Eliminating the structural deficit is aiming for the wrong target

HM Treasury logoThere is an appealing simplicity behind the idea of having a zero structural deficit. It is the policy the government is committed to, with its plans to eliminate the structural deficit. And it’s also wrong.

For all the problems in measuring the structural deficit accurately, the concept is a useful one – to measure what the deficit is, once you have allowed for where we are in the economic cycle. Or, as the FT puts it, “A budget deficit that results from a fundamental imbalance in government receipts and expenditures, as opposed to one based on one-off or short-term factors”.

Having a deficit in a recession is not only not a problem, it is (almost always) desirable. Moreover, measures to tackle the deficit shouldn’t look at what the deficit is in the middle of recession, but what it will be once the economy has returned to normality. Otherwise you panic and over-compensate – and the same happens the other way in the booms if you assume those bountiful tax revenues will come in forever and can be spent or given up in tax cuts. Just looking at the headline deficit figure would produce wild swings back and forth in economic policy. It is the structural deficit that guards against such exaggerations.

That is the theory. In practice, it is made rather tricky by the large adjustments often made even years later to estimates of the size of the structural deficit in any given year.

But there is another problem, rarely talked about. It certainly matters whether or not money is being well spent, but why aim for a zero structural deficit? Why should the deficit, in the long run as booms and busts even out, be zero?

Governments need to be able to afford to service their debts, but how does a zero structural deficit achieve that? In fact, it doesn’t.

What matters is how much it costs to service the government’s accumulated debts. That depends on five factors:

  • how much debt has been accumulated over previous years,
  • the deficit/surplus being added to/removed from that,
  • the interest rates being charged on government debt,
  • the rate of inflation (as inflation eats away at the real value of debt, unless it all inflation-indexed), and
  • the level of economic growth (as how easy or hard it is to service debts depends on their size relative to GDP; the higher GDP is the less burdensome any particular level of debt repayment is).

Eliminating the structural deficit and having a zero deficit in the long-run only affects one of those five factors. There’s no magic virtue to having a zero for one of the factors when there are four others to account for too.

Indeed, a zero deficit in the long-run may well be too austere a figure. If the economy is growing a bit and inflation is nibbling away at the real value of the accumulated debts, then even a small deficit year after year could be accompanied by the debts becoming less of a burden.

Consider a simple example. Year one, economy is £100bn in size, accumulated debt is £50bn and there is a deficit of £1bn. Year two, economy has grown to £200bn in size (I said it was a simple example!), accumulated debt is now therefore £51bn. Interest rates have stayed the same, inflation is zero and the economic is neither in boom nor bust.

Was that £1bn deficit a problem? No. In fact it could have been much higher. Covering £51bn in a £200bn economy is much easier than £50bn in a £100bn economy.

So what should the government target? Rather than the structural deficit, it should target what percentage of GDP it takes to service the public debt.

It would make for better economic decision making, as it means aiming for a figure that captures the effect of tax levels, spending levels, interest rates and growth. In other words, it protects against myopic focus on one measure and instead puts the attention on general economic health.

And it does so by aiming at the right target – making sure debt can be afforded rather than aiming for the vacuous simplicity of ‘no structural deficit’.

 

* Mark Pack has written 101 Ways To Win An Election and produces a monthly newsletter about the Liberal Democrats.

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19 Comments

  • Your example assumes a growth rate of 100%! We could have a massive structural deficit with that.

    What worries me is that lack of recognition that our previous growth rate was funded by massive borrowing, whether it be sovereign or consumer. The latter impoverishes millions of people now/in the near future whilst the former impoverishes people in the near future and the next generations. This is only covered up by the continual issuing of new money by private banks, which keeps inflation going, as well being the source of said debt.

    The trouble is if you pay down this debt growth stops, so there’s a vicious circle. The question is whether we want to pay down the debt and lose the growth or lose the growth (as we will via other collapse and factors) and be left with massive debts.

    It’s embarrassing that senior politicians and commentators talk as though we’ll return to growth, but where’s the proof? Perhaps they’re too scared to face the facts and contemplate recreating their economic model, nit least because it’ll dramatically impact the state’s interaction with society.

