Whenever we read articles on reducing the government’s budget deficit the underlying assumption is invariably that it needs to spend less and obtain more taxation revenue. This approach is known as economic austerity. We all know from our personal experience that if we have a debt problem we have to spend less and/or earn more to get out of trouble. So that must work. Or must it? All politicians in all parties need to get this one right if nothing else. Any government’s spending and taxation policy impacts just about everything else in its ‘to do’ list.
We saw in the last Parliament that the Coalition ‘reluctantly’ raised VAT to 20% to increase taxation revenues. All spending plans were subject to extreme scrutiny. Various bodies in the Treasury, or the Office of Budget Responsibility had previously been at work and had produced figures to show the extent to which the deficit would shrink over the course of several years. Usually just before the next election, hey presto! We’d have that surplus we were always promised.
It never does work. After a couple of years we see articles and more articles in the press saying that the Chancellor has been ‘blown off course’ by this or that event, and the story is usually that whereas government spending has been kept to plan the taxation receipts have been disappointing and consequently the promised date of a budget surplus is further away than was first predicted. There are lots of articles along these lines for anyone who cares to search them out online. There are never any at all, as far as I know, saying that the situation has turned around better than expected.
Does anyone really believe that it will be any different this time and the OBR will get it right by 2020?
So, what is going wrong and what is the right way to look at the problem? The first step is for us all to stop thinking that what works for our personal finances is going to work for government. Our spending and our incomes are very small compared to the size of the total economy. They can be treated as independent. Not so for government. In all modern economies money is a fiat of governments. It is nothing more than their IOUs which they can create at will by spending into their economies. When they re-acquire them in taxation revenue they tear them up, either physically or digitally, just like a theatre might tear up a ticket it had sold when we present it on entry.
Money flows from government out into the economy and then back again rather like electrons in an electrical circuit. The more electrons we push into the circuit at one terminal (spending) the more electrons come back at the other terminal (taxation revenue). If there are less coming back than are going in, it must follow that they are being stored (non-government savings) somewhere. That is what capacitors do. They store electrical current and then later discharge it. They are analogous to our piggy banks or savings accounts. A really big capacitor might be analogous to the savings account held by the central bank of a large net exporting nation.
So does it make any sense to expect that our deficit in electrons would be much different if we simply pushed less in? We’d almost certainly get proportionately less out too. The ‘deficit’ might even worsen. With any electrical circuit we can notice that it gets hotter according to the current flow and there is a parallel for us there in our economic thinking. Getting hotter might be a sign that inflation is likely to be the main issue and we should reduce the flow a little. We do this not because we are worried that we are running short of electrons, sorry pounds, but we do worry that those pounds might be losing too much value. On the other hand if the system is running too cold we increase the money flow to warm things up a little and so increase business activity and reduce unemployment. This is really nothing new. Keynes explained it all very well 70 years ago. If we want to really fix our economy it is high time the economists at the OBR dusted off their old Keynesian textbooks and re-read them in earnest once again.
* Peter Martin is not a LibDem party member but has voted LibDem in previous elections.
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26 Comments
The conclusion from this argument is that you can always improve public finances by borrowing and spending more. How, then, is it possible that governments ever get into debt crises?
The assumption that it doesn’t matter how much the government spends because eventually it will all come back as taxes ignores the issue of imports. Some of the purchasing power pumped into the economy goes overseas. In other words to use the metaphor of the original article it is possible to lose electrons from the UK system.
Oh, and how close is this to ‘supply sider’ theory that says if you borrow to cut taxes, that will pay for itself in the long run? Didn’t Reagan or Bush Snr create a massive deficit doing that, that Clinton had to clean up?
It seems to be essentially the same idea.
Analogies are useful for explaining concepts by comparing them to other things we already understand but they are a useless basis for reasoning, when you find yourself saying things like ” With any electrical circuit we can notice that it gets hotter according to the current flow and there is a parallel for us there in our economic thinking. Getting hotter might be a sign that inflation is likely to be the main issue and we should reduce the flow a little” you have taken your analogy too far.
The use of very poor analogy (e.g. the Tories’ favoured household budget/credit car analogies) has been deeply harmful to public discourse about the economy in recent years.
Doesn’t this totally ignore the difference between fiscal and monetary policy?
If the government was the sole creator of money the analogy would at least hold. But it’s not, banks create most of the money.
If the entire money supply was created by the government and initially spent by the government it would cause absolute chaos as we tried to match government spending to the amount of the money-supply required to level inflation. We’re far better off keeping them separate.
Thank you for your comments. I’ll do my best to answer them:
@ Joe Otten, The conclusion from the article should be that debt crises don’t originate in quite the way we might first think. Suppose a country started a new currency from scratch it would, in its first year, have to spend some money which it had just created. Lets say this was 100 million. It would get back maybe 80 million in tax (it could never get more than 100 million in the first year -unless it also lent out some new money). 20 million would then be the savings of the inhabitants of the country. If it did get back 110 million in the second year (after spending another 100 million) that would have to mean savings had dropped to 10 million.
