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...a blog by Richard Flowers

Tuesday, January 18, 2011

Day 3668: Economic Credibility Means Knowing the Difference Between DEFICIT and DEBT - A Brief History

Sunday:

"On this central question of why do we have or why did we end up with a deficit of more than 10% of our national income, the Conservatives and the Liberal Democrats I think are pedalling a very dangerous myth because they want to tell people that it was somehow all because of a decade of overspending under Labour. It wasn't. It was because of a financial crash; a financial crash that happened all round the world."


Ignore the bit about "peddling a very dangerous myth" and this statement is SUBSTANTIVELY TRUE. But also MASSIVELY MISLEADING. Let me explain:


The quote comes, of course, from Mr Potato Ed, Leader of the Labour Party and (though he'd rather we all forget it) former economic advisor at the Treasury under Mr Frown, answering Mr Andy Marrmite about Hard Labour's mistakes on the economy.

He's trying to create a very NARROW definition of Great Britain's economic problems, one which he can then palm off on the handy scapegoat of the not-so-very-much-beloved bankers, and thus absolve Hard Labour of responsibility for what happened while they were in Government.

So let's take this to bits:

The DEFICIT isn't the same as the National DEBT.

The DEFICIT is the amount by which the Government's spending in one year EXCEEDS its income for that year.

The DEFICIT is how much DEBT we ADD to the mountain of DEBT that we have already.

A deficit of more than 10% of what the country earns is, of course, appalling. Imagine adding 10% of what you earn to your credit card bill, and shudder.

You certainly can't do that on an ongoing basis. But in an EMERGENCY and so long as you pay it back again, you probably can. At least that's the theory of the famous economist Mr John Milton Keynes: if the economy contracts, the government can borrow to tide things over; when the economy grows, then the government can pay the borrowing back.


Now it is TRUE that the only year under Labour where the DEFICIT exceeded 10% of GDP was 2009/10 (although it is budgeted to do so again this year, 2010/11).

When the banking sector collapsed, the TAX coming in from their vast boom in profits also collapsed. At the same time, the Labour Government chose to cut VAT in the hope that this would stop a big fall in consumer spending, and that further reduced the tax money coming in. PLUS they increased spending (like good little Keynesians) at the same time.

This meant that the difference between spending and income suddenly jumped wider because of the credit crunch.

So it's also TRUE that the big deficit was because of the banking crisis.

But – and this is where the MISLEADING bit comes in – NO ONE IS DENYING THAT.

The REAL complaint of the Liberal Democrat / Conservatory Coalition is NOT that Hard Labour borrowed too much in one year of the emergency; the REAL complaint is that Hard Labour were borrowing YEAR IN, YEAR OUT throughout the BOOM years while the economy was growing and NEVER PAYING ANY BACK. And that ain't no myth!


In every year since 2001, the Labour Government spent MORE than it raised in taxes and used borrowing to cover the difference. That difference was of the order of thirty to forty billion pounds each year. Compared to the TOTAL earnings of the British economy, that was QUITE SMALL: only about 2 to 3% of the GDP. But it was MORE borrowing on top of borrowing, year in year out.

Between March 2001 and March 2007 the TOTAL amount owed by the Government increased from just over three hundred billion pounds to just under five hundred billion pounds. That's about 60% MORE debt.

Now, left-wing economists – by which I mean "Labour apologists who talk about the economy", in case you think I mean "people who know what they are talking about" – will tell you that it's FINE to run a deficit; we've run a deficit in thirty out of the last forty years, they will say; so long as the economy grows, then the level of debt remains manageable.

There's only one problem with this approach: it's TOTAL BOTTOM WASH.

Surely "we've been running up the credit card for most of the last four decades" is an argument that it is MORE URGENT to start cutting the debt not LESS!

In the last forty years, Great Britain has struggled though economic hardship every time the debt has gone out of control and, with enormous pain, we've managed to wrestle our total debt back down again TWICE: once in the late 'Eighties and again around the year 2000.

Historically, well let's say for the last half century, a level of debt in the British economy of 30-40% has been seen as SUSTAINABLE. It was much higher after World War Part Two, and that was why RATIONING got WORSE after the war was won than while it was going on. It was much higher in the Nineteen Seventies when, you may have heard, the economy was a total BASKET CASE, with rampant inflation and the IMF intervening.

