Sunday, 25 September 2011

Framing the Debate Over Public Finances - Austerity and Deficit Reduction

One year into austerity Britain and the data on the UK’s fiscal position has provided for some surprising twists in the perennial debate over how far and fast to cut the public finances: public spending isn’t actually going down. This seemingly perverse outcome has led to an equally perverse argument: if these are the cuts, then how can Labour say the cuts are too deep? This contention is among the most dangerous, as it springs from the complexity of interpreting public finances and is easily misunderstood.

The first thing to remember is that there are a lot of accounting tricks you can employ to change how these numbers look. The choice between expressing an expenditure as a proportion of GDP, or of total government spending, or in absolute terms for example, can produce markedly different results. If inflation is high an absolute figure may be misleading as absolute figures will natural tend to increase over time as prices rise. Similarly if government spending as a whole is rising or declining, then that can distort any single component expressed as a percentage of spending. If the overall budget is cut but health spending is protected, then health spending is increasing as a proportion of total spending. Last but by no means least, movements in GDP growth / decline can produce similar effects-- you can maintain the same level of spending as a percentage of GDP while cutting spending if GDP has fallen.

The UK currently has modestly high inflation, and this is doubly true in certain areas such as health. The payout on retirement benefits, health spending and education have tended to and are projected to soar over time because of demographic, technical and demand-based reasons. If government spending does not increase in absolute terms these areas will see a real-terms decrease in funding, they will not be able to keep up with the increase in costs. This is, if you like, a negative cut as opposed to a positive one. A passive cut.

The next thing to remember-- and a critical point for Keynesians-- is that government spending also goes on items such as welfare. In times of high unemployment the cost of providing benefits also rises. And as a result, cuts elsewhere may be cancelled out by increasing cyclical expenses. The so-called ‘automatic stabilisers’, which cause the government to spend more during downturns, have the side-effect of masking cuts in spending elsewhere.

As a result it is never reasonable to look at government spending as a whole. If the coalition cut spending in specific areas, but the effect of this was to lower employment, then given the current economic climate this would reduce demand in the economy and increase government spending on welfare. Moreover, companies would see the decrease in demand and cut investment and hire fewer people. These effects can quickly multiply, as consumers cut back on spending out of fear of what the future might hold.

So it is entirely possible that the government could cut spending, and yet fail to actually reduce total outgoings. It is therefore equally true that the opposition could have, were they in government, cut spending by less and not have been in much worse of a position fiscally. In fact, the UK’s debt is structured in a very long term, low interest rate way compared to most other nations, and is able to borrow at historically low rates. This is in part because investors can also see the bleak prospects for demand, and would rather put their money into national debt than private-- and some nations rather than others.

The experience of Japan, and of the US and UK today, is one where high debt has not proven catastrophic. The capacity to print money and the size of the economies concerned makes them very different to the greek situation. More importantly, the US and UK are growing--however slowly, and are able to produce revenues. As GDP grows the size of the national debt as a percentage of GDP falls, and government revenues tend to rise. This means that the long term position is sound provided a protracted recession does not re-emerge, and the low interest rates on government debt, combined with high inflation means the government can effectively borrow for free. This is why, during a liquidity trap, many economists argue government spending should actually rise in the short term, and fall in the medium and longer term. The government is taking up the slack in private sector investment created by an environment of low confidence and high risk, and taking advantage of its own low rates of interest.

There are therefore two ways to express the current situation: A) The government has barely cut anything, so how could it have cut less, and B) Despite its cuts the government has failed to reduce the deficit. Both arguments are easy to make in the media just now, and the only reasonable policy for the average person is caveat emptor: buyer beware. This is an area where it’s very easy to invent your own facts, and both sides are going to do it.

The conservatives like to call this a debt-based recession, and that’s true. It’s also a demand-led recession. Without demand for their products and services companies will neither hire nor invest. Households still have too much debt, household bills-- especially energy bills-- are rising too quickly and wages are not going anywhere. There are no private sector jobs in selling to people who won’t buy and demand has collapsed in Ireland, in the Eurozone, in the US. All our major trading partners, and the kind of goods and services we export go disproportionately to those countries-- not to developing countries. Cuts are not going to miraculously solve any of these problems, and there are no quick fix supply side measures to remedy them either.

In principle Labour were right, cutting the deficit needed to be a medium term priority, while in the short term the recovery was supported, however in reality it may not matter at all, as the looming crisis in the Eurozone threatens to plunge the entire world back into crisis.

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