The UK chancellor, George Osborne, today announced that he intends to legally bind current and future governments to running a budget surplus (an excess of tax receipts over spending) when the economy is growing. Does this make sense? The answer must be no.
I have written before that, given that the UK economy is at the moment running a large current account deficit, maintaining a budget surplus in a growing economy would mean that the private sector (households and firms) has to be running a financial deficit and thus accumulating debt. This is not an ideological point, but a matter of accounting. If the current account were balanced, the government could run a small surplus and the private sector a small deficit while the economy grew. But with the current account at around 5% of GDP, a budget surplus of say 1% of GDP would mean a private sector deficit of 6%. Unless the economy was growing at an unrealistically rapid pace (which would be silly to assume), this would imply that the already high level of private debt would grow further as a proportion of GDP and in an unsustainable fashion, eventually leading to another financial crisis and recession or a significant slowdown at some point. Is this really what the chancellor wants?
As I have written already, the performance of foreign trade and investment is key to reducing private and public sector debt and thus the financial fragility of the UK economy. At the very least, a roughly balanced current account under growth of 2-3%, would allow a small budget deficit or surplus to be sustained if the private sector was also roughly in balance. Some economists claim that over the long run, the private sector tends to be slightly in surplus, meaning that the government needs to run a small deficit on average over the economic cycle. If this is the case, the chancellor will simply not be able to achieve his goal of a fiscal surplus when the economy is not in recession, without a contractionary effect on growth. This is therefore an empirical matter. If the private sector tends towards balance over the economic cycle, the government could be successful in balancing the budget over the same time frame, as long as the current account were also roughly in balance. With a growing economy, public debt as a share of GDP would still fall, and in a more sustainable fashion than that planned by the chancellor.
The illusion that governments can maintain budget surpluses over long periods was exemplified in the early 2000s in the US. In the late 1990s, with the economy performing well, the government ran surpluses for several years, and officials predicted that these would continue on into a glorious imagined future in which the national debt would fall to zero. This was despite the fact that the US was running a significant current account deficit and the private sector was accumulating debt at a rapid pace. The economist Wynne Godley warned that the situation was unsustainable, as private debt could not rise at that rate forever, and so it proved. When the boom came to an end, the Bush administration was forced to run budget deficits to try and stimulate growth. The US government has not run a surplus since.
The point of all this is that the private, public and foreign sector balances act on and constrain each other as the economy develops. To repeat: this is a matter of accounting. It should be taken into consideration when analysing the prospects for any economy over time. George Osborne should take note: without a dramatic improvement in foreign trade and investment performance, which may be somewhat out of his hands given the current poor performance of the Eurozone export market, his plan will fail and he will have to rip up his own rulebook. If he does manage to run budget surpluses for a while, then the likely outcome is that one of his successors as chancellor will have to clean up the mess of another financial crash much sooner than is necessary.