Tag Archives: Budget Deficit

“Look after the unemployment, and the budget will look after itself ” (Keynes 1933). Is he still right?


(This article was first published in Liberal Democratic Voice)

Keynes was undeniably a genius of his time, but he wasn’t infallible. We should not just assume that he was always correct. As with all prolific writers we can cherry-pick quotations to suit our own political purposes. If we want to argue for more government spending, we can use this:

“For the proposition that supply creates its own demand, I shall substitute the proposition that expenditure creates its own income.”

(Collected Writings of John Maynard Keynes, Volume XXIX, pp 80-81)

Keynes meant that the mere supply of a commodity is not enough to ensure the sale of that commodity, but money from all government spending inevitably ends up in someone’s pocket. This is a statement of the obvious, maybe, but he evidently felt it needed making anyway. On the other hand, if we are suspicious of what sounds like “magic money tree” economics, as many scathingly describe any deviation from their understanding of ‘sound money’, we can find this quotation:

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

(Economic Consequences of the Peace, Chapter VI, pp. 235-236)

Rather than play these games we might look at how economics has progressed since his time and interpret his comments in the light of the now available evidence. This Huffington post article makes a good a case, in support of Keynes’s opinion, that a healthy economy will help minimise the government’s budget deficit.

One possible counter argument, from those of a more right wing disposition, would be that it is unclear which is cause and which is effect. Does a healthy economy with low levels of unemployment, and underemployment, naturally produce a small budget deficit or is it the other way around? If we force the budget to balance, by draconian measures, will unemployment fall too? A quick glance at the figures for Greece is enough to eliminate that possibility. It has a relatively modest budget deficit of 3.5% but an unemployment rate of over 25% with no tangible sign that any fall is imminent.

To give an answer to the question posed in the title, we can say “usually yes”, but we must acknowledge there are several, sometimes conflicting, factors involved. It is possible to conceive of a healthy economy with low levels of unemployment at the same time as the government’s budget deficit possibly being a little on what some may consider to be the high side.

To understand why, we need to look at the sectoral balances. To start with, imagine that everyone who issued or used the pound sterling as a currency was separated into either the government or the non-government sector. The assets of the non-government sector have to equal the liabilities, or debts, of the government sector. If money is paid as tax to government the assets of the non-government sector fall exactly as the government debts fall too. We can then divide up the non government sector into domestic and international. So in one year, and using the terminology of internal deficit for the Government’s deficit:

Internal Deficit = Savings of Domestic Sector + External Deficit.

For Keynes to be right on the question of unemployment and the internal deficit it should follow that everyone will save less when unemployment is low. This is a reasonable assumption but there could be exceptions. Everyone is more likely to borrow too, essentially the same as de-saving, when the economy is buoyant and there is confidence that money doesn’t have to be stored for those rainy days ahead. The effect on the external deficit is harder to predict. If the UK reflated its economy, when everyone else was in recession, we could well see that, even as unemployment fell, the external deficit, and so the internal deficit, could increase due to a local upturn sucking in more imports. Exporters could also switch their production to local markets. In that sense, and if we interpret “look after itself” to mean “fall”, Keynes could possibly be wrong! The important thing is that governments should understand these relatively simple relationships to make informed policy choices. The internal and external deficits may not be such a problem as we might be led to believe, if international investors see the UK as a safe place to park their surplus cash. The number one priority for any government, at least in peacetime, should be to ensure the health of the economy, both to offer jobs and business opportunities for all citizens and at the same time maintain the confidence of our external investors.

Ironically, if the UK lost that confidence, no-one would want to lend us any money. The pound would fall. Imports and exports would have to balance. We’d all end up somewhat poorer and we couldn’t then afford to save so much. The internal deficit would have to fall too and maybe even turn into a surplus. But, we have to ask ourselves: “Is this what we really want?”

We need to balance the Budget over the Business cycle as Keynes suggested, right?

(This article first appeared in Liberal Democrat Voice)

Firstly, we do need to ask if Keynes did suggest that. There are arguments either way on this point.  Keynes’ view unfolded and developed starting in the bleak 1920’s in Britain. There was no “roaring twenties” for the UK economy as the government deflated the economy to try to fit the Pound back on to its pre war Gold  Standard. Keynes then did argue that governments should run deficits if private spending declined and reduce those deficits when future growth was strong enough. This has been interpreted by many that his intent was that the budget was to be more or less balanced over the business cycle. If anyone is keen to research into his thinking they might like to start with his 1924 publication “A Tract on Monetary Reform”.

