I imagine a doctor when confronted with a set of symptoms being presented by a patient carefully goes through each one and draws on his/her bank of knowledge, understanding and experience to arrive at an interpretation. A patient that has been sick for some time and is in the early stages of recovery may still exhibit signs of stress and the doctor appreciates that and doesn’t ring any alarm bells. It seems that the same doesn’t apply to my profession. Members of my profession seem to jump on any bandwagon that arrives and which triggers their favourite narratives about excessive government spending and borrowing and all that sort of public misinformation. The most recent example of this came yesterday (December 21, 2010) when the UK Office of National Statistics released the latest data for Public Sector Finances (as at November 2010) which showed that British government spending continues to grow and tax revenue is still lagging. The press reaction and that of my colleagues was expected and as is typically the case way off beam. We can summarise the problem by stating that there is no such thing as a “weak” budget outcome. An economy can be weak but it makes no sense to say a budget outcome is weak unless you have an ideological bias towards some particular outcome.
The UK Guardian (December 21, 2010) said in its article – UK budget deficit reached record £23bn in November – that:
George Osborne received a blow as it emerged that state borrowing soared to the highest on record for a single month despite the government’s austerity measures to rein in the deficit.
News that higher spending on defence, the NHS and contribution to the European Union had left Britain in the red by £23.3bn stunned the City, which had been expecting the early fruits from the chancellor’s spending restraint to cut the deficit from the £17.4bn recorded in November 2009.
So the universal fact is that the bank economists are typically wrong wherever they are.
But why use terms like “soared” and is this “record” meaningful. The answer to the second question is that it makes no sense to compare budget outcomes in terms of their numerical outcomes. Record in relation to what? Some previous outcome? And what was the real economy
The only deficit that matters is the real deficit which we measure in terms of real output gaps, unemployment, underemployment, lower productivity, falling potential output, suppressed real wages and the like. I didn’t read any discussion about “real” deficits yesterday among the commentators reported in the British media.
All the talk was about this record deficit and the rising borrowing.
Coming back to the theme of the blog I note that in this UK Guardian commentary – UK economy may be on track but signals still mixed – (December 21, 2010) the writer says that:
… one set of weak data on public finances does not destroy Osborne’s thesis. But it does illustrate why you should not declare victory on the basis of one set of GDP numbers.
The use of the term “weak” tells me everything. There is no meaningful concept of a “weak” fiscal outcome. The actual numbers that appear on the budget sheet have no meaning in themselves. They always have to be related back to the real economy to aid our interpretation. A rising budget deficit is not good nor bad just as a falling deficit is not good nor bad. It all depends and the only metrics that matter are real aggregates (employment, output, productivity etc).
The UK Guardian was also concerned there was “virtually no improvement on last year” in the budget outcome. Exactly how do we construe an improvement? The mainstream economists who adopt the view that deficits are bad and surpluses are good – which is the sentiment reflected in the press coverage always conclude a falling deficit is an improvement.
However just as the concept of a “weak” budget is awry, the idea of an improving deficit also completely misses the point as to what a deficit is and what it reflects. As I have written previously the deficit is like a barometer of real economic health. But it is an ambiguous indicator. Why?
The budget outcome is the product of two separate but not fully independent components. Overall, the budget balance is the difference between total government revenue and total government outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. It is a simple matter of accounting with no theory involved.
Budget Balance = Revenue – Spending = (Tax Revenue + Other Revenue) + (Welfare Payments + Other Spending)
We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the budget balance are the so-called automatic stabilisers.
In other words, without any discretionary policy changes, the budget balance will vary over the course of the business cycle. When the economy is weak – tax revenue falls and welfare payments rise and so the budget balance moves towards deficit (or an increasing deficit). When the economy is stronger – tax revenue rises and welfare payments fall and the budget balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.
Decisions by the non-government sector to increase its saving will reduce aggregate demand and the multiplier effects will reduce GDP. If nothing else happens to offset that development, then the automatic stabilisers will increase the budget deficit (or reduce the budget surplus).
So in that sense, the causality runs from the non-government sector to the government sector.
However, the government may decide to expand its discretionary spending and/or cut taxes. This will add to aggregate demand and increase GDP. The deficit will increase by some amount less than the discretionary policy expansion because the automatic stabilisers will offset that increase to some extent. But the non-government sector will also enjoy the increased income and this allows them to increase total saving.
So the causality in this situation runs from the government sector to the non-government sector (and feeds back again as the automatic stabilisers go to work).
In general, if the private sector desires to increase its saving, the role of the government is to match that to ensure that the income adjustment will not occur – with the concomitant employment losses etc. In that sense, fiscal policy has to be reacting to private spending and saving decisions (once a private-public mix is politically determined).
Please read my blog – Structural deficits and automatic stabilisers – for more discussion on this point.
The point is that a rising budget deficit might reflect improved real outcomes in the economy just as it might reflect an ailing economy. It all depends which component of the budget is dominant and what is happening in the real economy.
Just mindlessly staring at some budget numbers and computing a change from month to month and then concluding if the deficit has risen that things are worse – just because the number is bigger – gets us nowhere. That is largely what the professional commentary on yesterday’s British data did.
This is the data that got everyone into a spin.
The next graph shows the annual growth in total central government spending and revenue in the UK since November 2007. You can see how significant the downturn in the economy was by the collapse in revenue. But you can also see that spending has hardly blown out in the period of the crisis.
In fact, the British government has been too stingy by far in its reaction to the crisis and that is why unemployment is persisting at high levels and the real output gap is also very high.
The prognosis for the British economy is that it will deteriorate over the next several months as the conservatives cut into spending and push up taxes. The reaction of the Treasury (as reported in the UK Guardian) to yesterday’s data was:
November’s borrowing figures show why the government has had to take decisive action to take Britain out of the financial danger zone …
Presumably that Treasury spokesman is looking to the Chancellor for a promotion because he wouldn’t say such a stupid thing if he wasn’t trying to curry favour with architect of the austerity vandalism.
The borrowing figures indicate that non-government wealth has increased in line with the government spending increase. The bond holders have traded in low or zero earning financial assets for interest-bearing bonds. They will then earn income which will be of benefit to the economy.
Why would we construct that as a negative outcome in the context of an extremely sick economy.
Britain is a sovereign nation (fully in its own currency) and will never enter “the financial danger zone”. This is bond market hype.
We got no better from the “Chief Economist at the British Chambers of Commerce” who said:
These figures are much worse than expected and show a significant increase in the deficit compared with the same month a year ago. Britain’s fiscal position is very serious and it is essential for the government to implement its tough strategy aimed at stabilising our public finances. British business supports these measures and wants to see the government continuing to focus on spending cuts rather than tax rises. But, in order for this policy to be successful the austerity measures must be supplemented by a credible growth strategy so that businesses can drive a lasting recovery.
The only reason the British economy is currently growing is courtesy of the fiscal stimulus (even though it was too small). Where does business think it gets its sale from? Private spending is still way to subdued in the UK for private firms not to suffer when the government starts to seriously cut back.
I also remind readers that the contribution from net exports to aggregate demand in the UK is negative at present and will remain so for the indefinite future.
So why would British business support measures that will damage its bottom line?
The UK Guardian (December 21, 2010) briefed us on Public borrowing: What the economists are saying but only seemed to interview financial market economists. Their responses were revealing.
One said that:
These figures really are a bolt from the blue and will ensure a miserable Christmas for the Treasury … the November figures pretty much wipe out all of the 2010/11 reduction in borrowing in one fell swoop … That it is largely spending which has caused the surge in borrowing is a concern … the strength of spending will provide more fuel for the sceptics who question whether the government can really achieve the scale of public spending cuts that it plans.
I don’t think the budget outcomes were surprising at all given the state of the real economy. Sure enough there has been some growth but there is still a very large output gap.
I am also not the slightest bit concerned that spending has grown
One commentator said that:
The public finances were truly horrible and much worse than expected in November. This is dire news for Chancellor George Osborne to digest over Christmas and is likely to reinforce the government’s belief that there must be no let-up in the fiscal consolidation efforts.
That takes the “cake” for stupid and misleading commentary. Words like horrible have no meaning in this context. They just reflect the ideological bias of the commentator.
A rising deficit which signals a weakening economy (which is probably what is going on at present) should tell the Chancellor that he is on the wrong track. Exactly the opposite to what this commentator thinks is the message.
