Budget deficits, public debt and economic recovery

by David Purdy

The recession that began in the second quarter of 2008 has been the longest and deepest since 1945. By the third quarter of 2009, UK GDP, the chief measure of the (unduplicated) market value of newly produced goods and services, had fallen from its pre-recession peak by 6 per cent.1 Over the same period, unemployment, as measured by the Labour Force Survey, a quarterly estimate of how many jobless people of working age have recently been seeking employment, regardless of whether they claim Jobseeker’s Allowance, rose from 5 per cent of the workforce to just under 8 per cent. Since unemployment tends to lag behind output and employers now have ample scope for increasing output without hiring new workers, it is likely to go on rising throughout 2010, albeit more slowly than before, perhaps eventually peaking at around 9 per cent. This is well below the post-war record of 12.4 per cent, posted in 1983 after Mrs Thatcher’s great deflationary purge. Nevertheless, even on the most favourable assumptions, it will take years to get back to the pre-recession rate. If from now on GDP were to grow at a steady rate of 2.5 per cent a year, in line with its previous trend, then with output per worker growing at 2 per cent a year, employment would grow by 0.5 per cent a year. Hence, even with no increase in the workforce, it would take eight years to reduce unemployment to 5 per cent.

We should perhaps be thankful it hasn’t been worse. Just about the only redeeming feature of Gordon Brown’s premiership was his government’s response to the financial crash of September 2008. To be sure, both the government and the Bank of England were slow to appreciate the seriousness of the credit crunch, which surfaced in the summer of 2007 and turned toxic in the autumn with the run on Northern Rock. Even in September 2008, as banks tottered and stocks tumbled, the Bank of England’s base rate stood at 5 per cent and, with the sole exception of David Blanchflower, the Monetary Policy Committee were still worrying about the risk of inflation rather than the danger of falling prices and a Japanese-style debt deflation. Similarly, one can argue that the fiscal stimulus announced in the Pre-Budget Report of 2008 was too little too late and relied too heavily on the “automatic stabiliser” of falling tax revenues rather than on discretionary and purposeful increases in public expenditure, though critics should bear in mind that it takes time to design and launch new projects and that in an emergency there is a premium on measures which can be introduced without delay and will have a rapid impact.

At all events, once the crisis broke, the authorities moved quickly and avoided the policy mistakes that were made after the Wall Street Crash of 1929. By March 2009, the Bank of England had cut its base rate to an all-time low of 0.5 per cent and was about to embark on a major programme of “quantitative easing”, buying up government bonds (gilts) held by the banks and other private investors in a bid to boost the money supply, support bond prices and hold down bond yields so as to avoid any rise in borrowing costs. At the same time, the Chancellor suspended the fiscal rules the government had unwisely imposed on itself, under which public borrowing over the cycle was to cover public investment, but no more, and outstanding public debt was not to exceed 40 per cent of GDP.

It would have been better to scrap these tokens of neo-liberal rectitude altogether and to make the case for functional budget deficits designed to offset an actual or impending fall in private spending on goods and services so as to maintain employment and prevent or at least mitigate any rise in unemployment. The scale of the current budget deficit (equivalent to 12.6 per cent of GDP, the highest since the Second World War) is a simple consequence of the severity of the recession – regrettable certainly, but as Maurice Chevalier said about old age, better than the alternative. If the government had acceded to the demands of the Tories and tried to reduce the deficit by cutting public spending, it would have made a bad situation worse, compounding rather than compensating for the fall in business investment and consumer spending, and thus exacerbating the recession. The fall in output and the rise in unemployment would have been even greater than they were; public services would have been damaged, yet the budget would still be in deficit thanks to the further loss of tax revenue; and business confidence would have been shattered, not just battered, extinguishing any prospect of an early and sustained recovery. In this sense, the Brown government saved us from a re-run of the Great Depression, though it is one thing to restabilise the economy and quite another to engineer a recovery.

Does public debt matter?

But now that the danger of headlong economic collapse is (we hope) past, clamour for action to rein in the budget deficit and reduce public debt grows louder by the day. Does it matter that UK public debt is heading towards 80 or possibly even 100 per cent of GDP? Should the budget deficit be cut and, if so, when: this year, next year or only when recovery is assured? As regards the debt ratio, three preliminary points need to be made. First, its measurement is a matter of convention. The ratio is a comparison between a stock (public debt) and a flow (annual GDP). If we compared the stock with quarterly GDP, the ratio would be four times as big. If we compared it with GDP per decade, the ratio would be one tenth as big. Arguably, it would make more sense to compare public debt with tax revenue, which normally accounts for 95 per cent of government income, the rest coming from service charges, trading activities, property income and fines imposed by the courts. A debt/GDP ratio of 100 per cent would correspond to a debt/tax revenue ratio of approximately 250 per cent, roughly comparable to the multiple that prudent building societies used to apply to the incomes of prospective borrowers in deciding how much they were prepared to advance as housing mortgage loans.