A better approach might be to try to understand why Keynes should made a break from tradition and start to advocate that budgets should at times be unbalanced. If we consider an economy which is neither a net exporter nor a net importer and in which everyone spends what they earn within the economy, Government spending and taxation must balance. This is true regardless of the level of taxation imposed (providing it is finite) and so regardless of the level of inflation within the economy. It has to, according to the principle of sectoral balances originally developed in the 60’s and 70’s by the late Prof Wynne Godley at Cambridge University.

If the participants of the economy don’t spend all they earn, ie when private spending declines,  we can have a tendency to recession. Keynesian economists would point out that prices and wages tend to be “sticky” and so don’t respond quickly to changing circumstances as more classically minded economists suggest they should. Therefore, Keynes was quite right to suggest that the Government should spend  more, or tax less,  to prevent recession from occurring. The government needs to borrow money from the savers and spend it on their behalf. Later, when the savers withdraw their money from the bank, or empty their piggy banks, and spend it, the Government needs to run a surplus in its budget to prevent the economy from overheating and inflation occurring. So the budget does indeed end up balanced over the cycle. It ends up being an approximately symmetrical pattern when expressed graphically.

This relatively simple model may have been adequate for the UK economy in the 1920s. However in recent times the extent of saving and desaving hasn’t been symmetrical over the business cycle. When times are good people may borrow and spend more but equally they may put more aside for their retirement. So if the spending/saving/borrowing pattern of the population isn’t symmetric over the business cycle, neither can we  expect the government to run a balanced budget over the business cycle. Instead of imports and exports balancing,  our economy has something like an annual  5% of GDP deficit in its current account. Our trading partners seem happy to supply more real things to us than we supply to them. They take our IOUs in the form of treasury bonds or gilts to make up the difference. In effect they are like a big net saver within the economy. As Keynes pointed out,  if people are saving more, and that includes our trading partners, the Government has to be spending more or taxing less.

The ‘balanced budget over the cycle’ is really just a special case which does not apply to our own 21st century economy. If we try to force the Government budget into balance, at the same time ignoring the trading position and the willingness or otherwise of the economy’s participants to net save then we are courting economic disaster. The budget will not balance, no matter how hard we try, and we will end up like a dog chasing its own tail as the economy spirals ever deeper into recession.

How to win and lose elections. (2)

There’s been a lot of navel gazing in British Labour circles recently about what went wrong last week and what needs to be done to prevent a re-occurrence next time. Presumably in about five years time. The arguments are pretty much along the same lines as the last time that Labour suffered an unexpected election defeat. Naturally, those on the right want to move more to the right. Those on the left want to move more to the left. Those in the middle think a new personality might do the trick.

Who’s right? Let’s just stand back and look at the numbers. According to my calculations the Tories received about 24% support from the electorate in the 7th May 2015 UK elections. Labour about 20% support. That’s including those who didn’t vote. So to win government, next time, Labour need to get at least another 5%. If they are positive, and were prepared to really go for it, they could aim for another 10%. If they achieved that they’d be back big-time.

So what’s the best way to do that? Let’s leave the politics out of it as much as possible and just think in pragmatic terms. Do they try to persuade nearly half, or a quarter if we allow for the same reduction in the Tory vote, of those who voted Tory this time to switch sides? I could be wrong, but I don’t think that’s ever going to work. I know a good few Tories and I can’t think of a single one who would ever vote Labour, even if the Labour Party were offering the most Tory of policies and had a picture of Maggie Thatcher on the front cover of their next manifesto. Of course, if the party did that they would jeopardise their own core vote. That’s never a good idea.

I’d say the same would be true in the USA too. Both the Democrats and Republicans would expect only limited success if either moved towards the other politically. Probably it wouldn’t be enough to make a real difference. It could well be counterproductive and would naturally give more justification to those who were disillusioned with the lack of political choices that were on offer. They’d choose to do other things, rather than becoming involved in the election and would be less likely to make the effort to vote. This argument probably wouldn’t apply to Australia which has compulsory voting – the Aussies are quite unusual in that respect.