After the recession of the early 'Eighties, the Conservatories managed to cut the total debts by about 10% from a hundred and sixty-seven to about a hundred and fifty billion pounds. Meanwhile, the economy grew sharply, meaning that the level of debt fell as a percentage of GDP, even if we weren't repaying that much.

But then Black Monday and the Poll Tax riots all happened, and Mr Norma Lamont lost all control of the economy, meaning he and then Mr Fatty Clarke more than doubled the national debt to three hundred and fifty billion pounds by the end of Mr Major Minor's Government. As a share of GDP that took us from a low of 26% to a peak of 42.5%.

Then Hard Labour reduced the debt again by about 10% from three hundred and fifty to three hundred and eleven billion pounds over the course of their first term. Remember, for that Parliament, Lord Blairimort and Mr Frown stuck to the CONSERVATORIES' spending plans while Mr Frown raised lots of extra money by (a) RAIDING the PENSIONS of their Advance Corporation Tax credits (b) levying a WINDFALL TAX on the privatised utilities and (c) auctioning off the 3G telecoms licences at hugely inflated prices.

But then from 2001 they spent more than they raised in taxes. Yes, I know I'm repeating myself but it's the MOST VITAL point. They spent more than they raised in taxes.

This meant that the ratio of debts to the size of the economy gently increased from 29.7% to 36.5%. Hard Labour were able to CLAIM that the debt was remaining ROUGHLY THE SAME.
And – and this is important – they were able to say that this remained LOWER than the figure they inherited from the Conservatories, which had been 42.5% of the economy in March 1997.

But remember, they were left in a BAD position regarding DEBT. Getting BACK to that position isn't a GOOD thing; it's a measure of FAILURE.

And at the time, the whole economy was growing too, inflated by Mr Frown's BOOM off the back of cheap Chinese loans and the sub-prime housing bubble.

Remember Prof Keynes' rules: when the economy is growing, you PAY BACK the debt.

THAT is the issue that Mr Ed needs to explain: why were they NOT paying back the debt in the boom years?

Times were good and the Labour government STILL needed to borrow to cover its spending: if that's not a DEFINITION of OVERSPENDING, then I do not know what is.

In fact, the Labour Government was getting EXTRA money because the BOOM was inflating its income. So there's the NORMAL sustainable amount of tax from the NORMAL sustainable economy; then there's the EXTRA cash on top of that from the boom, and then there's the spending HIGHER STILL.

But then the Labour Government's OTHER policy – of being intensely relaxed about people getting filthy rich – led to the casino banking disaster and all bets were off.

The total GROSS debt jumped to A TRILLION POUNDS. Net Government debt, which is the total we owe, less the value of assets that the Government own – e.g. shares in banks – increased to seven hundred and seventy-two billion pounds or from less than 40% of GDP to more than 60% of GDP (and may rise almost to 70% of GDP).

To tackle this DEBT we need to STOP ADDING to the mountain and start paying some back.

What would Mr Ed do?

"there's three ways you can cut the deficit: tax revenues, spending cuts and economic growth"

This again is misleading.

First, he talks about cutting the DEFICIT not the DEBT. To cut DEBT we need to ELIMINATE the deficit; we need to run SURPLUSES, probably for many years. Hard Labour's plan is only to HALVE the deficit, or – in plainer language – to KEEP ADDING to the DEBT.

Then there's the sleight-of-fluffy-foot over "economic growth".

The government controls taxes and spending directly. If spending is more than taxes, then you can see clearly that they could raise more tax or cut their spending and it will close the gap.

But how does "economic growth" work? Well, if GDP is more next year than it was this year, then you can borrow the same amount in cash terms and it will be a smaller PERCENTAGE of the GDP.

In other words, you've not really FIXED the problem; you've just used INFLATION to make it look smaller.

Of course inflation CAN help you with your debts: inflation makes wages go up and the costs of goods go up, so you can expect to get more money in from the existing taxes.

Some people might call that "raising more tax revenues", of course.

Then, as long as spending DOESN'T INCREASE by as much as the tax income, the deficit will get smaller.

This is EXACTLY what the Coalition are doing. Remember, the Liberal Democrat / Conservatory government is going to spend MORE this year than Labour did last year. Just not-as-much-more as Labour would have done.

Some people might call "increasing spending by less than the growth in the economy" "real terms cuts" or just CUTS (in particular people like Mr Potato Ed).

