Tuesday, 5 April 2016
Deficit? Which deficit?
By an amazingly successful piece of perception management our government has succeeded, since 2010, in convincing us that the government's internal deficit, or excess of current expenditure over current income, is way out of control and that our most important political objective must be to reduce it and, indeed, run a surplus of £10bn year by 2020. This is to be achieved by "austerity" which in practice seems to mean cuts in expenditure, particularly to the poor, and cuts in grants to local government.
"Britain must pay its way," says Gorge Osborne, Chancellor of the Exchequer, again and again and again.
It sounds common sense (especially when compared, as Mrs Thatcher so often did, to household economics) but is in fact nonsense.
First we need to distinguish between the government's current deficit and its accumulated deficit, otherwise known as the national debt.
It is orthodoxy among macro-economists that wise governments should not allow the national debt to exceed 60% of GDP. Indeed that was the qualifying level of joining the Euro and Britain could have met it easily, since when the Euro was launched our national debt was about 40% of GDP, as indeed it remained, (under a Labour government, remember) until the world financial crisis of 2007/8. Then it soared upwards to about 70% of GDP, through a combination of bailing our the banks and a fall in tax receipts as a result of the recession.
This level is higher than orthodoxy recommends, but not dangerously so. These were and are exceptional circumstances. Indeed in even more serious exceptional circumstances, the post 1945-50 period, our national debt was nearly 250% of GDP, but somehow the then government managed to establish the NHS and do all sorts of other useful things.. (The Debt/GDP ratio from 1945 to 2010 is clearly illustrated on an easy to read graph here)
Now to look at the current spending deficit, the one that George Osborne is so anxious to reduce.
It is well above the permitted maximum of 3% or GDP which orthodoxy recommends, and has been so since the crash. However, a look at this graph here shows that until 2007 the Labour government's borrowing was well within this range, much less profligate than the previous Conservative government, and that from 1999 to 2003 the much pilloried Gordon Brown even ran a surplus (ie took in more income than he spent.)
Now what has to be understood is that this national debt is largely "money we owe ourselves." As rich individuals, savers, institutions such as pension funds, insurance companies and other financial institutions, we lend to the government and the interest the government pays us finances our pensions, income from "gilts," insurance policies, unit trusts and other investments. Anyone who has some National Savings holds a part of the national debt. When the "oh-so-anxious-to-be-seen-as-thrifty" George Osborne offered we pensioners a share in the debt at about four times the going rate of interest I was happy to buy a chunk of it.
Clearly the government's borrowing, currently about 5% of GDP, needs to come down to the 3% figure, and even below because that figure should be a long-run figure, less in the good times, but more in the bad times, such as now.
It may surprise some, but steady borrowing at a long run rate of 3% of GDP will actually, because of growth and inflation, reduce the Debt:/GDP ratio. A permanent surplus, as envisaged by Osborne, is nonsense.
Now we come to the deficit that really matters, the Balance of Payments on Current Account. This is the difference between the value of the foreign currency we earn by exporting and what we spend by importing. If there is a surplus then we are more than "paying our way" in the world. If there is a deficit than we are indeed "living beyond our means."
This "balance of payments" dominated the economic headlines from the post-war period up to the 1980s. It is widely believed that the publication of some adverse figures, a flea-bite by today's standards, just before the 1970 election lost it for Harold Wilson., and Denis Healey's need to borrow from the IMF in 1976 for ever besmirched his reputation. (As it happened all the borrowing was paid back before the next, 1979, election, but that didn't impinge on the public's perception, and Mrs Thatcher was elected..)
This balance of external payments account has been in permanent deficit since the present government and its predecessor took office in 2010, and the deficit is getting worse rather than better, as this article and its graph explain. Last week' figures showed the largest deficit since records began in 1948. For the whole of 2015 the deficit was 5.1% of GDP, and was running at a yawning 7% for the final quarter.
This, unlike the government's internal borrowing, is not money within the family, but money which someday has to be repaid to others We are in increasing debt to the rest of the world.
Repaying this debt is the burden we are placing on future generations. It can be done in several ways.
First we can continue to sell off the country's productive resources to foreigners. This means that future generations will be deprived of the profits they make, which will go abroad rather than remain within the country. Or we can improve our productivity. This means that future generations will have to work more efficiently in order for our products to become competitive abroad. That's the hard way. The easier and more likely way is to further devalue our currency. One commentator, Brian Gould recommends a devaluation of 20%. That would mean future generations will have to pay 20% more for their imports, which include the cost of foreign holidays, and work 20% harder or longer or more effectively to finance the same volume of imports.
Righting this Balance of Payments on Current Account (just to spell it out in full again so there's no mistake) is the true test of a government's economic competence and it is the measure on which the Cameron- Osborne partnership should be judged.. So far they are failing miserably.
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Now what has to be understood is that this national debt is largely "money we owe ourselves."ReplyDelete
Not all over it: according to http://www.economicshelp.org/blog/1407/economics/who-owns-government-debt/ 'About 30% of UK national debt is held by oversees investors'. So that 30% isn't 'money within the family', it's money we owe to the rest of the world.
Apart from that, not much to take issue with (although I'm not sure that Osborne has ever claimed to want a 'permanent surplus': according to http://www.bbc.co.uk/news/business-33074500 'George Osborne outlined his plan to ensure governments run a surplus in "normal" times' and that word 'normal' would provide a lot of wriggle room for any future Chancellor who wanted to run a deficit).
I mean if I wanted to be picky I could point out that 'steady borrowing at a long run rate of 3% of GDP will actually, because of growth and inflation, reduce the Debt:/GDP ratio' is only true under certain (optimistic?) assumptions of interest rates and growth.
Of course, it's easy to point out that the trade deficit needs to be eliminated; actually doing it is the hard bit…
It's good to find us in broad agreement for once.Delete
Yes, I'm aware that 30% of public debt is now held overseas, but that means that, for now, 70% is held domestically, which I think justifies the adverb "largely." Of course, before the financial deregulation of the 1980s it was "almost entirely." I'm not sure the world is yet ready for this international free-flowing of capital.
As you say, actually doing something about the current account deficit is the hard bit, which is why I think this is the deficit on which the government should be concentrating.
Increasing productivity is a large part of the answer. In this area it is clear that the Monetarist/Thatcherite recipe of deregulation, privatisation, union bashing and low taxation, which was suppose to release the energies of our entrepreneurs, has failed miserably. I'd like to see a more supportive approach which would include employee representation on boards and profit sharing, better technical education, genuine craft-apprenticeships, and measures to encourage long-term investment and penalise short term take-overs designed for asset stripping.
What would your recipe be?
What would your recipe be?Delete
Well, it certainly wouldn't be to increase the costs of the raw materials for our major export industries by imposing tariffs on them!
I'm not sure I agree that 'the Monetarist/Thatcherite recipe of deregulation, privatisation, union bashing and low taxation, which was suppose to release the energies of our entrepreneurs, has failed miserably'. A large part of the things we do export are exactly the result of such entrepreneurs: the trade deficit would be a lot worse if it weren't for companies like ARM, which are exactly the kinds of companies that those policies were designed to create.
What would your recipe be?
If I knew that I'd be running the country, not pontificating on the inter-net.
Having said that, to pontificate, and given that we are a nation of islands and therefore we are inevitably going to need to import a lot, the only way we can achieve a trade surplus is to increase exports, correct? Which basically means we have to make our goods more attractive than those from Germany, China, India, the USA, etc etc. So they can't be too expensive (they're never going to be as cheap as those that come from places where labour is plentiful and cheap, but they must be competitive, price-wise, with those that come from other developed economies like Germany and the USA) and they must, absolutely, must, be high-quality.
Also, we mustn't neglect the service sector. Money that comes into the country for providing services rather than goods still counts towards the balance of trade, indeed, it could count even more as services generally require less importing of materials so the balance is better. So again I'd concentrate on building up a reputation for high-quality services. We will never compete with population-rich countries like India for sheer cost, so we have to sell the UK as the place where you go to if you want your service done right first time.
On the other hand this article I have just read (coincidental or what?) makes the case that this current account deficit isn't a bad thing at all, because it's caused by lots of inward investment (a good thing) raising the value of sterling and making imports cheaper: http://capx.co/great-news-the-uks-running-a-current-account-deficit/Delete
The argument, that current account deficits are not good or bad in themselves but are symptoms of more underlying issues that could be good or bad (eg, a current account deficit caused by your domestic economy being a basket case that can't produce anything anybody wants to buy because all your businesses are run like British Leyland is bad, but one caused by relatively high levels of foreign investment in your economy is good) seems plausible to me; what do you think?