Second, besides having liabilities, the public sector owns substantial assets: land, infrastructure, buildings, equipment, stockpiles, shareholdings etc. In 2007-8 the net worth of the public sector – the difference between the value of its assets and liabilities – was estimated at about 29 per cent of GDP. Moreover although most of the recent and projected rise in public debt is due to cumulative budget deficits, the total has been swollen by the liabilities of rescued financial institutions. In June 2009, the debt stood at £800 billion when these liabilities are included, and just under £660 billion when they are excluded. If and when bank share prices rise sufficiently for the government to sell its recently acquired holdings at a profit, there will be a corresponding fall in the national debt. More generally, if public borrowing is used to finance investment in assets that yield long-lasting benefits for society as a whole, the addition to public debt is matched by a corresponding addition to public assets.

Third, public debt is held by private individuals and institutions, mostly in the UK. For their holders, government bonds, national savings deposits etc. are assets, and in some cases – notably, pension funds – the associated interest payments are a significant part of their income, out of which pensions are paid. Gilts, of course, are free from the risk of default. It is possible that in the coming months, one of the credit-rating agencies – which, remember, gave their seal of approval to asset-backed securities that later turned toxic and failed to foresee the recent financial crash – will downgrade the UK’s triple-A status.2 Anyone inclined to worry about this should ask themselves when was the last time the UK government failed to repay or to service its debt. To be sure, the higher the debt, the more it costs to service it. Debt interest payments are currently running at about £30 billion a year, or 4.5 per cent of total public spending – hardly a negligible sum, but perfectly manageable as long as yields on government bonds remain at current levels.3

A public debt ratio of 100 per cent is not high by historical and international standards. Throughout the whole period from 1918 until 1963, the ratio exceeded 100 per cent. By the end of the Second World War, it stood at 250 per cent. Currently, compared with other G7 countries, the UK is a middling public debtor with a ratio of 65 per cent – just below the US (69 per cent), but some way above France and Germany (57 per cent) and Canada (33 per cent). Italy and Japan, on the other hand, both have debt ratios well in excess of 100 per cent and have done for years.

A high public debt ratio is sustainable as long as it does not keep on rising. A little algebra helps to clarify the relevant relationships. Let Y stand for the level of GDP and g for its percentage rate of growth; let B denote the budget deficit and D the public debt, measured in absolute terms; and let b and d denote the corresponding ratios, so that, by definition, b = B/Y and d = D/Y. When the government runs a budget deficit, public debt grows at the rate B/D (= b/d). But whether the debt ratio rises, stays constant or falls depends on whether b/d is greater than, equal to or less than g. Suppose, for example, g = 5 per cent and d = 100 per cent. Then d, though high, will be non-increasing as long as b does not exceed 5 per cent. Notice that since B and D are measured as nominal magnitudes, without adjusting for price inflation, it is the rate of growth of nominal GDP that matters. This, by definition, equals the rate of growth of real GDP plus the rate of price inflation. In the UK from 1993 to 2007, real GDP grew, on average, by 2.5 per cent per annum and the rate of price inflation averaged 2.5 per cent per annum, giving a figure of 5 per cent for g.

Fiscal politics

In practice, the critical issue for a government which is running a budget deficit and allowing the debt ratio to rise, is whether it has a credible strategy for reducing the deficit over the medium term, at least to the point where the debt ratio stops rising. Otherwise investors may start to switch out of government bonds into other assets, putting downward pressure on bond prices, driving up yields and raising the general cost of borrowing. So far the UK government has had little trouble in issuing new bonds, partly because gilts offer a safe haven in troubled times, and partly because the Bank of England has supported bond prices by means of quantitative easing. But as the recession recedes and QE comes to an end, the government must convince financial investors that its fiscal plans are realistic. Three questions arise here: How should the deficit be reduced and how fast? When should the process of deficit reduction start? And how far should the process go? 4

The first two of these questions already dominate what is, unfortunately, going to be a long election campaign. Throughout 2009 the Conservatives inveighed against deficit finance, giving the impression that in government they would take an axe to unprotected public spending programmes and would confirm the tax increases that have already been announced, but have not yet taken effect. On 1st February 2010, they modified this stance and moved closer to Labour by announcing that they did not now propose to introduce “swingeing” spending cuts in their first year in office. Labour has consistently argued that fiscal retrenchment is necessary, but insists that it should be delayed until 2011 when the economy is stronger. A general point that needs to be borne in mind amidst the political posturing is that the largest single contribution to reducing the budget deficit as a proportion of GDP will be the growth of GDP itself, for even with unchanged tax rates and rules, tax revenues rise as the economy grows. There will have to be some tax increases or spending cuts since revenues will no longer be buoyed up by a booming financial sector, but the state of the public finances will depend mainly on the strength of the economic recovery.