    That said, you are of course right that more than th deficit must be considered in economic policy making :)

  • Mark you really also need to cover the example:
    Year 1: economy is £200bn in size, accumulated debt is £50bn and a deficit of £1bn.
    Year2: economy is £100bn, accumulated debt is £51bn and a deficit of £35bn (assume government spend was 35% of £200bn).

    Whilst reality isn’t quite as extreme as this, we should be talking about the fact that economies can grow and shrink and that past performance is no indicator of future performance…

  • “Interest rates have stayed the same, inflation is zero and the economic is neither in boom nor bust.”

    For this to happen and for the total ecomony to effectivey grow from £100bn to £200bn means we cannot be comparing apples with apples. The only way I can see this happening is for the economy to cover a larger population and economic base -such as the UK annexing France … Which is effectively what New Labour did by promoting unsustainable levels of immigration, they increased the cumulative GDP but did very little to positively change the per capita GDP.

  • Half way through a parliament where the government’s central, primary, overriding aim is to abolish the structural deficit is an amusing time to make the case that it’s all unnecessary!

    I had assumed, perhaps fatalistically, that the growth we have experienced in the past would be unlikely to recur – for most of my life we’ve had temporary props to our economy & government balance sheet – from North Sea oil&gas, to selling off state assets (firstly through privatisation and subsequently sale of those shares to overseas companies), to stoking up the city of london and finally overseas debt; its been a long time since we have paid our way as a country without these artificial boosts and none of them are going to recur in a hurry.

    I had wondered if all the sloganeering about dealing with the structural deficit were akin to targets around zero waste, or 50% renewables by 2050 or similar in the last decade and more – without an absolute commitment to something that might be beyond reach, we’ll never get anywhere at all down the road to achieving some of it.

    My one other point, is whilst agreeing that cost of debt is key, we also need to understand likely costs of servicing debt in the future – if we’re selling debt for 30 years it perhaps doesn’t matter, but like the household that can afford a mortgage with base rates at 0.5 but would be crippled if they rose to the average base rate, selling debt at a good rate now is a problem if the rates are much higher when it comes to rolling it over

  • This is a reasonable outline and a very reasoned argument into why the structural deficit ought not matter too much, because future growth (GDP), will take care of the problem. Mark has also given a 5 bullet point list of the factors at play, and economists recognise these. However there is a crucial, sixth bullet point not listed. That factor is ‘cheap energy’, or more accurately cheap oil. Very few economists understand energy, and how significantly important it is in this debate.
    Here is one economist, that does, and is far more articulate than I am in getting the point across.
    http://www.youtube.com/watch?v=KU14fItHGgc

    Or Copy / Paste this search into youtube
    (End of growth: How to achieve a truly sustainable future Featuring Jeff Rubin and David Suzuki )
    Mark is absolutely right in his analysis, that growth would solve or negate, the debt/deficit problem. But the growth we have enjoyed in our lifetime, functioned on oil at $20 per barrel. The price of oil today, is around $110 per barrel. So I would suggest, that having benefited from 80 years of cheap oil, we have been seduced into believing growth, will always be there. But at triple digit oil prices, will growth resume,… can it?
    Yesterday I heard we had entered triple dip recession. Apparently it has never happened before?

  • Mark: Perhaps I am reading too much into the numbers, as I (and I suspect that many others) agree that eliminating the structural deficit many be the wrong target and that the target needs to be around affordability (hence reason why I reversed your numbers) and whether there are better uses for the monies eg. sometimes it is better to pay a lump sum off the mortgage at other times it is better to use the monies to replace the car.

    Yes I think we all hope that somehow we will return to growth and hence make our debts easier to afford, I’m not that confident that grow like we saw in the 80’s through to 2007 is going to come back anytime soon.

  • Simon Beard 19th Nov '12 - 3:57pm

    Bloody brilliant Mark – here here!

  • From Mark’s list of 5 factors that determine the cost of servicing public debt, the only one that the Chancellor of the Exchequer really has any direct control over is the size of the deficit (or surplus) in forthcoming years. The past can’t be changed so the accumulated debt is what it is. Inflation and GDP are created by the whole economy, not George Osborne, and interest rates are set by the Bank of England based on inflation (and not-so-secretly GDP).

    So even accepting Mark’s assertion that it’s the debt servicing cost what matters, that only gives 2 options: get the structural deficit under control, or cross your fingers and hope the economy does what you want to make your debt servicing cost affordable for future taxpayers.