Alternatively, Labour could aim for the 56% who didn’t vote for either them or the Tories. This, again, would include those who didn’t vote at all. Labour wouldn’t persuade them all, that’s for sure. But, they’d just need to sway 1 in every 5 and they’d be home and dry.

This is an implied conclusion which, I have to acknowledge, will be more appealing to the left than the right. But, I’d argue it’s the reality too. The left would argue that by being true to their historic principles, and offering a message of hope rather than despair to working people they would have a better chance of winning. They’d argue the need to have a distinctive message which wouldn’t allow anyone on the doorstep to say “but you’re all the same”.

I’d add that the party, as a whole, needs to make a start on the explanation of how the economy really works which is not at all how most people think it works. Once more people have that understanding it will become apparent what the real choices are from both a left and a right perspective.

Why not give control of the fiscal deficit to the Bank of England?

In a democratic society, I would argue that decisions regarding interest rates, both long and short term, should be made by the elected government. They used to be. However, for nearly 20 years, short term rates in the UK have been set by the BoE. The level of short term interest rates is important and it can be adjusted to stimulate a slowing economy or slow an overstimulated economy. But there are other adjustments that can be made too.

Just as a pilot has all the control levers at his disposal when he’s flying a plane (if he, or she, does hand over to the co-pilot it would be all the controls not just one) then all the controls need to be either in the hands of government or the hands of the central bank.

But just who has the controls when it comes to controversial policy decisions like QE? Does an  independent Bank of England decide, all on its own, to buy up £375 billion of government securities from the private financial sector? I don’t think so!

QE is no big deal. That’s not a common view, I’ll agree, but from a scientific perspective, there seems to be no reason why the issue of government , or the BoE if you prefer, IOUs in the form of cash should be any more or less inflationary to the economic system than the issue of IOUs in the form of gilts (treasury bonds). If it is necessary to buy back gilts from the private sector to control longer term interest rates then that’s what needs to happen.

So why not give control of the fiscal deficit to the BoE too? The BoE could calculate the best combination of fiscal and monetary policy, including whatever level of QE is needed, and tell the government what it needs to do. Arguably the government could decide to raise income tax a bit here or reduce VAT a bit there , etc, but it would not have complete control of fiscal policy as it now does.

This is not my favoured option BTW. But, if the pilot is going to hand over the (macroeconomic) controls to his or her co-pilot it should be all the controls and not just one.

Balancing the Budget !

As election time draws near in the UK , and the US presidential election campaigns start to get underway across the Atlantic,  we’ll no doubt hear a lot about this topic shortly, if we haven’t already.  Apologies if you’ve heard this all before but the political and economic mainstream still don’t grasp it. Political parties will accuse their opponents of making “unfunded promises”, and of having “black holes” in their budgets etc . Nations’ finances will be likened to a household.

Except that Sovereign Governments, like the USA and UK are issuers of currency. They aren’t at all like a household. If a household has a deficit of say £10k pa then, generally speaking, spending cuts of £5k coupled with an extra £5k of earnings will fix the problem. How many times do we see see the same logic applied to countries too? It never works. It can’t work. Governments afterwards wonder why. It isn’t difficult to understand:

Money Flow

Money coming into the Private Domestic Sector , which is essentially what we all think of as “the economy” can only be from two sources. Government spending directly into it (Gsp) , and payments from overseas for exported goods and services. How can anyone possibly think that reducing Gsp isn’t going to affect Taxes paid? Every £ or $ collected in tax originally comes from Govt spending.

The ability of the economy to deliver taxes to the government has to be directly related to its income. Reducing its income will  make us all poorer and reduce our ability to deliver those taxes.  Spending cuts won’t do anything like as much towards reducing that deficit as is usually supposed.

How much simpler could it be?

And yet if the “balanced budget” cretins get their way what will happen?  The government will makes cuts, tax revenue will fall and the deficit will end up not much different to what it was previously. The cretins will then argue they didn’t make enough cuts and that they’ll need to make more on the second round. And so it will go on, with increased levels of unemployment and business failures at every stage.

We just can’t let this happen. It’s madness.  Instead of forcing the budget to “balance”, we should should look at balancing all the money flows to maximise our economic potential.