The UK government’s dangerous and probably delusional ‘economic plan’

The UK Chancellor of the Exchequer (or finance minister), George Osborne, presented his ‘Autumn Statement’ this week, which acts as a preview of plans for tax and spending to be presented next March in the budget. As the next budget is perilously close to the general election, now is the time for the Chancellor to make announcements with an eye firmly fixed on polling day. However with the budget deficit (how much the government needs to borrow each year, to be distinguished from the national debt, which is the total stock of debt the government owes) coming down slower than forecast despite fairly rapid economic growth, he had little room for large tax cuts or new spending promises.

This coalition government, and especially its two effectively most senior Conservative figures, the Prime Minister David Cameron and the Chancellor, have at every opportunity since the economy began improving in 2013, been banging on about how every piece of good news is a result of their ‘long term economic plan’. Of course every piece of potentially bad news is blamed on either the ‘mess’ inherited from the previous Labour government or on economic ‘storms’ blowing in from abroad. This political spin is, while depressing, probably par for the course and most politicians are guilty of it. Labour’s Gordon Brown, Chancellor for ten years under Tony Blair, and then Prime Minister for three years, made the claim that there would be ‘no return to boom and bust’ as had happened under the previous Conservative administration and when the 2008 economic bust hit the UK, he made out that there had been a global financial crisis and none of it was his fault. But this is now water under the bridge.

I want to take issue with the current government’s obsession with blaming everything on the deficit, as if the latter actually caused the economic crisis rather than the other way around. Back in 2010 and 2011, government figures warned of the dangers that would befall us if we did not reduce the deficit over a few years and that what was happening in the Eurozone to countries with large deficits would also occur in the UK. Well, it is four years on and we still have a fairly large budget deficit of about 5%, and in his actions, which contrasted with his rhetoric, chancellor Osborne actually eased up on deficit reduction in 2012 as the economy stagnated. Despite a failure to meet his targets for a largely eliminated deficit in 2015, now shifted to 2019, the crisis never occurred. Here I concur with economists such as Simon Wren-Lewis and Paul Krugman that the chancellor’s real aim is to dramatically shrink the size of the state by placing almost all the burden of cutting the deficit onto spending cuts rather than tax rises. He raised VAT in his first budget, but has since cut income taxes for low earners so the net effect on tax has not been that great. Cameron, in one speech a few years ago, blamed the economic crisis on too much government spending, borrowing and taxing, failing to notice that too much taxing would surely involve less borrowing. In fact, as already pointed out, most of the rise in the deficit can be laid at the door of the economic crisis. Typically in a recession, as growth falls and unemployment rises, tax receipts fall and benefit payments rise, automatically increasing the deficit. With a smaller economy, spending as a percentage of GDP automatically rises, but will tend to fall once again as the economy starts to grow once more. This process is known as the ‘automatic stabilizer‘, as the changing balance between spending and tax acts to stabilize spending in the economy between booms and recessions. At the moment, this process is not proving so automatic as UK tax receipts have not recovered as fast as hoped alongside the economic recovery. This may be due to the large proportion of low-paid jobs created in recent years, which along with the raising of the income tax threshold on lower earnings have diminished the tax take.

Returning to my claim that the chancellor’s aim is to significantly shrink the state: it is noticeable that the government has set about this goal by stealth and that key figures have not been consistently making the case for it. This may be because they would be open to attack from the Labour opposition that public services that most people rely on may well suffer as a result. Cutting the state by stealth and framing it in terms of preventing a return to, and I quote, the ‘economic chaos’ of a large deficit, is clearly what this government is doing. This seems to be devious politics but it may well be unsustainable and unpopular in the long run, eventually necessitating tax rises to pay for improved services once again. Of course, higher spending does not automatically produce better outcomes, but slashing spending remains a risk to public service quality without radical reform that leads to improvements and it is not clear that the chancellor has this firmly in mind.

Moving on from the politics of the size of the state to rest of the fiscal ‘long term economic plan’ with which I have an issue, it is not evident that running a budget surplus (taxes exceeding spending) of 1.5% of GDP by 2020 is possible with the current structural trajectory of the UK economy without taking serious risks with financial stability and promoting a new boom in private sector debt. This argument follows that of the FT’s Martin Wolf in his commentary on this week’s Autumn Statement. It can be demonstrated by using some simple algebra. The textbook economics of aggregate spending flows in the economy as a whole are as follows:

Y = C + I + (G – T) + CA

Where Y is national income, C is consumption, I is investment, G is government spending, T is taxation, and CA is the current account of the balance of payments. The G-T terms in parentheses represents the government deficit, or the excess of spending over taxes. Some simple algebraic manipulation gives us the following:

Y – C = I + (G – T) + CA

Since income minus consumption, Y – C is equal to total private saving, which we will call S, we get the following:

S = I + (G – T) + CA

and therefore:

(S – I) = (G – T) + CA

This equation says that total private net saving (of both firms and households) is equal to the budget deficit plus the current account surplus. This is an identity and is true by definition for an economy.

In the UK, the deficit is about 5% of GDP, the current account is about minus 5%, so private net saving is close to balance. However the latter can be split into household and corporate saving. Household saving is a about 1.5% and the corporate surplus or saving is close to balance or zero. The chancellor wants to run a budget surplus of 1.5% of GDP by 2020. If the current account deficit (the inverse or negative of the current account surplus) falls to 2% and the economy continues to grow robustly, the domestic private sector will have to shift into a deficit, borrowing 3-4% of GDP, and if households account for all of this, the change from surplus to deficit will about 4.5% of GDP. In other words, household debt would have to rise rapidly once more from already high levels, which would only be possible with another stock market or house price boom. This would seriously threaten economic stability and inevitably lead to another crash. If the current account deficit falls only to 4% or 3%, for the government to achieve a surplus as above, private (household and corporate) borrowing would need to rise even more. These trends would be extremely adverse from the point of view of long-term economic performance. A crash and recession would tip the budget back into deficit and the ‘long term economic plan’ would have been shown to be a dangerous and unsustainable one.

The Labour party’s plan to reduce the deficit more slowly than the current government plans and to borrow for investment in infrastructure would seem to make more sense. With a small deficit, and a reasonable growth rate, the national debt could start to fall as long as interest rates remain low, and we could be less reliant on private borrowing for ‘prosperity’.

Some of these arguments are not easy to make to an electorate in the run-up to a general election, which is a shame, especially when we have been told repeatedly that we (meaning the government) have to ‘deal with our debts’. This is true, but it is equally true, and perhaps more so, for the private sector, whose level of debt is much higher and potentially a greater drag on growth than that of the government. To quote the sentiments of Martin Wolf, the arguments being made by both the government and the opposition with an eye on the ballot box are ‘utterly dispiriting’.


2 thoughts on “The UK government’s dangerous and probably delusional ‘economic plan’

  1. Pingback: How the UK economy can reduce its public and private sector debt | The Political Economy of Development

  2. Pingback: Binding fiscal policy | The Political Economy of Development

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