quickly outpace that of imports and if domestic savings do not fall enough, it will not be possible to balance the budget. This is not a matter of conjecture but of national accounting definitions. Moreover, as Sawyer’s piece rightly argues, since the probability of each of the above outcomes is not high, the probability of their joint occurrence is remote.

The views of Lord Wolfson and his business colleagues notwithstanding, George Osborne’s gamble looks problematic indeed!

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[1] See http://www.compassonline.org.uk/news/item.asp?n=11115

[2] See M. Sawyer ‘Why the structural budget deficit will not be eliminated by 2015’; http://129.11.89.221/MKB/MalcolmSawyer/budget2010.pdf

[3] See HM Treasury (2010a), Budget 2010, London: The Stationary Office, HC61; also Office for Budget Responsibility (2010), Budget 2010:The economy & public finances– supplementary material

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