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Budget deficits and noble lies Samuel Brittan Financial Times 02/09/05 Having assailed the conventional wisdom on national savings on August 5, I now turn to the budget deficits which horrify so many orthodox commentators. This horror reached a peak in the UK in the recession of the early 1990s when the high borrowing of the then chancellor Norman Lamont in the early 1990s came under attack both from the puritan left and from the financial right. The issue came up again when the now defunct Growth and Stability Pact was negotiated for the European Monetary Union. Moralistic outrage is not enough. When large successful economies like that of the US run large budget deficits for many years critics can no longer get away with pretending that the economy will collapse every time the national finances go into the red. There is however a prevailing economic orthodoxy which purports to draw the safety limits of safe government borrowing. The issue can be made to seem enormously complicated. But at bottom the new conventional arithmetic is extremely simple. Let GDP in the initial year be 100. Let us assume that the national debt is then 50 per cent of Gross Domestic Product and that the national growth rate is 2 per cent. Then if you want to stabilise the ratio of debt to GDP the budget deficit should not exceed 1 per cent of GDP. This gives us in the following year debt of 51, GDP of 102 and still a ratio of 50 per cent. But if the safety limit is for long exceeded the debt will grow faster than the national income and more and more of the government’s budget will have to be devoted just to interest payments. So a “debt trap“ will have been sprung. So far so good. The arithmetic has the common sense consequence that if GDP grows more quickly, so can the allowable budget deficit. It has the less attractive quality that allows the budget deficit to grow more quickly if faster growth simply reflects inflation. It also has the paradoxical consequence that a highly virtuous country, with say a debt to GDP ratio of 10 per cent, will need a much smaller deficit to avoid the trap. An obvious difficulty is that there is no one right debt ratio. All that one can say is that, whatever the starting ratio it will rise indefinitely so long as the deficit safety limits are exceeded. As a matter of fact, net general government financial liabilities tend to be between 40 and 60 per cent of GDP in the main industrial countries with Japan an outrider at over 80 per cent and Italy approaching 100 per cent. Among the main industrial countries deficits, measured by general government financial balances, tend to be 3-4 per cent of GDP. Japan is an outrider with more than 6 per cent. If you are an IMF economist or a European central banker you can then easily draw up shock horror scenarios. The consensus among analysts is that these numbers are too high and need to be gradually reduced. If you play around with debt ratios and growth rates you nearly always end up somewhere in the range of 0 to 3 per cent as the deficit range consistent with non-inflationary growth, which is the rationale behind the attempt of the former euro area Growth and Stability Pact to put a ceiling on deficits at the latter percentage. But before going any further, please remember that the conventional arithmetic depends on one crucial assumption. This is that employment and growth are not affected, except temporarily, by deficit spending. If however such spending can offset a deficiency of private sector spending and boost the national growth rate, then the arithmetic is misleading. For in that case the transfer burden of higher taxes to service the national debt would have to be offset against the gains to growth and employment - an exercise which few if any economists have carried out. One recently fashionable case against deficits as an economic stimulus is known by the off-putting term “Ricardian equivalence” after the British 19th century economist David Ricardo who is supposed to have discovered it. The argument is that citizens know that government spending has eventually to be financed by taxes; and if taxes are lowered to boost output and employment, taxpayers will simply offset this stimulus by saving up for the time when they know that taxes will have to be raised again. The argument about this notion has turned on how far sighted taxpayers really are. But it is not the only issue. For if tax cuts or a spending increase can really boost output and employment permanently then future taxes will not have to rise as much as crude calculations would suggest; and in any case the price might be worth paying. Optimists might say that economies normally operate at the highest rate of utilisation compatible with a stable rate of inflation, at least over a business cycle; or, if not, that monetary policy can provide any needed boost; and that the Great Depression of the 1930’s was a one-off event. But you do not have to go so far into high and improbable theory to make a pragmatic case against over-indulgence in deficit finance. Once governments feel that they can borrow without all hell breaking loose the temptation always is to find some excuse for cutting taxes or increasing spending. This is often backed up by an overoptimistic idea of the speed at which the economy can be run and a slowness to move from deficit to surplus when inflationary overheating begins to threaten. This is the story of the 1970’s in a nutshell. Historical experience argues that monetary policy should be the first line of defence against both slump and inflationary boom. Not only can it be changed much more quickly and with less political embarrassment. But the record suggests that fiscal changes on their own without adequate monetary backing are often ineffective in dealing with both inflation and recession. The classic example of the first was the failure of tighter budgets to curb the inflationary excesses associated with the Vietnam war in the US. The classic example of the second has been the failure of huge budget deficits in Japan without adequate monetary follow-up. Moreover monetary policy has the great virtue, when used as a stimulus, of not leaving behind a mass of deadweigt debt requiring to be serviced from the public purse. Unfortunately we cannot just leave matters here. It is easy to envisage situations in which both monetary and fiscal policy would be necessary to achieve a modicum of stability, but they would have to work together to do so. Some compromise policies have been promulgated which allow budget deficits but try to prevent them getting out of control. The not-so-golden rule, championed by Britain’s Gordon Brown, is to aim for a current balance and exclude public investment - now rising towards 3pc of GDP from the calculation. This is however based on a false analogy with private investment. If one could imagine a genuine socialist market economy in which the government owned the means of production, then indeed the sort of borrowing rules used by large corporations such as Unilever or BP might apply. But most public investment in mixed economies is not of this kind at all. However desirable new schools and hospitals might be, there is no known method of estimating how much, if at all, additional tax revenue they will generate to service the borrowing cost. It would be much better, in my view, to accept a modest permissible overall deficit and put much less emphasis on the current-capital distinction. Another compromise, also favoured by Mr. Brown, is to take into account the state of the business cycle. One way of doing this, which he has adopted, is to try to achieve balance over a whole cycle. This runs into the problem that to carry this out effectively you need to know where the current cycle is going to end. In fact it has been almost as difficult to decide when it began, as was shown when the British Treasury recently put back the beginning of the cycle from 1997 to 1999. This leads to the absurd result that the permissible deficit well into the 21st century appears to depend on a subtle reworking of the history of the best part of a decade ago. An alternative approach, which I have previously favoured, is to look at the cyclically adjusted balance in the current year. This has the advantage of not depending so much on crystal gazing or past history. But it has the disadvantage of having to estimate the capacity gap -- which is a much more contentious idea than appears on the surface and involves guessing the level of output and employment consistent with a stable rate of inflation. Moreover in practice politicians, analysts and commentators are not going to work for too long with two sets of wide apart data, the actual budget balance and the cyclically-corrected one. If the actual deficit starts to balloon, as it did in the UK in the early 1990s, the Treasury will sooner or later decide that there was much less excess capacity than it previously thought and adjust the “adjusted deficit“ upwards. My present inclination would be just to make a balance or some small deficit the norm but to accept that in emergencies -- whether due to war, slump or outside shocks such as oil price explosions -- the budget rule may have to take a second place to other imperatives. Much of the orthodox attitude is a form of “not in front of the children”. Many in the financial world know that unbalanced budgets may sometimes be theoretically desirable but are against admitting this, lest politicians misuse this knowledge and borrow to excess. This is the old fallacy of telling noble lies to encourage good behaviour. A myth can only serve a useful function if people do not realise it is a myth. Once the age of innocence is over it cannot be recovered.
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