Does the deficit really matter?

An anti-austerity march in central London in June 2014An anti-austerity march in central London in June 2014 (Source: Rowan Gillette-Fussell)

It has become an article of faith among the financial, economic and political commentariat in Britain and Europe that a budget deficit is an important issue, and one that requires urgent redress.

In the UK, this partly results from domestic politics. Over the last five years, government rhetoric has argued that deficit reduction through government cuts is vital for economic survival. This recently reached its peak with an aggressively on-message Chancellor George Osborne, who has been drilling the phrase “long-term economic plan” into public discourse so enthusiastically that it seems permanently etched into the public consciousness.

Yet political parties are only partly to blame. This assumption has been replicated in much of the UK print and online media. One only needs to recall the howls of derision and incredulity at Labour Leader Ed Miliband’s omission of the deficit in his latest conference speech to see that the deficit has almost become an obsession of economic and political journalism today.

Moreover, this deficit focus has emerged against the dramatic backdrop of the Eurozone crisis, and the fraught negotiations between the Syriza-led Greek Government and the powers of Europe over debt-repayments. As a result, it is likely that the average reader will believe that a budget deficit is a highly undesirable economic disease to be avoided at all costs.

However, is the deficit really that important?

Potential dangers, alternative outcomes

This is not as stupid or contrarian a question as it first appears. In some circles, especially among academia and (unsurprisingly) the left, the importance of a deficit and, consequently, deficit reduction has been increasingly questioned. For instance, the Nobel Prize-winning economist Paul Krugman has been a stern and consistent critic of deficit-reduction economics in works such as his 2013 book End this Depression Now! Even the International Monetary Fund arguably performed a U-turn on the subject when it called for ‘fiscal expansion and accommodative monetary policies’ in Autumn 2013, after terrible growth and unemployment figures from countries such as Greece and Spain.

After all, what actually happens if we let a deficit persist without cutting back government expenditure? According to the austerians, demand for government bonds will start to plummet as the market loses confidence in that nation’s ability to honour their loan. The evidence for this will be sky-rocketing yields on those bonds. This makes borrowing much harder for that government, putting their provision of public services at risk. As a result, the Leviathan machine of the state begins to stutter and falter. Cue mass unemployment, a breakdown of society and general mayhem.

However, when one examines the evidence, this doom-ridden prophecy becomes hard to justify when discussing the UK economy. Consider, for instance, that during the crisis years America’s bond yields were consistently as low as Britain’s. This is despite the fact that its deficit (which at 13% of GDP was higher than the UK’s 10.6% in 2009) only fell by 1.6% when cyclically adjusted, compared to Britain’s 4% reduction. “Cyclically adjusted” is an attempt by the IMF to remove the distorting factor of economic growth, to (imperfectly) allow us to juxtapose budget deficits with changes in government spending. When we remove this adjustment, America’s deficit fell by roughly double the rate of the UK between 2009 and 2012 – largely because of higher economic growth. Crucially, this shows that, despite much higher spending relative to the UK, the deficit in the US was in reality still falling (because of economic growth), and its yields were not affected by this ‘looser’ fiscal policy. Indeed, interest rates on the government bonds of every post-industrial Western nation outside of the Eurozone fell to record lows in 2011, despite persistent structural deficits, suggesting market confidence. Of course, we must consider the possibility that the Eurozone crisis had an impact on bond demand – encouraging investors to switch from Eurozone to non-Eurozone bonds. Still, these inconvenient truths do not sit easily with the theory outlined above.

What about Greece?

Admittedly, the case of Greece and, to a lesser extent, the other ‘PIGS’ countries (Ireland, Portugal and Spain), could lend weight to the austerian argument. Yields were indeed rising for those countries during the crisis. However, comparing the UK and Greece is thoroughly misleading. It ignores the scale of indebtedness and chronic problems in tax collection in Greece, both of which would distort market confidence in the Greek government’s solvency.

Crucially, such a comparison would also ignore the Eurozone factor.

Because Greece is a paid-up member of the Euro club, it has no direct control over its monetary policy. The European Central Bank in 2009/2010, unlike the Anglo-Americans, decided not to pursue a ‘loose monetary policy’ of quantitative easing and lower interest rates. In comparison, the Bank of England’s quantitative easing policy, however flawed it was in practice, made it clear that the UK government would never actually run out of money, as Oxford economist Simon Wren-Lewis has argued. The ECB’s inaction suggested the opposite of the Eurozone countries to the watching world. Moreover, the ECB refused to be the lender of last resort to Greece and other debt-stricken countries in 2010 and 2011. Whatever the motivations were for this decision, including the belief that Greece needed to be able to stand on its own two feet, it had a sharp effect on market confidence. All of this raised real fears of a Greek default.

Therefore, the difference could not be more stark. Unlike the United Kingdom, during the crisis years Greece was at actual risk of defaulting on its debts.

Household vs government

Misleading simplifications are not exhausted here: “mediamacro” is a regular, pernicious factor in economic reporting. Often, there is a conflation between a household and a government, and consequently between wise household economics and beneficial state economics. The thoroughly misleading ‘nation’s credit card’ soundbite exposes this common misconception, as does Merkel’s ‘Swabian housewife’ rhetoric, as Madeleine Bell has already pointed out. Unlike credit-card or household debt, governments owe money to their own citizens as well as to the speculators who play the debt market and to each other. Some of you may own government bonds – in effect, this makes you a creditor to the government. This means that in times of recession, a government can theoretically increase spending and run on a deficit until the economy returns to decisive, balanced growth. This is because its creditors are, to a large extent, its own citizens.

