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The colour of debt

6 May 2015 By Edward Hadas

The next British prime minister will be committed to a balanced government budget. In the campaign leading up to Thursday’s election, David Cameron, the Conservative Party incumbent, has stressed the need for “fiscal discipline”. His argument with Ed Miliband, the Labour Party challenger, is only over the right pace for eliminating the deficit, expected to be 4.8 percent of UK GDP in 2015.

The debate is unedifying. It is filled with outlandish promises and historical fictions. The worst part is the general agreement that fiscal deficits are basically bad and that high levels of government debt are a clear danger to the nation. The truth is far more subtle.

Government deficits are not like other deficits and government debt is not like other debt. The basic difference was popularised by John Maynard Keynes in the 1930s.

Households and companies are allocated economic resources through their cash incomes. When they borrow, they are taking more than they are earning. The borrowers may be ambitious, desperate, greedy or over-eager. But justice usually requires them eventually to repay their debts, so the loan-financed immediate spending is matched by lesser future spending mandated by repayment and interest costs. Over time, personal and corporate budgets should balance.

Governments are different. True, they are allocated economic resources, much as wage-earners and product-sellers are. However, a government is much more than a single tax-financed cog in a complex economic machine. It stands over the whole thing. It is ultimately responsible for ensuring that there is the right amount of paid work and the best possible array of goods and services. More often than not, balanced budgets get in the way of these broad goals.

Keynes pointed out that an excess of government spending over the tax take can put money in useful places, for example into the bank accounts of consumers and companies. Their additional cash leads to more spending, and the spending brings more goods and services into the world. If the government’s allocations are correctly calibrated, everyone is better off.

The UK government took this advice after the 2008 financial crisis had reduced both economic activity and tax revenue. It basically kept on spending as before, allowing the fiscal deficit to rise to 10.9 percent of GDP in 2009. The policy, which was adopted in all developed economies, was right. The U.S. experience at least hints that more borrowing then led to stronger GDP growth later. In the UK, both Labour, which was in power until 2010, and the Conservatives can be satisfied with that part of their record.

The many years of high fiscal deficits have led to a doubling of the ratio of overall British sovereign debt to the country’s GDP, from 38 percent in 2007 to an expected 83 percent in 2015, according to the International Monetary Fund. But as long as British government debt is held by UK taxpayers, the effect on the nation’s economy can be small. The cash flows related to debt – issue, interest payments and redemption – can be fully integrated into the tax system.

Government debt and deficits do raise serious political and technical issues. Politically, many voters clearly fear too high borrowing. Investors also fear that high deficits eventually lead to high inflation, while rating agencies fret over defaults. The Cameron government used these concerns to justify its commitment to rapid deficit reduction.

As for the technical considerations, there are finely balanced arguments about the appropriate size of any government’s deficit in any year. How should they be funded? How should the government spend the money it raises? Should governments be anxious to take money from foreigners, who cannot be taxed? Is deficit financing harsh on the poor?

Neither Cameron nor Miliband seems interested in finding answers to these serious questions. The preference for ignorant sound-bites is all too typical of contemporary politicians. In Germany and the United States, the cult of the balanced budget also has strong political support.

The professional economic debate is better, but it is marred by extreme views, simplistic rhetoric and biased historical studies. Deficit-loving economists such as Paul Krugman seem to believe that a bigger fiscal deficit is almost always better for the economy than a smaller one. He and other expansionists slug it out with a smaller number of deficit-hating economists, for example Harvard’s Ken Rogoff. The fans of fiscal austerity are persuaded that big deficits are a sign of political-economic incompetence and that big sovereign debt loads tend to lead to crisis and stagnation.

In line with their too often simplistic analysis, mainstream economists frequently provide excessively simple nostrums about deficits. The recent result of following their advice was the credit boom of the 2000s, the worst global financial crisis since the 1930s and six years of sluggish recovery.

The right approach is not ideological but detailed. Macroeconomic management cannot be reduced to deficits or no deficits. It is the delicate art of guiding the complex interactions of fiscal policy, monetary policy, financial regulation, labour markets, industrial structures, savings habits and international trade and capital flows. That requires carefully calibrated policies. Demonising government deficits, and debt, is counterproductive.


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