Thanks for your suggestions and comments.Delete
I have looked up the capx link and suggest you treat this chap with caution. Either he is being deliberately provocative, or he is too clever by half.
In particular this assertion; “. . .but the key thing to grasp is that current account deficits are caused by capital account inflows” is extraordinary.
I suppose that, at a pinch, it could be argued that successful inward investment could create an increase demand for imported raw materials and semi-finished products and so place a drain on the current account. Similarly such investment provides employment and enables the lucky workers, who would otherwise be on the dole, to buy imported consumer goods and services and go on foreign holidays.
But to claim that current account deficits are "caused" by capital inflows is a bit far-fetched.
It is, I think, truer to take the orthodox view that current account deficits are "covered" by capital inflows, and this is what has been happening in the UK for many years. In so far as these inflows are “hot money” seeking a higher rate of interest, a “safe haven” or in anticipation of an appreciation of sterling, it has to be remembered that such funds can just as easily, and suddenly, flow out again They are an unreliable sticking-plaster.
If the inflows purchase existing capital, then they fill the gap on the balance of payments in the short run, but lead to an outflow of profits, interest and dividends in the long run, which make it even more difficult to pay our way.
So in my view relying on capital inflows to balance the book is another example of the short-termism which bedevils the UK economy in so many areas. The only long-term solution is to improve our productivity.
I suppose that, at a pinch, it could be argued that successful inward investment could create an increase demand for imported raw materials and semi-finished products and so place a drain on the current accountDelete
Maybe, but I think his key point is to do with the floating currency. The idea is that if investors put their money in Britain, then the value of Sterling rises, relative to other currencies. This seems a fairly uncontentious point.
Now, clearly a high value of Sterling is going to both make British exports less competitive against other countries' (especially Germany, which should have a massively valuable currency but which has benefited, and continues to benefit, from the Euro's value being dragged down by the southern economies) and is going to make people who live in Britain more willing to import goods.
So that part of his argument, that inward investment into an economy with a floating currency can cause a trade deficit by raising the currency's value, seems fairly plausible to me. Does it not to you?
And if so presumably the same thing could happen in reverse, if the 'hot money' leaves. Indeed one of your own suggested methods for reducing the trade deficit was devaluing the currency, wasn't it? Well, isn't that what will happen automatically if investors start pulling their money out of the UK? Indeed, haven't we been seeing exactly that happening in the uncertainty in the lead-up to the referendum in June: investors don't like uncertainty, so they have been holding off investing in the UK until the result is know, and that has caused falls in the value of Sterling versus the Euro: see http://www.bbc.co.uk/news/business-35343792
And if that happens, then our goods will become more competitive, our appetite for imports will fall, and the trade balance will shift back in the direction you want it to, won't it? Due, in fact, to one of the mechanisms you yourself suggested: currency devaluation (you suggested a 20% devaluation; by my glance at the charts Sterling has devalued against the Euro about 7.5% since the start of the year, so we're well on the way to that figure).
In a very real sense a floating currency is a self-correcting mechanism for exactly this kind of situation.
The only long-term solution is to improve our productivity.
Well, yes, but that is always true because improving productivity is always good. That doesn't mean that other things, like inward investment, aren't also good.
But more specifically, it doesn't mean that having a trade deficit is necessarily always bad. After all, if we increase our productivity, then our currency will remain strong, our goods will still be less competitive, and imports will be cheaper, so we'll still have a trade deficit even with a highly productive economy, won't we?
I suppose it's because we have a floating exchange rate that the current account deficit doesn't hit the headlines any more, but, as I've indicated above, trying to "balance the books" by allowing the currency to depreciate continuously is the lazy way out.Delete
One oft he much vaunted merits of the fixed exchange rate system was that it obliged economies to exercise "discipline", something of which the Tories used to be very fond. While this could be carried to excess when the value of a currency was regarded as some sort of national virility symbol, the lack of it, in the sense of allowing us to ignore our poor productivity, really does mean that we pass on a burden to future generations.
In my childhood one pound's worth of British output would buy four dollars' worth of US goods and services. The present generation of workers have have to work nearly three times as hard, or as long, to buy the same amount.
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