In fact, even George Osborne acknowledges this. When the global economic landscape worsened after the Eurozone crisis erupted, Osborne slowed down deficit reduction. This was one of the reasons why he consistently missed his deficit targets, regardless of the potential state-driven ‘paradox of thrift’ (where any reduction in government spending will only worsen tax receipts and increase expenditure in other areas). The supposedly unbendable executor of ‘Plan A’, reducing the deficit as a first priority, became remarkably more flexible when faced with new circumstances.

Thus, in certain circumstances, it is possible to allow a budget deficit to increase in the short-term without triggering rising yields and a debt crisis. The coalition government did not need to take a swinging scythe to the state.

But what about the ‘innovative’ private sector?

Some may argue that there are long-term benefits to solving a deficit with state cutbacks. It is often argued that the contribution of government expenditure to the real economy is less productive than the private sector. This well-entrenched assumption may be backed up by statistics from the Labour years, which show that public sector spending was less productive than it might have been. However, it is not a given that the public sector is inefficient, or even that it stifles innovation. Economist Mariana Mazzucato’s recent work, such as her book The Entrepreneurial State, throws significant doubt on this familiar free-market argument. Research grants also mean that a lot of the technological innovation for which Cambridge has become renowned falls under the same category.

And perhaps, in the very long term, consistently large deficits in times of sustained economic growth may lead to increased yields. If so, Gordon Brown’s “borrowing to invest” strategy may have been mistaken. And, contrary to Keynes’ famous “in the long run we are all dead”, the long run deserves attention. In this sense, the deficit could ‘matter’.

Still, these are debates to have while we enjoy a stable economy, not when large swathes of the country are losing their jobs at rapid rate. In times of economic difficulty, when the private sector contracts, consumer expenditure nosedives and the global economic picture darkens, the situation is very different. In those circumstances, the deficit should not be the main priority for a sovereign government with full control over its monetary policy. Indeed, in such an emergency, perhaps the welfare of its citizens should be the state’s highest priority.

It was argued in 2010 that a loose monetary policy, such as near-zero interest rates and quantitative easing, would be enough to ease the burden of the cuts. In essence, because of these policies, we could cut the deficit and not harm economic growth. This was exposed to be false after GDP fell from positive growth (around 2-3%) in 2010 to another recession and slower growth. As many have argued, the UK is in a liquidity trap, which removes the possibility of utilising monetary instead of fiscal stimulus to restart economic growth.

If this were true, the UK government would have had to completely abandon austerity and boost the economy through old-fashioned Keynesian stimulus in order to ensure the welfare of its citizens. In other words, it would have had to have spent more money. However, when deficit-obsession rules the day, this policy falls outside the Overton window.

The human cost of deficit obsession

Austerity is almost universally recognised as harmful to growth, ultimately reducing the amount of money in people’s pockets. The Office of Budget Responsibility (very conservatively) estimates that the austerity of the last five years took 1% off overall growth. Because of this, in the words of economist and Investor’s Chronicle columnist Chris Dillow, praising Osborne for the recovery is “like praising a taxi-driver for getting us home when he has taken us on a two-hour detour”. According to this train of thought, it is no coincidence that the last five years have seen another recession, flat-lining growth and rising indicators of poverty such as the increased use of food-banks. According to the Trussell Trust, 128,957 people were given “emergency support” for three days in 2011/12. In 2013/14, the figure had ballooned to 913,138. Over 330,000 of these were children.

Whatever the government believed would happen, and whether this was due to overconfidence in monetary policy or the private sector, the bogus fear of the deficit trumped the need to protect the well-being of the population at large. The fact that the latter wasn’t a priority for the coalition government, not to mention the IMF and the EU, may indicate an ideological blindness among deficit hawks, who are obsessed with shrinking the state at all costs. One begins to suspect, to use a tired phrase, that deficit obsession was a symptom of a ‘neoliberal’ ideology. A sympathetic view would be that this ideological tendency led the coalition to overestimate how much the private sector was going to replace the state. A more cynical view would be that the Tory-led government essentially decided that ‘food banks be damned if we can roll back the state’.

All of this matters deeply for the future. Examining the past in this way is not simply an intellectual exercise. Given Osborne’s recent Budget, with its “rollercoaster” of cuts and spending, and given the arguably unproductive and imbalanced nature of the UK’s current growth patterns, the importance of the deficit for policy makers is a crucial factor in the direction of our society. If the general election this May returns a Conservative-led government, or an ideologically neutered Labour-led government, the issue will become vital. In that scenario, deficit obsession, past and present, will deserve much further scrutiny.

  • Craig Thomas

    Great stuff, Colm. Have just been Tweeting a link to the article to my (meagre band of) followers.

  • Graeme Bird

    “It has become an article of faith ….” Stop right there. Its not faith. Its economic science. What is the justification for the debt? Writing debt contracts to bankers produces no new resources. So where is the justification for it? It means more obligations without benefits. Its just a trick by conmen to bring us into slavery-lite and not so lite.