  • Liberal Eye 19th Nov '12 - 7:09pm

    Consider the situation when the government is running a deficit – i.e. it’s accumulating liabilities. That means that someone else is accumulating assets – it must be so by basic arithmetic. Those assets are, of course, claims on the government and and the ‘someone else’ is the private sector. That might be the domestic private sector or the external one. If domestic it might be banks or those saving for a pension or companies. If external it is because exports are less that imports so foreigners are accumulating future claims on us that outweigh our claims on them.

    Now read that understanding into our current position. If the government wants to reduce the deficit it has to stop its liabilities increasing but that means that the private sector can’t increase its assets overall (although subsectors might at the expense of other subsectors). Reducing liabilities (which the private sector needs to do in response to the crisis) is the same as increasing assets. For most of us that means paying down debt which reduces demand in the economy which inevitably slumps unless the government deficit-spends. So there is a problem. For the private sector to do what it needs to do to get back onto an even keel means that the government has to run a big deficit. One way or another the excess debt accumulated in the private sector tends to seep into the government’s accounts.

    There aren’t a lot of ways out of this box but don’t expect a recovery until this problem is resolved.

    One way it might be done is to run a big trade suplus for a long time but we are running a stonking trade deficit so that’s a negative. Another is for debt to be paid down but that takes a long long time (20 years and counting for Japan after a similar crisis). The only realistic plan is for problem debt to be written off where its unpayable but creditors naturally don’t like that and, so far, they are calling the shots.

    By not addressing this reality Osborne is living in fantasy land – understandable when you consider how important the banks are to Tory party finances. What’s really going on is well disguised can kicking.

  • Geoff Crocker 19th Nov '12 - 9:26pm

    Mark’s analysis is all built around an accountant’s or banker’s financial view of an economy, ie that governments should run accountancy books and incur and pay off debt. I maintain the alternative thesis that as productivity in real high technology economies grows faster than, and diverges from, real wages, then consumer and government debt is inevitable. Current experience suggests that this inevitability is indeed real. It is the experience of nearly all developed economies. A totally automated economy (thought experiment) would have no wages and all products allocated by government consumer credit ie the whole GDP would be ‘debt’. If this factor were even partially acknowledged, then we could drop austerity and fund real growth and accept constant ‘debt’ write offs. I’m prepared for the rush of adverse comment from the traditionalists and monetarists to this, but the logic of the point has not so far been dismissed.

  • Andrew Suffield 20th Nov '12 - 12:54am

    Worth noting that your #4 is largely irrelevant here because the UK’s debt is largely inflation-indexed – a lot of pro-spending pundits like to ignore this detail. The US, UK, and French bond markets are the ones which, unusually, issue a large amount of inflation-indexed bonds – some other nations have them, but not as large percentages of their national debt.

  • Just one point to add (and I think it is quite important), understanding the concept of ‘structural deficit’ and applying lessons for how to manage debt levels depends entirely on how you measure the economic cycle.

    Returning to a Gordon Brown’s period in the Exchequer, he set out several excellent general rules in fiscal policy in his first budget speech as Chancellor in 1997, such as the golden rule and the sustainable investment rule, which he later manipulated for political ends.

    These rules were also applied to govern entry into the Euro via the Stability and Growth Pact that came into force in 1998 and 1999, but, again, measurements of economic cycles in the case of Greece and others were manipulated for similar reasons of political expediency.

    The failure to follow the rules domestically and internationally combined to cause the current crisis.

    So, today, criticising a policy of ‘eliminating the structural deficit’ as simplistic, and preferring to concentrate on reducing the percentage of GDP required to service the total accumulated debt is essentially to bring us back to Brown’s misapplied and manipulated fiscal rules without understanding potential weaknesses.

    We need to look at three things: the ratio of public sector net worth to national income, the ratio of public current expenditure to national income and the ratio of public sector income to national income.

    This system failed previously because regulators were overridden and prevented from doing their job by legislators, which was because legislators felt a political need to cover for their failures in other areas (eg the Iraq War and ‘War on Terror’), and consequently because monetary policy diverged from fiscal policy.

    Using tax policy to keep a firm grip on interest rates is a powerful tool to manage debt in the economy, but we’ll lose sight of the real-world impact if we don’t keep our eyes on inflation too.

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