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12/10/2015 17:57 BST | Updated 12/10/2016 06:12 BST

Getting Over the Fear of Fiscal Deficits

The Austerity Dogma

If you follow the debate (fight) over economic policy in Britain, you know that Chancellor George Osborne asserts that a negative balance between public revenue and overall public spending (deficit) is a problem requiring immediate policy measures to eliminate it. And recently he has gone further, asserting the need for legislation requiring the fiscal balance be positive (surplus) when the economy is at or near its capacity. His invariant way to "correct" a negative balance is expenditure reduction (aka "austerity").

He and his supporters give three justifications for this dogma. There is the reductionist argument that compares public sector budgeting to households, so obvious to the austerity advocates that it requires no explanation. Households must balance their books ("live within their means"), and the same applies (or should apply) to governments.

Anyone who believes that households must spend no more than current income has never bought a house, sent an offspring to university or found her/himself between jobs (due to redundancy, firing, or voluntary employment change).

Plus, statistics refute the like-households argument. Households across the income distribution spend more than their incomes in almost every advanced country, early and often. That is why PwC projects average UK household debt to reach £10,000 at the end of 2016 excluding mortgages.

The very limited truth in the false comparison comes at the bottom of the income distribution, where households have no choice but to engage in desperation borrowing (see study by Johanna Montgomerie).

The fundamental falsifier of the household-equals-government argument is that the UK government and any with its own currency can borrow from itself, and a household cannot. The government of a country that has a national currency is not constrained in its spending by revenue flow alone.

Superficially more serious is the argument that public sector deficits put upward pressure on market interest rates. Government bond sales compete with private borrowing, interest rates rise and private debt become more expensive and investment declines ("crowded out"). Whether this represents an important macroeconomic interaction in general remains subject of empirical debate.

At the moment, it is obviously irrelevant because the Bank of England rate is below one percent and money market rates hardly higher. Indeed, a rise in interest rates could bring benefits, such as higher returns to pension funds. Were the UK government concerned about "crowding out," it has an obvious way to avoid it, borrowing directly from the Bank of England ("monetizing" the deficit).

Another frequently encountered assertion is that the Chancellor should avoid public sector deficits because they generate inflationary pressures. There exist concrete circumstances when this would happen, but at the moment the overall rate of inflation in the UK is slightly negative, and the "core inflation rate" is barely over one percent.

Finally, the deficit has been falling (albeit slowly), and for fiscal year 2014/15 was less than £60 billion (below five percent of GDP compared to over 10 percent in mid-2012). With inflation at zero, government borrowing falling, and no empirical or theoretical basis for the dangers of deficits, further budget cuts would qualify as gratuitous and ideological.

Anti-Austerity Variations

Among critics of Chancellor Osborne's policies appear two counter proposals for fiscal policy guidelines, 1) borrow only for investment, and 2) balance the budget "over the economic cycle." Close inspection of these suggests that they are variations on the austerity argument rather than alternatives.

The first would maintain balance or a surplus for current expenditure, and fund public investment through borrowing by sale of government bonds in the financial market, or borrowing from the Bank of England. In mainstream economics the former has no impact on the supply of money, while the latter increases it by the amount of the borrowing.

The "borrow only to invest" position accepts that deficits are a problem, though limiting the problematic role to the current budget, total revenue flows less non-investment expenditure. In practice the distinction between current and capital (investment) expenditure is far from black and white, making implementation arbitrary.

The borrow-only-to-invest policy encounters another serious problem. When economic contraction causes public revenue to fall below current expenditure, should a government initiate cuts in public services and social support? If so, this policy becomes a variant on the Chancellor's austerity dogma. And not making cuts implies that the policy cannot be implemented.

The second approach also considers deficits as problems needing correction, over the economic cycle rather than continuously. The concrete guideline is that the fiscal balance can be negative when the economy falls into recession, then moves into surplus as it recovers, very close to the proposed Osborne rule.

