THE BLOG

Will Austerity Really Reduce the Government Deficit?

10/09/2014 17:39 BST | Updated 10/11/2014 10:59 GMT

In 2013, the government deficit, according to the latest available Office for National Statistics (ONS) figures, was £92.9billion, which was 5.8% of GDP. All our major political parties are fixated on getting this deficit down by cutting expenditure and raising taxes. But should they be quite so determined to do so? Is austerity really the best way to cut the deficit?

The current problem we certainly do have is that, even allowing for inflation and the growth achieved in 2013, government debt is still growing faster than the economy. On this basis, with current policies in force, it will go on rising to eventually unmanageable levels. If we could get the growth rate of the economy up to, say 4% to 5% per annum, as the Pound Campaign believes is certainly possible, on the other hand, the deficit would fall and total government borrowing as a percentage of GDP would go down too. On this basis, the position would continue to be manageable indefinitely. How could this be done?

The government deficit is one of four major borrowing and lending aggregates in the economy - the others being corporations, households and the foreign balance - which have to sum to zero because all borrowing has to exactly equal all lending.

The foreign balance, which measured the extent to which foreign interests have to lend us money to finance our balance of payments deficit, is fixed by a combination of our trade deficit, our net income (now substantially negative) from abroad and our net transfer payments overseas, and is outside the government's immediate control. Allowing for any borrowing or lending by corporations or households, the government deficit then becomes the balancing item. Without the government deficit, demand in the economy would spiral down. In practice, it stays up because, with depressed conditions, the tax take falls and social security charges rise. This is why reducing the government deficit by cutting expenditure and raising taxes - which at first sight sounds so obviously the practical and sensible thing to do - is in fact anything but. Here's why, in a little more detail.

The foreign payments balance is trending upwards and may be as high as £80billion in 2014. As a result of the fundamental weaknesses in the UK economy - our very low rate of investment, our attenuated manufacturing base, our rising balance of payments deficit and increasing government debt, and consumer demand depending too heavily on asset price inflation - it is unlikely that additional borrowing will materialise either from the corporate or household sectors. Corporate lending in the UK during 2014 is trending towards about £35billion and consumer borrowing to about £15billion. In these circumstances, it is very hard to see how the public sector deficit can fall below around £100billion. On the contrary, it may even start to move upwards above this figure again.

But surely, common sense seems to tell us, a determined government could still get the deficit down by cutting expenditure and increasing taxation. The reason why this approach does not and will not work is because it contains a fallacy of composition. It might make sense for individuals, faced with expenditures exceeding their incomes, to cut back to get the situation back under control. It does not do so for the economy as a whole, however, because everyone's expenditure is someone else's income. Cutting spending will thus finish up by cutting aggregate revenues, as the economy contracts. GDP growth will stall or maybe even turn negative, but the deficit will stay stubbornly high and may even increase.

One of the huge advantages of a devaluation-led expansionist policy is that this problem will just disappear. First, even if the eventual position is that there is still a government deficit, provided that the growth plus inflation rates added together come to more than the deficit as a percentage of GDP, government debt will go down, again as a GDP percentage, rather than up every year. Second, if - to ensure that sterling is established at a competitive level and stays there - the balance of payments gap has to be widened temporarily and the government deficit widens with it for the time being, this does not matter.

Provided it is clear that before long government debt as a percentage of GDP will start going down, the position would remain manageable, because we could be sure that a sustainable position would be reached before long. Once the net trade - exports minus imports - position started to improve, after the inevitable transitional period, the balance of payments gap would start to close and the government deficit would fall with it. A stable position could then be reached with perhaps something like a foreign payments deficit of £50billion, net lending by business of £20billion, net borrowing by consumers of £20billion and a government deficit of £50billion.

Austerity programmes are therefore both unnecessary and entirely counter-productive. They will not reduce the government deficit and nor will they reduce the proportion of GDP going through government hands. Instead, a far more rational strategy would be along the following lines:

First, increases in public spending, mainly at least initially on capital expenditure, and reductions in taxation, targeted mainly at disinflationary policies such as reducing VAT and NI contributions, should be used to drive down the exchange rate.

Second, the medium-term aim should be to have a government deficit of perhaps 2.5% of GDP, with government expenditure taking up around 40% of GDP, and with government taxation, fees and charges bringing in about 37.5% of GDP.

Third, with a growth rate of, say, 4% and inflation running at 3%, total government debt as a percentage of GDP would fall by 7.0% minus 2.5%, which is 4.5% per annum.

Finally, once the transitional period to higher growth was over, public expenditure could be increased in line with GDP growth, with no risk of this destabilising the economy.

Over a ten year period, if government debt as a percentage of GDP fell by about 4% to 5% a year, as would happen under the Pound Campaign's expansionist policy, total debt would fall from about 100% of GDP to less than 60%.

If we carry on as we are, by contrast, within a decade government debt will rise at about 3% per annum to about 125% of GDP. What is the point of having years of austerity to produce this dismal result?