The riddle of the deficit (or deficits for Dummies)

Quote

Riddle: When is a ‘deficit’ not actually a deficit?

Answer: When it’s a Government budget deficit.

 

 Dear [insert name of virtually any Journalist or Politician]

It seems that you’re still having a bit if a struggle to understand what a budget deficit is, and what it does.

Let me try and explain.

Imagine that I’m the ‘Government’ and you are the ‘Private Sector’.  I give you a bar of chocolate.  Now, I (the ‘Government’) am in deficit to the tune of one bar of chocolate… but you (the ‘Private Sector’) are in surplus to the sum of one bar of chocolate.

Are you with me so far?  The government sector and the private sector or non-governmental sector, are opposite sides of the same coin.  A deficit for the government means a gain in the private sector and vice versa.  (The private sector means everything in the domestic economy, which is not government – I’m leaving out exports/imports to keep it simple).

One way or another, Government spending all goes into the private sector … payments for the NHS, Education, the military, unemployment benefits, working tax credits, child benefit, the Police, the judiciary, pensions, motorways, new infrastructure, grant to local governments and much more, are each paid for out of government spending.

OK?   So government doesn’t just spend, it also taxes.

So I’ll be the ‘Government’ again, and I’ll give you (the ‘Private Sector’) a bar of chocolate and then take back half of it, as a tax.   Now both the ‘Government’ and the ‘Private sector’ have half a bar of chocolate each but the government has a budget deficit of half a bar of chocolate whilst the private sector is increased by half a bar of chocolate.

With that extra half a bar of chocolate you have a lot of options.  For example, you could eat it (i.e. consume goods and keep someone in a job replacing them); give it to someone to mend your bike (i.e. create employment); put it in the cupboard for another day (i.e. save) or repay your friend the chocolate you owe him (i.e. pay off debts).

The way to work out if the government has a budget deficit, a balanced budget or a surplus is simply to subtract the total amount collected in tax from the total amount that government spends.   At the moment, the UK has a budget deficit, which means that the amount spent is greater than the amount of tax collected.

However, George Osborne says this is absolutely ‘frightful’ and that under his new policies, the UK will be in surplus by 2020 (!)

So what does a surplus mean for those of us in the private or non-governmental sector?

Well, if I pretend to be the ‘Government’ again, and I give you (the ‘Private Sector’) a bar of chocolate and then take it all back again … the budget will be balanced. Government spent a bar of chocolate and collected a bar back again… but you in the private sector have nothing more than you had before the ‘Government’ started spending!   (How great does a balanced budget sound now?)

To be in surplus, I as the ‘Government’ would give you a bar of chocolate and then demand a bar and a half of chocolate back from you (the ‘private sector’).  Now you have the problem of how you are going to get me that additional half a bar of chocolate?  Maybe you have some saved bars of chocolate which you can use for a year or two but eventually you may have to go into debt or even sell your house to give me, the Government, that extra half bar of chocolate!

As J.D. Alt writes in his excellent US post:

 If [government] runs a “budget surplus” for long, the Private Sector will either have to diminish its economic activity in general (go into recession)—or plunge hopelessly into debt (borrowing bank money it can’t repay, possibly causing a banking crisis)—or both.

 

Instead of creating jobs by spending, paying off debts or saving, a surplus budget eventually leads to redundancies, greater household indebtedness and greater precariousness of the workforce.

Obvious questions are raised by this simple story, like where did I (the ‘Government’) get the money to buy the chocolate in the first place?   Answer: I created it – that’s what Governments do if they’re the sovereign issuer of its own currency!   This is an incontrovertible fact – only the UK government can create Pounds Sterling – anyone else is committing the criminal act of counterfeiting.

If sovereign governments can create as much money as they want, why does the UK government need to collect tax to fund public spending?   Answer: It doesn’t – there are many essential reasons* for the government to collect tax but taxes do not pay for anything.

Think about it, if government kept on spending into the private sector without having a means of also draining the economy, we would have rampant inflation. (Literally, if it was all in bars of chocolate!)  So tax is one of the means of keeping the amount government spends into the private sector equivalent to the number of goods and services available for people to buy… thus preventing price inflation.

That is probably enough for now. I would recommend this and this for more information but please don’t hesitate to contact me if you need further explanation as to how the economy really operates.

Kind regards

Yours sincerely

Syzygysue

* Tax is important for lots of reasons including giving value to the currency but it does not fund government spending.

PS.  We’re constantly told that the deficit means that future generations will have to pay off our debts. This is simply rubbish.  Which would your children really benefit** from?   Half a chocolate bar (deficit budget), no chocolate bar (a balanced budget) or increased household debt and a potential recession (a surplus budget)?  It would be no contest in my family!

(** Obviously, caveats re: inflation apply)

 

DIAGRAMS & DOLLARS: modern money illustrated (Part 1) 

DIAGRAMS & DOLLARS: modern money illustrated (Part 2)

 

Has Austerity led to a Recovery? (Hint: No)

Quote

Did austerity lead to recovery? No, GDP was increased by government spending

By Michael Burke

First posted on Socialist Economic Bulletin 9th September 2013

The government and its supporters have been quick to claim that the most recent GDP data have vindicated its austerity policy.  George Osborne says the argument in favour of austerity has been won, some more excitable commentators have even talked of a boom.