In practice this policy flounders on several empirical and analytical flaws. First, defining the length of the period over which the sum of deficits and surpluses sum to zero defies consensus. Without clear definitions of the beginning and end of a cycle this framework cannot be implemented without arbitrary guidelines.

Both approaches offered as a counter to austerity suffer from the same fallacy as the dogma itself. Any rule requiring a fiscal balance must apply arbitrary assumptions and definitions in order to define when the outcome conforms to the rule.

Falling back on ideological rhetoric, supporters of budget cuts have attacked critics of austerity as "deficit deniers." The meaning of this accusatory term remains elusive, but it carries the implication that opponents of expenditure cuts "do not care" about the deficit and/or do not consider it a problem.

The counter proposals might be seen as being "semi-denials." Those advocating balancing the current budget deny the need for revenue to cover public investment. The cyclical balancers deny any necessary to correct deficits in the short run. Arriving at sensible and rational fiscal rules requires abandoning budget balancing as a goal and converting it into an outcome derivative from effectively achieving macroeconomic stability and high levels of employment.

The Role of Taxation

Aversion to deficits comes from an analytical confusion, the common sense generalization that the purpose of taxation is to fund public expenditure. For the government of a country that is part of a currency union (e.g., the euro zone) or a regional or local government the generalization is valid. These governments do not control the monetary system in which they operate their fiscal policy.

The generalization is not true for a government of a country with a national currency over which it has control either directly or via the central bank. Call the former shared currency countries (SCC) and the latter national currency countries (NCC).

A SCC government has two methods of funding expenditure, taxation and selling bonds to the private sector (typically to banks and other financial institutions). The SCC government must pay the debt service, interest and principle, to private bondholders from taxation for the life of the bond. For SCC governments borrowing is similar to what households and businesses do. The cliché "living within means" could be applied, meaning precisely that the combination of current outlays and debt service must be consistent with revenue flows.

NCC governments operate within quite different fiscal constraints, possessing an additional funding option and a quite different goal for fiscal policy. The core purpose of fiscal policy for an SCC government is to provide public goods, and fund these in a sustainable manner.

The core purposes of fiscal policy for the NCC government (e.g. the US or the UK) are to maintain macroeconomic stability and increase productive capacity for the medium and long term. The NCC government uses current expenditure to achieve stability and capital expenditure to enhance capacity. Any expenditure by an NCC government, current or capital, obtains its funding from taxation, bonds sales to the private sector, and/or borrowing directly from the country's central bank ("monetization").

The defining characteristic of borrowing from the central bank is that in practice the debt need never be repaid; for example, the UK Treasury could sell the Bank of England 100-year bonds (though in practice the maturity period is much shorter), or "roll over" the bonds (issue new ones to replace those that reach their redemption date). The Bank of England holds about 25 percent of UK public debt.

The short-run goal of macroeconomic stability determines the mix of these three funding alternatives. If the economy falls into recession with deflationary price pressures, the NCC government increases expenditure to compensate for the fall in private demand, covering the increased outlays through monetization. As the economy approaches full capacity with inflationary pressures, bond sales to the central bank end. Rising tax revenue from the expanding economy replaces borrowing.

Whether the public budget is in balance should be of no concern for the NCC government. If economic activity is declining or stagnant, public borrowing should increase. Whether this results in a deficit on current expenditure is little importance, for the policy purpose is recovery not hitting a fiscal target. An overheating economy calls for increased taxation, perhaps generating an overall surplus.

Balancing Policy rather than Budgets

For the British government, and all other NCC governments, expenditures and taxation have different policy functions and motivations. Current expenditure delivers public goods and services to the population, and regulates the short term stability of the aggregate economy. Simultaneously achieving those two goals represents the main challenge of a rational fiscal policy.

The rational approach to fiscal decisions is to balance policy not budgets. The fiscal balance in itself is neither a target nor an indicator of successful policy. Whether the fiscal balance is positive, zero or negative reflects the outcome of this rational approach. This is not deficit denial. It is rejection of deficit fetish.