So Mr Ed's three ways of cutting the deficit are "tax revenues, spending cuts and economic growth" where "economic growth" basically means "raising more tax revenues" or "real terms cuts". Which is just the first two again, isn't it.

And how does a Government MAKE "economic growth" anyway?

You could INCREASE SPENDING to invest in growth – but that means INCREASING the deficit.

Or you could CUT TAXES to stimulate growth – but that means INCREASING the deficit.

Or you could do nothing and HOPE for growth – which at least DOESN'T increase the deficit.

The Coalition strategy is to spend LESS but BETTER, to try to invest for growth without increasing the deficit; and to change taxes around in the hope of finding a combination that will stimulate growth better (or at least less worse) than the current arrangement (hence increase VAT but cut corporate tax and freeze employer's NI; increase tax on capital gains but cut income tax for basic rate payers). It may not work. But at least it's a PLAN.

Mr Ed opposes cuts and says that the VAT rise was wrong (and presumably the NI rise would have been right). It appears that he is opting for option three: do nothing and hope.

Essentially, he's offering us a third alternative that DOESN'T EXIST; he's trying to tell us that there's a PAIN-FREE third way that the Coalition have overlooked (or ignored for "ideological" reasons), but it's just not true.


Mr Ed refuses to accept that spending more than you earn when we were earning the most we ever have was a mistake. It seems, though he won't be drawn on any actual policy, that he would go back to the same old attitude of never pay any debt back.

But if you don't ever pay it back, then you create a RATCHET effect, where you keep adding to the debt in the good years and every crisis you jump to a new and higher level of debt: 60%... 80%... 100%... where does it stop?

Or, more to the point, where does the economy go Greek and IMPLODE?



Numbers quoted are from HM Treasury.
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13 comments:

Mark Cole said...

An illuminating blos post. Very good.

economist said...
This comment has been removed by the author.
economist said...

An extremely simplistic and partisan economics lesson.

"the REAL complaint is that Hard Labour were borrowing YEAR IN, YEAR OUT throughout the BOOM years while the economy was growing and NEVER PAYING ANY BACK."

You'd better email Clegg and tell him that because that isn't the myth he is peddling. He, Osborne, Cameron, etc have repeatedly stated that Labour's overspending caused the *deficit* (a totally incoherent argument but what does that matter). The size of the national debt relative to GDP is not an issue, we had the 2nd lowest debt-GDP ratio of the G7 countries when the banks went tits up. Almost all western countries are facing increased national debts because of deficits resulting from the financial crash. Under Labour's deficit reduction plan net debt would have stabilized around 70% of GDP. As it will under the coalition's plan if their predictions are right.

"But then from 2001 they spent more than they raised in taxes. Yes, I know I'm repeating myself but it's the MOST VITAL point. They spent more than they raised in taxes."

Labour were perfectly open about doing this and your party supported it. Would a lib dem government since 97 have run surpluses and paid down the national debt? Well, your manifestos contained greater spending commitments in 97, 01 and 05 without the necessary tax increases to cover them - so I wouldn't have thought so.

And you're forgetting there are two sides to a balance sheet, Labour only spent that borrowed money on capital projects. It paid for the infrastructure that had been neglected by the tories for 18 years. Those capital projects are an investment that will provide economic and social benefits for decades and it is not burdening the next generation to ask them to contribute to infrastructure that they will use. Hell, your party just burdened the next generation with ~£50,000 of personal debt at commercial interest rates!!!

economist said...

"THAT is the issue that Mr Ed needs to explain: why were they NOT paying back the debt in the boom years?"

Because we paid down the debt-to-gdp to historical lows, debt interest-to-gdp were also much lower and the country needed investment.

Are you arguing that before Labour spent any money it should have paid the debt down to nothing? If so, were you arguing that at the time?

Are you arguing Labour shouldn't have borrowed to invest in capital projects? If so, were you arguing it at the time? And where would have found 2% of GDP to invest in that infrastructure?"But then the Labour Government's OTHER policy – of being intensely relaxed about people getting filthy rich – led to the casino banking disaster and all bets were off."

Light touch regulation was/is a disaster. What extra financial regulations has coalitions implemented so far to stop another banking crisis?

"But how does "economic growth" work? Well, if GDP is more next year than it was this year, then you can borrow the same amount in cash terms and it will be a smaller PERCENTAGE of the GDP.

