Archive for December, 2011

Why you should be unimpressed by the deficit debate

December 9, 2011

Since 2009, Labour has not explained what it would cut if it were in government right now. Now the latest budget forecasts suggest that if Labour wins the next election, it would have to continue making cuts. They have a dilemma: they need to restore their economic credibility by having a plan for reducing the UK’s debt, but if they announce the sort of things they would cut, it may reduce their core support. As a Labour party member, Politics graduate and someone who has an A-level grasp of economics, I’ve been unsatisfied with the debate around this. So I’m going to explore this area of policy as a lay person and see if I can either come up with any answers, or conclude that we really are screwed. In this piece I’ll start with regurgitating what I understand. (Disclaimer: this is pretty stream-of-consciousness, so no references I’m afraid.)

Labour’s main problem

Except when you have a war, a strong economy is what normally wins incumbent parties elections, and a weak economy is what lets opposition parties in. To be more precise, it is a perception of economic competence that will secure a party’s place in government. The past two changes of government can be explained this way: Labour won in 1997 because even though the economy had been growing for the previous 3-4 years, the Conservatives’ ignominious exit from the European Exchange Rate Mechanism had destroyed their reputation as economic managers. In 2010, Labour was given the heave-ho because of the perception that, notwithstanding Gordon Brown’s heroic efforts to rescue the economy from total collapse, the party was at least partially responsible for the biggest recession in living memory, and this was compounded by an irresponsible fiscal policy.

The Conservatives used a couple of lines to convince the electorate that Labour had wrecked the economy. Comparing the country’s books to a household budget doesn’t hold water, unless your house has its own internal market economy. The analogy that Labour finds it more difficult to shake off is that it “failed to fix the roof when the sun was shining”. Objectively, this is a pretty handy summary of the structural deficit problem.

Fiscal policy – the basics

The core argument of Keynesian economics is that, through a multiplier effect, tax cuts and public spending increases help economic growth by putting more money in people’s pockets. A fiscal policy of balancing the books is unhelpful because when there is a recession, raising taxes to maintain the level of revenue while more people are out of work and cutting discretionary spending to maintain the level of spending while more people are claiming benefits will take money out of people’s pockets and lead to a downward economic spiral.

Allowing deficits to happen in recession – at a bare minimum, through the “automatic stabilisers” of lower tax receipts and higher benefit payments – means that more money is flowing to the economy from the government and the multiplier effect will help lift the economy out of recession. Discretionary stimuli, like tax cuts or capital spending projects, will help boost a flagging economy even more. Therefore fiscal deficits aren’t necessarily bad.

The corollary to this is that in a period of economic growth, the government should seek to balance the long-term books by seeking fiscal surpluses. Once again the automatic stabilisers play a part – in a boom, people who were on the dole in the recession are now earning money and paying taxes. The general prosperity of the nation gives the government a bit of leeway to raise taxes or cut spending without damaging their electoral prospects too much.

Labour’s approach

Labour, famously, played around with those rules. After sticking by the Tories’ spending plans for the first few years of government, they started running deficits, even though the economy was growing. Brown invoked the golden rule, whereby deficits are okay if the money borrowed is spent only on investment (or, to put it in economic terms, capital spending). This investment, in hospitals, schools and infrastructure, is a one-off payment and is expected to pay for itself through a healthier, better-educated workforce and an economy with greater capacity, reflected in higher tax receipts.

What doesn’t happen under the golden rule is increases in current spending that aren’t paid for by taxes. To use a simple example, increasing the number of policemen – who will, naturally, expect to be paid every year once recruited – needs to be paid for by either finding savings in the rest of the police’s budget, cutting other public spending, or raising taxes. If you do none of these things, you have to borrow to pay their wages and you will need to borrow the same amount every year. This is basically what the structural deficit is. And this is what the government have been trying to eliminate by 2015.

When the economy returns to pre-2008 levels of activity – which is apparently years away – the “cyclical” part of the budget will be balanced, but there will still be a structural deficit. Only when the structural deficit is out of the way can Britain’s debt then start being paid off.

The structural deficit

This is where my understanding starts running out of steam. I presume that you have the public spending that is paid for by taxes, the capital spending that is paid for by borrowing (and can be paid for in the long term) and then the current spending that is paid for by borrowing. It is the latter that we ought to be worried about. What I don’t understand is how it originated; between the last surplus in 2002 to the recession, there must have been some unfunded current spending increases. Assuming that these increases were on “nice to haves”, and using the principle of “first in first out”, would these not be the first areas to target spending cuts on? What we seem to have instead is a free-for-all where our cherished public services are being cut to the bone. Maybe I haven’t delved as deeply as I could, but I haven’t seen any explanation of this by our leaders.

A lot of the blame for the crisis has been put at the door of the PFI projects, which do involve current spending commitments that cannot be got out of easily. But that – and the perennial problem of “public sector waste” – surely cannot be the whole obstacle we face. Elsewhere you hear the charge that Labour built too many schools, for example. Here there may be a distinction between schools replacing old ones (which will, presumably pay for themselves down the line) and brand new schools requiring brand new teachers, which involve expenditure on an annual basis. Can there be many of these that weren’t adequately funded?

The Coalition’s priorities

Assuming that the cuts to spending that the government wants to eliminate will be unsustainable even by the time the economy has recovered, I can appreciate why the bond markets have been frightened and why the government believes that pursuing austerity in a time of economic fragility trumps an extended stimulus (though I’m not qualified enough to condone it or not).

But I can’t help thinking the government are going above and beyond this, by using austerity to compensate for the high levels of investment and the rescue package under Labour, which are one-offs and can be paid off once the budget is in surplus again (i.e. once the economy is on a firm footing again and unsustainable current spending has been eliminated).

George Osborne made a great deal of his “expansionary fiscal contraction” which aimed to stimulate the private sector by scaling back the public sector to free up credit and labour. This approach is said to have worked for Canada in the mid-1990s. What has become clear since Osborne’s espousal of this is that the conditions Canada enjoyed – a booming US export market – are absent for the UK as the Eurozone suffers the current crippling crisis.

Rather than encouraging the private sector to take up the slack, withdrawal of public sector spending has depressed aggregate demand for goods and services, thus weakening rather than strengthening the private sector. The Chancellor has now pledged more support for capital projects, but who knows if this is going to be enough to balance the books in six years.

This is what I want to find out:

  1. What current spending increases were made by Labour without a corresponding rise in tax receipts (or, vice versa, what tax cuts were not matched by spending cuts)?
  2. How much of the structural deficit the government wants to eliminate consists of this type of spending?
  3. Of these items of spending, what is being cut and how painful will such cuts be compared with the others?
  4. Given the amount of investment the economy needs, is it really the structural deficit we’re worried about, or unsustainable current spending? Can the markets not be kept happy with reductions in the latter as long as a longer term structural deficit only consists of capital spending which will deliver future growth?

Any useful pointers welcome.