Tuesday, 11 October 2011

Deficit spending

Deficit-Funded Growth

Regarding the importance of deficit-funded growth, John Lanchester (London Review of Books, 8th Sept 2011) finds that electors in developed Western democracies, and the majority of their politicians, fail to grasp the important point that national finances differ from domestic finances. "The problem is" (he writes) "in large part to do with the application of an incorrect metaphor, the easy-to-understand idea that a household has to live within its income. But Governments are not households, and the idea of cutting your way to prosperity cannot be read across from an individual's finances to those of the state. It is a manifest fact that these policies, and the refusal to embrace stimulus spending, are causing economic slowdowns all over the world...."

He is right that we, the public, cannot easily shake off the simple notion that deepening government debt seems a desperate way to reduce government debt. And the majority of conservative politicians seem to think likewise (e.g. Matthew Hancock MP in his blog: http://conservativehome.blogs.com/platform/2011/02/matthew-hancock-mp-we-can-ensure-growth-whilst-making-cuts-to-reduce-the-deficit.html)

We can agree (of course) that governments are not households; but what are the differences that makes the metaphor invalid? Neither a household nor a government can "cut its way to prosperity", they can only cut their way to balancing income and expenditure. One crucial difference is the effect of "the multiplier". A household can live very well on 90% of its previous expenditure. Lower household spending will tend to lower consumer prices and the 10% cut in spending will have a less-than-10% effect on standard of living. With governments it is different. A large fraction of government spending goes on wages, and therefore straight into the pockets of domestic consumers, and from there (by the multiplier effect) into the pockets of domestic and foreign producers. An ill-considered cut in government spending will cut demand out of the economy; business will languish; by this multiplier effect, a 1%  cut may take 2% out of gross domestic production, and therefore 2% out of tax revenues. The deficit is not decreased; it is increased! Cuts in public spending should be made very carefully. Perhaps benefits could be cut without fiscal loss, if that forced recipients to work; though not without hardship. Or NHS spending on medicines, but not on salaries. 'Surgical' cuts!


Another crucial difference is that governments can, at the stroke of a pen, increase their income — by raising tax revenue. But again they should be cautious; money taken out of the pockets of the average household will lower demand and thus (by the multiplier) lower GDP and the global tax take. However, I cannot see that taxing financial transactions would do any harm; they are entirely valueless to the real economy. Nor taxing large incomes, for they are not spent anyway. Nor blocking tax loop-holes; Mitt Romney made a big contribution in Massachusetts by closing tax loopholes to businesses. And above all, large accumulations of wealth should be taxed, by death duties or inheritance taxes.


Table 1 — Interest rates paid on sovereign debt by different countries in recent years.






















In the short term, governments (like households) can borrow money to bridge the deficit.  When interest rates are low, as at present (See Table 1), there is little incentive to pay the borrowed money back. Japan has an enormous government debt, but a miniscule rate of interest (perhaps because the debt is held by Japanese citizens and businesses). Depending on the bond, or 'gilt', issued (5 year gilts, 10 year, etc.), the debt becomes due for repayment in a rolling manner, and is usually paid back by simply taking out another loan. But, what if interest rates are then higher? There is little to no chance of the British Government defaulting on its (our) debt. We never have in 250 years. For debts in Sterling we can always repay the debt by printing money. However, the consequent inflation would raise interest rates just as surely as a perceived risk of default. A government would be mad to borrow simply to sustain its deficit (its hypertrophied civil service, National Health Service, or army). Except (you may ask) in the very short term? Yes (I would answer), even then.


John Lanchester talks sardonically of the "non-scenic route" to where we are going, meaning I suppose the one that involves a decade of tightened belts. But is there an alternative? Which is his "scenic route"? Surely he is not advocating increased borrowing in the hope of increasing GDP? In my analysis we have lived in a bubble of borrowed money for a decade and there is no way back to that level of prosperity. We never did have that level of GDP, for it was not wealth that we produced. To borrow more money now to "stimulate growth", is like a bankrupt borrowing money to bet on the horses; there is little chance that it will do anything other than increase the country's indebtedness.  To borrow money from the open market seems to be equivalent to stretching oneself over a barrel and inviting punishment.


Classic Keynsianism may now be out of date. The crucial question in regard to government borrowing is the question of where the money is coming from; who holds the debt. If it is internal, interest rates may be low; if it is external, interest rates will rise with inflation and the country is in hoc to the international money-markets. Talk of 'growing the economy' raises questions of where the increased GDP is going to come from. Are we going to under-cut the Chinese and make our own telephones? Real growth in a global sense can only come from an increase in efficiency. It is a slow process.


As far as I can see our only way to fiscal balance is a mixture of 'surgical' cuts and judicious realignment of government spending, together with carefully controlled increases in overall taxation (e.g. capital gains, death duties, and stock market and banking activities). To this might be added a tiny amount of focused devaluation ('quantitative easing)'?

No comments: