Fiscal austerity is self-defeating

The British Office of National Statistics published the latest National Accounts data for the third-quarter 2012 yesterday, which showed a modest burst of growth, consumer driven via the Olympic Games. It is a temporary spike in a downward trend. I will consider the growth data another day. It follows the release last week (November 21, 2012) of the latest – Public Sector Finances – for October 2012, which demonstrates why fiscal austerity is self-defeating. By failing to acknowledge that when non-government sector spending is insufficient to drive economic growth at levels sufficient to reduce unemployment there is a need for increased discretionary government net spending to support growth, the British government not only is creating an increasing economic malaise but failing to achieve its own (mindless) targets – a reduction in the deficit and outstanding public debt. The lesson is that fiscal austerity is self-defeating on all counts – the things that matter (the real economy including unemployment) and the things that don’t matter (financial ratios).

The October Public Finances Data tells us that:

  • Public sector net borrowing was £8.6 billion in October 2012, a rise of £2.7 billion over the year (compared to October 2011).
  • The Public sector current budget deficit was £6.7 billion in October 2012. The deficit was £2.3 billion higher than the outcome recorded in October 2011.
  • ONS say that for the “period April to October 2012, public sector net borrowing (excluding the capital payment recorded as part of the Royal Mail Pension Plan transfer in April 2012) was £73.3 billion; this is £5.0 billion higher net borrowing than in the same period the previous year, when net borrowing was £68.3 billion”.
  • “Public sector net debt was £1,068.8 billion at the end of October 2012” or 67.9 per cent of GDP, a rise of 4.5 per cent over the 12 months.

Now the point of quoting those figures is not to give them any credence in their own right. They can only be interpreted with reference to a meaningful context – which in this case is the state of the real economy. Public deficit and debt ratios have no meaning in their own right, in isolation, when we are discussing a sovereign currency nation such as the UK.

Remember a sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

Also note that the October 2012 outcomes are actually highly misleading because they include the impacts of some monumental fudging from the Government, aimed at misrepresenting the data to all those who do not take the time to read the publications in full.

Refer to dot-point three above – the reference to the “Royal Mail Pension Plan transfer”. What is that about? Sleaze is the answer, but I better explain.

The ONS publication (linked above) contains a section entitled (euphemistically) – “Recent events and methodological changes” (starting page 6). On Page 8 you encounter the explanation for the “Royal Mail Pension PLan” transfer.

The nub is that the Government is preparing the Royal Mail for privatisation. As part of this process it transferred all the assets of the Royal Mail to the public accounts (£28 billion) but not its liabilities, which were much larger (£38 billion). As a result net borrowing didn’t rise by as much as is indicated by the true state of public finances in the UK.

We read that:

Following Royal Assent for the Postal Services Act, on 13 June 2011 the Department for Business, Innovation and Skills (BIS) has transferred assets and liabilities from the Royal Mail Pension Plan (RMPP) to a new government run unfunded public sector pension scheme. Under the terms of the Act, the Government assumes both the RMPP pension liabilities, accrued up to March 2012, and the bulk of the RMPP’s assets. These transactions took place in April 2012 …

The value of the RMPP assets transferred was £28.0 billion and the value of the transferred liabilities was approximately £38 billion. Under National Accounts rules, the pension liabilities of unfunded pension plans, like those for the Civil Service, are contingent liabilities and are therefore not recorded as liabilities in the National Accounts or Public Sector Finances. However, the transfer of the assets will provide the government finances with a one off boost in the short term, though government expenditure rises over the longer term as it pays out the pensions to retired Royal Mail workers.

So fudge of the best variety. Without it, the Public Finances data would reveal a much bigger rise in the deficit and public debt outstanding.

Closer examination of the data reveals that the “activity”-based components are moving in ways that tell you economic activity is waning, notwithstanding the Olympics-blip.

For example, corporate tax revenue fell from £8.9 billion in October 2011 to £8.1 billion in October 2012, a decline of 9.5 per cent over the 12 months. Of significance, is that the rate at which company tax receipts is falling is accelerating. Institutional arrangements also dictate that October is usually a stronger than normal month for company tax receipts.

Overall, tax revenue is slightly up (1.8 per cent over the 12 months) but so is government spending (up 9 per cent), which is why the deficit has increased. Despite its intended austerity, government departments are still increasing spending.

The tax revenue rose on the back of the 2.5 per cent increase in the VAT, which is a deflationary measure overall. But the rising deficit means that the public contribution to aggregate demand is still rising despite its intentions.

That is the point that people do not typically understand. As fiscal austerity impacts negatively on the economic cycle, the damage is attenuated by the cyclical effects that a manifest in the final budget outcome.

I have explained previously how we can decompose a budget outcome into two components – that which reflects the discretionary spending and taxing decisions of the government (so the policy choices) and that which reflects the state of the economic cycle (the so-called automatic stabilisers).

To summarise, a budget balance is the difference between total revenue and total outlays. 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.

If the budget is in surplus then the fiscal impact of government is contractionary (withdrawing net spending) and if the budget is in deficit the fiscal impact expansionary (adding net spending).

But the complication is that we cannot then conclude that changes in the fiscal impact reflect discretionary policy changes. To see this, the most simple model of the budget balance we might think of can be written as:

Budget Balance = Revenue – Spending

Budget Balance = (Tax Revenue + Other Revenue) – (Welfare Payments + Other Spending)

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 automatic stabilisers.

Therefore, without any discretionary policy changes, the Budget Balance will vary over the course of the economic 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.

So a rising budget deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind or vice versa.

What this also means is that fiscal austerity policies that damage economic growth will also likely result in a rising budget deficit and via the voluntary (but unnecessary) institutional arrangements that dictate that the state issue debt to the private markets on matching ($-for-$) basis with the recorded deficit, a rising public debt.

The point is that it is easier to bring a deficit down by using deficit spending to promote robust economic activity, which has the side-effect of flooding the government sector with tax revenue (without altering the tax structure at all).

Overall, Modern Monetary Theory (MMT) tells us that an obsession with these financial outcomes are likely to lead to poor fiscal interventions, exemplified by pro-cyclical fiscal shifts, and be self-defeating in terms of their own mis-guided logic.

Please read my blogs – Structural deficits and automatic stabilisers and Structural deficits – the great con job! – for more discussion on this point.

I was most interested in the reaction of the corporate elites to the Public Finance data release.

As an example, the CEO of the British Chambers of Commerce reacted to the data in the predictable (and pathetic) way saying in their Press Release that:

To maintain credibility, the government must persevere with a realistic plan to reduce the deficit over the medium term. But there is also a risk that if weak growth continues, borrowing could overshoot even further, which could in turn threaten the UK’s credit rating. The government should look to make cuts in areas such as welfare reform, pensions and the size of the civil service to ensure that the structural deficit is gradually reduced. We will also be looking to the Chancellor to announce measures in his Autumn Statement that will boost growth and enhance the productive capacity of the UK.

Contradiction personified. What this is really saying is that they want the Government to cut the income support to those who are the least advantaged (and have marginal propensities to spend of 1 – that is, they spend every cent they get) and increase the dose of corporate welfare that these parasitic business groups expect from government as their right.

Hypocrisy has no limits when it comes to these characters.

Corporate welfare is not just about direct government handouts to private businesses in the guise of industry policy and tax breaks. Firms have long enjoyed government support for credit guarantees, cheap labour (via wage and training subsidies), export promotion and other handouts.

But no