Since the election in May 2010 that brought the Tory-led coalition to government not one major political figure in England has publicly disagreed with the austerity doctrine, that the first priority of fiscal policy must be reducing the budget deficit.  I have called this astounding cross-party degeneration into economic illiteracy the “acute deficit disorder”, a pathological fear of public expenditure exceeding public revenue, a phobia in its purest form.
There seemed no party leader or would-be leader with any immunity to this neoliberal malady until this summer.  Jeremy Corbyn asserted unambiguous opposition to the theory and practice of fiscal austerity, and by doing so emerged from the depths of the backbenches to take a commanding lead in the contest for the Leadership of the Labour Party.The sudden and unexpected emergence of Corbyn at what appears to be the choice of a large majority of Labour Party members has one overwhelming explanation — his rejection of the ideology of austerity.  It is astonishing that Corbyn may be on the brink of winning the leadership.  Even more astonishing is high-profile supporters coming forward to assure us on Corbyn’s commitment to deficit reduction,  albeit in a manner quite different from the Tories (see analytical article by Jeremy Smith).The clear purpose of these unexpected interventions is to reassure people that Jeremy Corbyn favours “sound fiscal policy” and, therefore, can be trusted to manage the country’s economy.  The fundamental problem with this attempt at reassurance is that the great burst of enthusiastic support for Corbyn results from his explicit rejection of deficit reduction as a necessary priority.   A few weeks ago in a speech on economic policy he reinforced his anti-austerity message, when he stated “austerity is a political choice not an economic necessity”.   It is such statement that bring people flocking to his rallies.In the same speech also referred specifically to the budget balance, “Labour will close the deficit through building a strong, growing economy that works for all, not by increasing poverty.”For the victims of the phobia the words convey an “austerity lite” meaning, a promise that a Labour government would take direct steps to reduce the deficit; that the time scale would be longer and the deficit reduced by a combination of tax rate increases and cuts that do not harm the poor (e.g. Trident).This “progressive prudence” position is more than mistaken. It is fundamentally wrong because it perpetuates the neoliberal myth that fiscal deficits are a bad thing, that they are an imbalance that must be corrected through policy action.  The retro-reaction, “Jeremy really is for getting the deficit down, but in progressive manner”, is totally wrong and requires going back to basics.

A fiscal deficit is not prima facie a problem.

A fiscal deficit is not an imbalance that needs eliminating (or even reducing).

A fiscal deficit is a compensating response to imbalances elsewhere in the aggregate economy.

To further dispel confusion and misrepresentation before going into the analytics, I can state the central point — the public budget need not balance in the short run, long run, or over the economic cycle.  Indeed, a government can practice “sound fiscal policy” without ever balancing the public budget and without the budget ever showing a surplus.  Yes, I am a “deficit denier”;  being one is sound economics (see the excellent “confessions of a deficit denier” by Malcolm Sawyer).

Market economies expand when total (“aggregate”) demand exceeds the aggregate production of goods and services, and contract when demand falls short of supply (leaving part of production unsold, unintended inventories).  These dynamics of the aggregate economy become clearer when we divide it into three parts, the public sector, the private sector and the export and import or trade sector.

For an economy to expand the sum of the spending across the part must exceed the sum of the “non-spending”.  The familiar terms for non-spending are 1) household and business saving (private sector), 3) taxation (public sector) and 4) imports (trade sector).

During 2000-2007 the growth of demand was sufficient to drive expansion of the UK economy at a rate between two and three percent per annum.  During these years imports exceeded exports, meaning that the trade sector made a negative contribution to expansion of the economy of about -3% of GDP annually.

Had the private sector “balanced its budget” and the public sector done the same, the economy would have contracted, not grown.  The economy expanded because both the private and public sectors had net expenditure that more than offset the negative demand generated by trade.  That is, the private sector and the public sector engaged in deficit spending during 2000-2007 (by about 1.5% of GDP each).

Then, the global financial meltdown hit.  As a result, business investment collapsed.  Net private spending went negative (household plus business saving exceeded investment).  Businesses were very much “living within their means”, and as result, the economy contracted.  It would have contracted even more had the government sector not increased its spending, which stimulated a nascent recovery in late 2009 and early 2010 (Gordon Brown’s fiscal stimulus), which George Osborne aborted with his fiscal cuts.  Attempting to “balance the budget” and “have the government live within its means” was unsound fiscal policy.

This brief excursion into the theory and practice of “sound fiscal policy” produces important lessons.  A government practices sound finance by using the public budget to compensate for expenditure shortfalls and overruns by the private and trade sectors.  If the economy is stagnant or contracting, sound policy requires that the government increase net expenditure — a larger budget deficit.

This generalization, public demand should compensate for private shortfalls, holds even if the economy is at or very close to full capacity.  Indeed, the reason that the UK economy was close to full capacity in the years just before the great financial collapse was because it had a small deficit.  The deficit was not a problem, it was the solution to insufficient private demand.

The message for the foreseeable future is clear.  Until private investment and exports are sufficient to keep the economy near full capacity, a fiscal deficit is the appropriate policy.  Following the “balance the budget/run a surplus in goods times” can mean that the good times never arrive, because demand from the private and trade sectors can be too low to take us there.

The reverse is also the case.  When private demand is robust and booming sound fiscal policy requires a surplus in public budget.  Thus, we have the “sound fiscal policy” generalization:

 

Policy makers should aim for a fiscal balance that compensates for the sum of net private and trade demand when the economy is at their desired level of capacity and employment.  This explanation of fiscal policy is not “Keynesian”, though Keynes would probably have agreed with it.  The more accurate way to understand the difference between neoliberal budget balancing and sound fiscal policy is an analogy with the differences between alchemy and chemistry, or astrology and astronomy.

Each of the three sectors (private, public and foreign trade) of the UK economy run deficits at some times and surpluses at others.  The conviction that the public sector should have a special status such that a deficit is a problem that needs solving is based on ideology not analysis.  It is not an ideology that a Labour Party leader should adopt in any form or variation.

It is self-defeating to pay lip service to the ideology because the Tories have convinced a large portion of the public to believe it.  This belief is a relatively recent phenomenon, dating from 2010 at the earliest.  Attempting to dispel it is more likely to bring to success than further indulging it.