On the question of timing, Labour is surely right. While the prospects for 2010 are brighter – hardly difficult after such a savage downturn – the upswing will be muted. In 2009 consumer spending, which accounts for two thirds of GDP, fell by 3 per cent. This year it is more likely to stand still as households continue to pay down debt, but fear of job losses abates. Private investment in fixed capital, which fell sharply last year, will probably fall less sharply this. On the other hand, since firms have been meeting demand out of inventories, restocking will provide a modest expansionary impetus. And the depreciation of sterling should enable British firms to take advantage of a recovering world economy. Since mid-2007, the trade-weighted value of the pound has fallen by almost a quarter. This did little to stimulate British exports when world trade was shrinking, but net exports should start to grow from now on. Nevertheless, it is clear that without a hefty budget deficit, aggregate demand in 2010 would be too low to sustain even the current, sub-capacity level of GDP.

What of 2011 and beyond? Will the private components of aggregate demand – consumer spending, business investment and net exports – grow sufficiently for the budget deficit to be halved by the fiscal year 2013-14, as envisaged in the 2009 Pre-Budget Report? According to the Treasury, we can expect the same strong recovery – in GDP that is, not employment – as occurred after the recessions of the early 1980s and early 1990s. But the current recession is different from those previous episodes. They were recessions of choice, deliberately induced by government in order to beat down inflation. The crash of 2008 resulted from the interplay between a housing bubble, easy credit and financial speculation. Notwithstanding the bail out of the banks, little has been done to reform and restructure the UK’s bloated financial sector and British households are still weighed down by record levels of personal debt. In these circumstances, the Treasury’s optimism seems unfounded. But if private spending remains subdued and government is bent on fiscal retrenchment, where is the expansionary stimulus to come from? Yet how can any government, whatever its political complexion, maintain an expansionary fiscal stance if it does not have the confidence of investors?

There is no easy way to resolve this dilemma. Is there any way at all? In principle, yes, but only if the case for fiscal expansion to promote economic recovery is coupled with the need to tackle the profound social and environmental challenges we face, and only if we set about winning broad support for a new political economy, including the support of business interests. The values, beliefs and general view of the world that underpin the state of business confidence at any given time are not set in stone and impervious to reason, though changing them calls for imagination, courage and stamina. In the 1920s and 30s, for example, conventional wisdom held that any attempt to create new jobs by increasing public spending was futile because it would lead to an equal and opposite fall in private investment. After the 1929 Wall Street Crash, this doctrine, the “Treasury view” as it became known, was gradually discredited, partly by the experience of the Great Depression and the persistence of mass unemployment, and partly because Keynes and his followers undermined its theoretical foundations and legitimised activist economic management. But although the crisis of 1929-31 marked the death of laissez faire, it took a decade for the proponents of the new approach to win the battle of ideas. Not until 1941 when the wartime coalition government announced its first budget, was Keynes the undisputed architect of macroeconomic policy, and by then the problem was no longer how to conquer unemployment, but its twin: how to control inflation.

The comparable battle today is to reinvent economics as a moral science which takes proper account of the social and environmental consequences of economic activity, and to shift the focus of policy debate away from the question how to restore business as usual towards the more daunting, but nobler challenge of creating a sustainable way of life in a fairer, happier and more cohesive society. Proposals for a green new deal point the way forward. 5 They have so far received scant attention in the media. Whatever the outcome of the coming election, our task is to develop these ideas to the point where they cannot be ignored.

1 Provisional estimates suggest that in the fourth quarter of 2009 GDP had (just about) stopped falling. Over the calendar year 2009, GDP fell by 4.75 per cent.

2 The Conservatives make much of the need to protect the UK government’s credit rating, pledging that if they form the next government, this will be one of eight benchmarks by which their economic stewardship should be judged. Of course, governments cannot afford to ignore financial market sentiment, but neither should they defer to it. The trick is to lead it.

3 Over the past two years, the nominal yield on ten-year UK government bonds – i.e. before adjusting for inflation – has averaged 3.5 per cent. Over the past two months, it has edged up to 4.0 per cent.

4 Once the debt ratio has stopped rising, the government has to decide whether reducing it should be one of the aims of budgetary policy. As the argument in the previous paragraph shows, this need not entail running a budget surplus: as long as the ratio of the budget deficit to public debt is less than the rate of growth of nominal GDP, the debt ratio will fall. From 1945 to 1965, for example, the UK government’s budget was, on average, in deficit, yet the debt ratio fell steadily. In any case, since no one knows what the economic situation will be at the point when the debt ratio peaks – perhaps in three or four years’ time – it is best to cross this particular bridge when we reach it.

5 See Green New Deal Group (2008) A Green New Deal (New Economics Foundation); David Purdy (2009) “Recovering From Recession by Combating Climate Change: The Case for a Green New Deal” Perspectives, No 21, Spring 2009; and Tim Jackson (2009) Prosperity without Growth (Earthscan).

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