I wonder if he would be so comfortable if we said that his job would vanish if unemployment rose in the face of Osborne’s austerity cuts. I wonder if his message wouldn’t change somewhat.
The rescue packages have helped the financial sector in the US (and elsewhere) and feathered the pay packets and job security of these sorts of commentators. It is easy for them to propose cuts for everyone else but it would have actually been better if the government had have let most of these banks and speculators go broke and instead concentrate their stimulus measures at the bottom end of the labour market.
The same commentator also said:
A further serious problem for the government is that interest payments are increasing markedly. Indeed, the breakdown of central government expenditure shows interest payments were up to £4.5bn in November from £3.0bn a year earlier. The government is highlighting this as a key reason to why the public finances must be improved as quickly as possible.
Given that the British government is sovereign and not revenue constrained and given there is excess capacity in the economy why are these interest payments a “further serious problem”. They provide the non-government sector with income and there is zero opportunity cost to the government.
Why is interest income from the government bad and dividends from a private firm good? I can only ever interpret that sort of claptrap through as ideological statements which reflect the distaste of the commentator for public life and public service.
Another “capital markets” economist said that:
If borrowing continues to increase in this manner in the next few months, the government will be in danger of overshooting the £149bn deficit projection set out by the OBR for the current financial year. And while the higher VAT rate from January should help to boost revenues, a sharp slowdown in consumer spending will dampen its near-term effect on revenues.
Yes and yes.
The projections are nonsensical and the government cannot control the budget outcome anyway. It is always better for the government to concentrate on ensuring there is enough spending in the economy to support employment growth and the desire to save by the non-government sector.
Further, the fiscal austerity will be counter-productive if the government’s aim is to reduce the deficit. You need economic growth to achieve that outcome and that will be better achieved via increasing the discretionary component of the budget.
What really matters …
To see these results in perspective you need to look at the real economy. The following graph shows the real GDP output gap as a percentage of potential output as measured by the IMF in its World Economic Outlook database as at October 2010. The dotted segments are the IMF forecasts to 2015.
As at October 2010, the UK output gap was as bad as it was in the second year of the 1982 recession. In that episode it took a further five years before the economy reached potential again (according to this measure). For various reasons, the gaps are likely to be very conservative (that is, understate the true gaps). So you best consider them in relative terms.
The point is that the UK economy has improved a little as the spending boost from the deficit has been working its way through the system. But even with the improvement there is still a huge shortfall of capacity that is being underutilised. With fiscal austerity about to bite the economy will go into reverse.
The next graph is an alternative depiction of the UK Output Gap produced by the Office of Budget Responsibility and used by the British Treasury in framing the current Budget which was released in June 2010.
The graph shows the percentage deviation in actual real GDP from trend (expressed in terms of trend output). This is also likely to understate the extent of the real output gap given the methodology that the Office of Budget Responsibility uses to estimate trend real output.
You can read about the issues involved in the production of an output gap measure in the Economic and Fiscal Outlook November 2010 produced by the Office of Budget Responsibility – look for pages 129-132.
They detail various measures that have been produced using different methodologies. Their best guess is an output gap around 4 per cent which is larger than that produced by the IMF.
Whichever way you want to look at it the British economy is still a long way from reaching its capacity and in that sense still requires fiscal support.
I could have also produced several perspectives of the idle labour story in the UK at present. While unemployment and underemployment have an important human dimension which should never be ignored, from an economic perspective they tell us the same sort of story as the output gap. Foregone incomes, foregone output – never to be regained – wasted daily which would be reduced if aggregate demand was stronger.
So I see yesterday’s fiscal outcomes as heading in the right direction relative to what the real economy (the patient) is telling me. Now is the time to expand government net spending in the British economy.
The consternation about the rising debt in the UK is also amusing and demonstrated that the commentators have not really understood what public debt is and the voluntary nature of its issuance.
Please read my blogs – Debt is not debt and On voluntary constraints that undermine public purpose – for more discussion on this point.
To repeat: The UK economy requires further fiscal support and that indicates a rising budget deficit. In that context, the figures for November released yesterday are heading in the right direction.
Whatever, using terms such as “weak”, “horrible”, etc to describe some budget numbers is as stupid as describing a logarithm as yellow!
That is enough for today!