May 1, 2013 by johnmillsjml
Exchange Rate Reform Group
BULLETIN – May 2013
What really needs to be done to get the government deficit under control
In 2009, the total government deficit was £152bn and in 2010 it was only marginally lower at £147bn. Since then the underlying deficit has stabilised at about £120bn a year, although some special one off transactions to do with the Royal Mail Pension Fund and the Bank of England reduced the published 2012 figure to £100bn. As a percentage of GDP £120bn is 7.8%. Not surprisingly, government debt arising from the annual deficit had doubled from 43% of GDP in 2006 to 88% by the end of 2012. It is currently rising by an average of about £2.3bn per week.
The projections on which the government is currently working – reflected in the figures set out in March 2013 Office for Budget Responsibility (OBR) publications – show the annual deficit dropping to 2.3% in 2017/18 mainly as a result of growth picking up from 0.6% in 2013 to 2.8% in 2017. If, however, this increase in growth does not materialise, the percentage rate at which government debt is accumulating will remain higher than the percentage rate at which the economy is growing. This is unsustainable. It is therefore crucially important that the OBR projections of increasing growth and a falling annual percentage deficit are realistic.
Unfortunately, it seems all too likely, based on past experience, that, with current policies in place, the OBR growth figures are going to turn out to be too optimistic. The figures at the top of the following page, taken from Table I in the Q4 Quarterly National Accounts ONS Statistical Bulletin, show why there will then be little or no prospect of government borrowing being reduced.
The key point about these figures is that all the surpluses and deficits attributable to each of the main sectors in the economy – Government, Corporations, Households and the Current Account Foreign Payment Balance – have to net out to zero. In other words, all borrowing has to be matched pound for pound by exactly the same amount of lending. This means that the total surpluses generated by Corporations plus the net savings of the Household Sector plus the deficit with the Rest of the World, all of which involve lending to the rest of the economy, have to equal the Total Government Deficit, which is borrowed from the rest of the economy. The figures on the right of the table show the figures summing to zero in 2008, 2009 and 2010. The reason why there is more lending than borrowing, leaving a relatively small positive residual for 2011 and 2012, is that the ONS has not yet fully reconciled all the figures for these years.
Net Lending and Borrowing by Sector
All figures are in £m. Net Lending is (+) and Net Borrowing is (-)
All Govern- All Corporations
ment – Public and Private Rest
Central Financial and non- of the
Year & Local Financial Households World Total
2008 -70,698 99,559 -40,031 11,172 2
2009 -152,053 110,173 27,779 14,100 -1
2010 -147,013 95,986 17,447 33,580 0
2011 -120,140 96,787 14,363 17,006 8,016
2012 -100,173 28,133 24,674 53,974 6,608
Source: Table I – Net Lending by Sector – in ONS Statistical Bulletin – Quarterly Accounts Q4 2012.
The crucial issue is whether it is possible to get enough changes made in the surpluses or deficits generated by the other sectors in future to enable the government deficit to be significantly reduced. Consider them in turn:
Corporations Between 2008 and 2011 the corporate sector invested an average of about £100bn a year less than it retained as profit or surplus, making it a major net lender to the rest of the economy. In 2012, this figure fell to £28m, partly because the government took over the assets of the Royal Mail Pension Scheme, reducing its net borrowing in the current year but increasing its pension liabilities in the future, while also crediting Bank of England Asset Purchase Facility balances to the Exchequer. Looking ahead, however, it seems unlikely that the corporate surplus is going to be anything like as small as it was in 2012, mainly because as long as the economy continues with very little growth in prospect, corporate investment will be subdued. The corporate sector is therefore likely to remain a major net lender to the rest of the economy unless there is a very substantial increase in the growth rate, warranting a much higher level of investment.
Households In 2008, Households were net borrowers from the rest of the economy. Since 2009, however, as consumers have become much more cautious, they have become net lenders and – especially if the economy shows little sign of recovery – this seems very unlikely to change. Without, again, an increase in the growth rate, therefore, Households are also likely to remain substantial net lenders
Rest of the World Every pound of the UK’s current account deficit has to be financed by creating corresponding obligations to foreign interests within the UK domestic economy. Unfortunately, this deficit has recently been trending strongly upwards to a total of £54bn in 2012. An even higher figure – over £60bn – was projected for 2013 in the 2012 Autumn Statement. Until the foreign payments deficit is very substantially reduced or eliminated, therefore, it is extremely difficult to see how the public sector deficit could possibly be significantly reduced – or brought down at all. If no countervailing action is taken, therefore, far from declining, the government deficit may well rise, and with it total government debt as a percentage of GDP. What action could then be taken to get the situation back under control?