In other words, you've not really FIXED the problem; you've just used INFLATION to make it look smaller"

Nope, you're way off mark here. Economic growth means increases in tax receipts for the government, which closes the cyclic part of the deficit. Osborne is banking on increased economic growth to help close the deficit. We have a "structural" part to the deficit because economists are guessing that around 5% of our trend growth has been destroyed by the financial crash. If we were to have an economic boom with above trend growth we could close the deficit without doing a thing.

economist said...

"Mr Ed refuses to accept that spending more than you earn when we were earning the most we ever have was a mistake."

I'll say it again, there are two sides to a balance sheet. Labour borrowed money to fix lots of roofs while the sun was shining, including my Primary schools, Comprehensive, FE college and universities. Oh and my local swimming pool, train station, the council housing down the road and some other stuff I've forgotten.

"But if you don't ever pay it back, then you create a RATCHET effect, where you keep adding to the debt in the good years and every crisis you jump to a new and higher level of debt: 60%... 80%... 100%... where does it stop?"

Ed isn't arguing to never reduce the deficit or pay down the national debt. He is arguing for a slower pace which would lessen the deflationary impact on the economy, lessen the social impact (which is going to be huge particularly for those reliant on social services like my sister) and raise taxes through progressive taxation rather than regressive taxation (i.e. VAT). Labour's plan would involve harsh cuts but not as harsh as the coalitions at the cost of incurring a bit extra in debt interest payments.

"Or, more to the point, where does the economy go Greek and IMPLODE?"

The IMF estimates Britain could increase debt to GDP to 150%. But that is not what Ed is arguing for and at no stage under the Labour government or the past 8 months was the UK in danger of a sovereign debt crisis.

But, hey, you carry on with the misinformation and childish name calling. Oh and helping the tories finish off what they started in 1979.

Gareth Aubrey said...

If I may offer the metaphor that just occurred to me (in the appropriately elephantine voice...)

Prof Keynes said you should SAVE FOR A RAINY DAY. Mr Frown said HE'D ABOLISHED THE RAIN!

PS Economist, on what earthly planet did Labour borrow money to fix our infrastructure? They got the PFI projects to do that so they could get it off their balance sheets and defraud (and I mean that in the criminal sense) the public.

Millennium Dome said...

Dear Mr Mark,

Thank you very much, and thank you for the link also. I'm very glad you found it helpful!

Millennium Dome said...

Dear Mr economist (or is it Ms?),

Um, thank you for your contribution; I have composed what Daddy Alex calls a "very brief" reply.

Millennium Dome said...

Dear Mr Gareth,

Thank you for saying in 76 words what it took me 5460!

And excellent summary; we should use it more!

Radar said...

Mr Economist I fear you are a bit confused. You repeatedly state that there are two sides to the balance sheet (or Statement of Financial Position as it is now known), however the actual formula is:

Assets + Liabilities = shareholders equity.

Therefore by increasing creditors (ie debt ie liabilities) you may not have actually increased assets, you may have just reduced shareholders equity. This is done very simply by expenditure (and therefore reduction in retained profits).


And surely you say Labour only borrowed to spend on capital projects? Surely if these capital projects needed to be run then the savings should have been made from reduced expenditure. To govern is to choose, they had a choice, they decided to have their cake and eat it. It's typical economic theory that a government will always spend more than it should as this will make them more electable and if they don't get elected then the other side can clear up the mess.

Radar said...

Note to self don't post on political blogs when drunk, you make stupid mistakes:

*Assets - Liabilities = Equity

or

Assets = Equity + Liabilities.

The point still stands thought that there are three aspects to the equation and as such an increase in debt (liabilities) doesn't always increase assets, in fact it can even be offset by a reduction in another liability. Economist's assertion was very basic.

Millennium Dome said...

Dear Mr Radar,

You put it very succinctly; I couldn't put it better myself - in fact: I didn't!

{And don't worry, no one noticed ;)

Since liabilities are credits (or negatives in the books), we read your Assets + Liabilities as adding a positive to a negative amount :)

Anyway, Daddy Richard's been banging on about ASSETS = LIABILITIES, which is SIMPLER, but only really true in accounts in Frenchwhere the Shareholders' Equity is included as a liability!

Mind you, it's probably because he HAS been doing accounts in French!

Of course you are right, in English Accounts the Balance Sheet balances the Net Assets (ASSETS - LIABILITIES) = Equity.}

Caron said...

Fluffy one, thank you for this. For your next topics, can I suggest you do interest rates and inflation?