Usually, SEB would provide analysis of the GDP data after the publication of the national accounts, the third release in the cycle from the Office of National Statistics, which provides a detailed breakdown of the components on economic activity and the final revision to the data.

But the claims made for the British economy following the most recent GDP release (and some subsequent surveys) are so outlandish, and so at odds with the facts, that is worth providing a short analysis now.

The data is still partial and subject to revision.  But there is enough evidence to demonstrate factually that the weak recovery is not a reward for austerity, but is in fact entirely a function of increased government spending.

The economy has expanded by just 1.8% in 3 years of austerity, an annual rate of 0.6% which is less than one-quarter of previous trend growth.  The gap between the current level of GDP and trend growth for the British economy is widening.  In addition, the growth to date is entirely a function of increased government spending.

Factual Analysis

This verdict is so at odds, with both stated government policy and the overwhelming commentary on the latest data.  Therefore it is important to provide the hard evidence supporting this analysis.  This can be found on Table C2 of the latest release, Second Estimate of GDP, Q2 2013 (ONS).

Total government current spending was barely changed from the time the Coalition took office to the end of 2011.  (In the ordinary course of events real government spending should rise in line with population growth and in a recession should rise much faster to offset the effects of recession.  Unchanged government spending represents a harsh ‘austerity’ stance).

However, from the 4th quarter of 2011 to the 2nd quarter of 2013 government current spending has risen decisively by an annualised £15.1bn.  GDP did not begin to expand until two quarter later.  This is the time lag SEB has previously identified in the relationship between changes in government spending and changes in GDP.  Rising government spending has led the recovery.

While the increase in government spending since the 4th quarter of 2011 to the most recent quarter amounts to £15.1bn, the rise in aggregate GDP over the same period is just £14.8bn.  Therefore, the rise in government spending not only led the recovery, but more than accounts for the entire expansion over the same period (as some other components of GDP have contracted).

Rising government current spending tends to support consumption, which is exactly what has happened over the last 18 months.  The rise in household consumption has been the strongest of all components of GDP over that period, rising by £25bn.  The chart below shows the changes in the national accounts since the government began increasing its current spending after the 4th quarter of 2011.

Fig 1

But weak household spending is not the source of the crisis.  This remains the slump in investment.  GDP is still £50bn below its previous peak in the 1st quarter of 2008, but investment (Gross Fixed Capital Formation) is £65bn lower.  Household consumption also remains below £24bn its pre-recession peak.  But it has been rising continuously for 2 year and now accounts for under half of the total decline in GDP.  The fall in GFCF more than accounts for the entire fall in GDP.

It is not possible from the partial release of the data for the 2ndquarter of 2013 to establish the role of government in the continuing investment strike.  But from the 1st quarter national accounts, it is clear that declining government investment has been exacerbating the private sector decline in investment.  Government investment peaked under the last Labour government and has been cut continuously ever since.

But the analysis is confirmed by the separate ONS data on public finances.  The presentation of the public finances data vary significantly from the presentation of government consumption data in the national accounts.  Among the many differences is that the former are presented in nominal terms only.  Even so, these show (Table PSF5) that in nominal terms the level of departmental outlays rose to £305bn in the first half of 2013, from £283bn in the same period of 2012.  This is a rise of 7.8% and way above the rate of inflation.

Conclusion

There is no mystery to the current very weak recovery.  It is led by a moderate increase in government spending, which more than accounts for the entire increase in GDP over the same period.

This runs counter to the government’s stated ‘austerity’ policy.  But it is accompanied by a cut in government investment, which exacerbates the private sector investment strike.  It is this investment strike which remains the source of the crisis, which cannot be resolved by increasing current spending.

Logic would dictate that any government which wanted to support the economy would increase investment, which is the source of the crisis.  Conversely, any government fixated on deficit reduction would probably be inclined to cut both current and capital spending.

This government is committed to neither economic recovery nor deficit-reduction.  Instead, it is committed to boosting profits.  That is why it is willing to increase current spending which supports consumer demand but refuses to increase investment as this would displace private capital from potentially profitable sectors of the economy.

Since this government is not sticking to its own spending plans, it makes even less sense for an incoming Labour government to do so.  Instead, it needs to address the source of the crisis by increasing state investment.