Public Expenditure Cuts The obvious way to cut the total government deficit may seem to be to cut government expenditure and to increase taxation. The table above, however, shows how improbable it is that this policy will work. It is unlikely either to get corporations to increase investment or to encourage more consumer expenditure. It may reduce the external deficit, but only if the economy shrinks enough to cause a significant reduction in imports. What is therefore likely to happen is that attempts to cut the government deficit in this way will simply lead to the economy contracting while the government deficit remains about the same size as it was before. Government debt as a percentage of GDP will then continue to rise sharply to unsustainable levels.
Reducing the Size of the Public Sector A variation on public expenditure cuts is to pursue a policy involving reducing both expenditure and taxation, in the hope that reducing state expenditure as a percentage of GDP will stimulate investment and increase consumer confidence, thus raising the growth rate. There are, however, huge political difficulties about pursuing this kind of policy, especially in the absence of any growth to absorb the pain involved. A leap of faith is also required to believe that a smaller role for the state would make a big difference over a short enough period to make a policy of this sort work. Available evidence from either the UK or elsewhere is not encouraging. The chances of this approach significantly reducing the government deficit in present circumstances, therefore, look equally remote.
Monetary Policy Another approach, actually much in evidence at the moment, is to combine tight fiscal policy with a very loose monetary stance. The object is to encourage both increased investment by the corporate sector and more expenditure by consumers as a result of low interest rates and easy access to loan facilities. Leaving aside the problems involved in getting Quantitative Easing to translate into actual availability of cheap funding to either businesses or consumers, there also needs to be a substantial appetite to borrow among both these sectors to make this policy work. In the absence of confidence that the economy is about to start growing much more quickly, both businesses and consumers are evidently largely inclined to retrench rather than to borrow and spend more, therefore once more leaving the government deficit as high as it was before.
Reflation While the Coalition has focused on cutting expenditure and trying to reduce the percentage of GDP running through the state’s hands, combined with a lax monetary policy, the Labour opposition has been more inclined to favour reflation. Again, the problem is to make the numbers sum to zero. Other things being equal, reflation is likely to increase the foreign payments deficit, which depresses the economy, while not doing sufficient to increase the confidence of business and consumers to offset the deteriorating foreign payments position. The government deficit is therefore likely to remain unmanageably high while an increased balance of payments deficit may spook the markets, leading to credit downgrades and higher interest rates.
The Foreign Payments Balance There remains one policy approach which would unambiguously improve the situation. This is to use a major reduction in the exchange rate to reduce the foreign payments deficit. Export led growth would then radically increase both business and consumer confidence as the economy was stimulated into sustainable growth and falling unemployment. Net lending by the corporate and household sectors would then be reduced while the foreign payments deficit would also trend sharply downwards, albeit very probably after an initial period when the payments balanced worsened before it started to improve. Once this had happened, policy should be orientated to keeping it at zero, taking one year with another. The equilibrium to be aimed for should be for government income and expenditure to be in balance, with borrowing and lending among Corporations, Households and Rest of the World netting out to zero. Small government deficits, if required, could remain but the interest burden on them should be easy for a growing economy to sustain. Once small government deficits were combined with economic growth at 3% or 4% per annum, total government borrowing as a percentage of GDP would start to fall.
The key issue for the UK’s future is whether there is a realistic prospect, in the absence of radical exchange rate policies to make the economy more competitive, of getting the corporate and consumer sectors autonomously to increase their expenditure and thus to reduce their net lending sufficiently to offset at least most of the government deficit while there is still a large foreign payments deficit. The prospects for this happening look extremely remote. Without these conditions being met, however, there is no prospect of the future for the UK being anything other than endless austerity, high unemployment, increasingly unmanageable debt, mounting inequality, static or falling living standards and relative if not absolute decline in our position in the world.
We will also – eventually – have the major devaluation we need, but not without having suffered grievously by putting off for years what needs to be done now. This is because our current economic policies are very likely to turn out to be completely unsustainable. It is impossible for either the UK as a country or its government to go on running up more and more debt with no increasing economic capacity with which to service the interest on it let alone to pay back the principal. Eventually, the markets will realise this, sterling will be heavily devalued – and recovery will then begin, as it always does when export prices are sufficiently low to attract buyers in world markets.
There is not, therefore, a choice as to whether sterling will fall in value against other currencies. The choice is about when this is going to happen. To avoid years of completely unnecessary austerity, it needs to happen now.
Published by the Exchange Rate Reform Group
JML House, Regis Road, London, NW5 3ER
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