Fig. 2

Investment Slump Greater Than Whole Loss of British GDP

Quote

First posted on Socialist Economic Bulletin  Monday, 10 December 2012

Investment Slump Greater Than Whole Loss of British GDP

By Michael Burke
The latest estimate for Britain’s GDP growth in the 3rd quarter of 2012 left the initial estimate unchanged with growth of 1% in the quarter. Boosted by a series of special factors to do with the prior Jubilee holiday, the Olympics and other events, most forecasts suggest that this will give way to much slower growth in the 4th quarter. There are even forecasts that there will be a ‘triple-dip’ with growth contracting once more at the end of the year. In reality the overall situation is better characterised as stagnation, with growth fluctuating around zero. The source of the current crisis is becoming ever more apparent. As the chart in Fig.1 below shows GDP has fallen by £47bn in real terms from its peak in the 1st quarter of 2008 to the 3rd quarter of 2012. Over the same period investment (Gross Fixed Capital Formation) has fallen by £49bn. That is to say the fall in investment is now greater than the entire fall in economic activity. Of the other components of GDP only the fall in household consumption comes close to matching the negative impact of declining investment. Consumption fell by £37bn over the same period.

Figure 1
12 12 10 Chart 1

By contrast government current spending rose by £14.7bn over the period, while net exports rose by £29.3bn. The rise in net exports is almost wholly attributable to a slump in imports as exports have barely increased. Imports have fallen by £19.1bn.

Without the detail provided in the third and final estimate of GDP it is not possible to determine the source of the slump in investment. It is possible that the public or private sector which is responsible. But SEB has previously shown that the entire second recession was caused by the decline in public sector investment and this is in line with the stated plans of the Coalition government to sharply reduce its own investment.

This highlights an important point. Governments across the OECD have increased their current spending in the crisis. According to the OECD government current spending is up from 19% of GDP on average to 22%. This covers government expenditure on areas such as pensions, unemployment and incapacity-related benefits, health, housing supports and other social policy areas. In some cases the efforts to limit these outlays have been severe, but the growth of unemployment and poverty has automatically pushed them higher.

However OECD governments have tended to sharply reduce government investment. In Britain and elsewhere this is highly damaging to growth and therefore has a negative impact on government finances. But growth and improving government finances are not the aim of ‘austerity’ policies. Their aim is to restore the profit rate of the private sector and removing government from productive areas of the economy is a step towards that.

A number of commentators have recently called for a currency devaluation as a way to revive the British economy and outgoing bank of England Governor Mervyn King has described a recent very modest rise in the value of Sterling as ‘unwelcome’. These calls tend to ignore the fact that Britain has already had very substantial devaluation. As the Bank of England chart shown in Fig. 1 below shows the decline in the pound’s exchange rate index (ERI) from 2008 onwards. The ERI fall was nearly 30%, with a slightly larger fall against the US Dollar and a less pronounced fall versus the Euro. The recovery in the currency’s exchange rate has only been a partial one.

Figure 1
12 11 29 Chart 1

There are usually two main effects arsing from a sharp currency devaluation. One is to increase the price of all imported goods which cause inflation. This is what happened and the British economy was the only major economy to experience both a sharp economic downturn and a rapid rise in inflation during the crisis. The other usual effect of currency depreciation is to cheapen the price of exports in foreign currency terms, and so provide a boost to exports and the growth and jobs that depend on them. But following that devaluation exports have barely grown in volume terms.

Figure 2
12 11 29 Chart 2

From their pre-recession peak exports fell by 11.3% to their low-point. They have since recovered but were still 0.8% below that peak in the 2nd quarter of 2012. Since George Osborne announced the ‘march of the makers’ as the theme of his first budget in 2010 export volumes have actually fallen by 0.4%. This is possibly the only time in British history where there has been a very substantial currency depreciation and no recorded improvement in export performance.

This is a remarkably bad performance given that world trade has expanded since the recession of 2008 to 2009, according to the World Trade Organisation, by 13.8% in 2010 and by 5% in 2011. It is also a remarkably poor performance even compared to sluggish major trading partners. Fig. 3 below shows export volumes compared to both the US and the Euro Area. Euro Area export volumes are now 3.6% above their pre-recession peak while US exports have increased by 8.3%.

Figure 3
12 11 29 Chart 3

Of course, these are not the strongest performers. As a group, Newly Industrialising Countries’ exports have risen by approximately 50% over the same period according to WTO data.

There are numerous reasons for the exceptionally poor export performance of the British exports over the recent period. Patterns of trade are highly dependent on the weak export markets of the industrialised countries, financial services played a disproportionate part in the exports of services during the upturn, exporters responded to the devaluation by raising prices rather than winning market share, and so on. But all of these can be essentially reduced to the current problem of not producing enough goods or services that the rest of the world needs to buy. To correct that requires investment.

Given that the private sector remains on an investment strike, the government could respond as a minimum by investing in high-speed rail links, improved port facilities, super-fast broadband and through investing in education by scrapping fees and bringing back EMA. It could also remove the restrictions on visas including student visas so as to increase trade and educational ‘exports’. A government committed to creating hi-tech jobs would invest directly in carbon-reduction and renewable technologies for which there are very large and growing export markets. But that would all require a very different type of government.

See other Michael Burke posts:

BRITAIN’S EXPORT PERFORMANCE IS WOEFUL

The new recession is directly made in Downing Street

WHY MORE ‘AUSTERITY’ IS ON THE WAY

THE UK’S BUDGET DEFICIT IS RISING NOT FALLING