Reagan was actually an accidental Keynesian. He was convinced by Arthur Laffer that he’d get more tax revenue if he reduced tax rates. This can work for one particular tax in the way Laffer understood his own argument. It may or may not work for all taxes. If it does, it’s not in the way Laffer understands it. The deficit still has to equal the increase in savings. But, nevertheless, the reduction in taxes, not to mention that he was no spending austerion, certainly gave the US economy a huge stimulus just when it needed it.
@Richard, Often we do separate out overseas from domestic but we don’t have to. We can treat the Bundesbank as a user of pounds just like you and I are users of pounds. If Germany want to sell us more stuff than it buys from us, then the Bundesbank is going to end up with lots of pounds which it has no real use for. So it buys up gilts which show as an asset on its books. It becomes a big saver essentially.
@Jack. Yes I take your point about analogies. Sometimes they can be misleading. But the ‘heating’ one is not a new analogy wrt to Keynesian economics. We say an economy is overheating when we really mean aggregate demand is starting to exceed the capacity of the economy to deliver, and that inflation is a potential or actual problem.
@ Stephen W,
Banks can’t create money in the way some naive people in groups like “positive money” suggest. If they tried they end up on a charge of counterfeiting -unless they were really good at it! They can only create the digital equivalent of those Bristol and Brixton pounds. Anyone can do that. They are just asset/liability pairs which net to zero in the economy.
My view:
Yes, we should tax more. Yes, austerity is necessary, but not as much or fast as the Chancellor suggests. Keeping public spending as low as it will be 2018/19 isn’t sustainable for public services, e.g. NHS, education. I think the cuts up to 2015 were necessary, but they should have been supplemented with increased tax. Then we wouldn’t have a deficit now, and we could be more selective about what we cut.
After the words “So that must work” delete “Or must it?”. Otherwise the piece is just discredited Keynesian rubbish. A magic potion, a silver bullet, a painless cure with no effort required whatever. When does the economic miracle arrive, that pays all this back?
What form does it take? Why would our fortunes turn round because we have injected money that’s turned into Korean flat screen TVs and Chinese smartphones?
No more of this sophistry, please. Let’s return to common sense.
@Barry ,
Keynes was an economic genius. And a member of the Liberal Party too! It’s fair enough to disagree with him but you’d have to understand what he was saying first.
I think your point about our grandchildren (on diiferent thread) being saddled with debts illustrates this. If you think about it we can’t leave them anything that will be much use except a productive economy, with a good infrastructure and a clean environment. They can’t repay our debts as they won’t be able to travel back in time to do that. Have you ever had a tax bill to repay war debts for example?
You offer the traditional economists’ answer – “You don’t understand”.
Please. That’s the defining response of the sophist.
The best we can do for our grandchildrens’ generation is to rescue them from the excess and extravagance of ours.
Our creaking infrastructure was built by a generation which created the workshop of the world and made the money before they spent it.
You mention three bequests. Infrastructure and clean environment would be nice but we can’t afford it. The third ‘productive economy’ is the key and no economist I ever heard from (least of all Keynes) has any ideas to generate one of those, they being stuck with numbers one and two. The combined efforts of the nation’s Keynsians would not only be incapable of designing a ‘phone to rival the Samsung Galaxy series, but working together for a year they couldn’t produce the cardboard box it comes in. I am eager to hear from economists with real world, UK centric, practical solutions that don’t include magic pixie dust like printing money or borrow and squander.
@Barry
I wouldn’t say you didn’t understand I would just you are completely wrong.
“Infrastructure and clean environment would be nice but we can’t afford it”
Utterly ridiculous what we can’t afford is NOT to do those things, if we don’t clean up after ourselves who will? It will be our grandchildren, you seem concerned what they will be left with, fine that’s correct but the 1 thing we can’t run out of is ‘money’ it is better to fix things now rather than later when it has completely collapsed (cheaper for one thing).
One thing we can all be pretty sure of is we will all be dead, the people holding those financial assets now will be 10 feet under the same as the rest of us, somebody then will be holding those assets.
We are still paying off ‘debt’ from the Napoleonic wars…does that bother you? Course not.
Andy,
The fundamentals can not be wished away. I have a Bank of Zimbabwe 100 trillion Zimbabwe Dollar note pinned to my noticeboard to prove that no one can run out of ‘money’. Governments can print ‘money’ but they can’t print ‘value’. They can not print the wherewithal to engage in world trade, whatever ‘tokens’ are used. That wealth has to be created with hard work. We have sold the family silver long ago. We are now selling the right to harvest our children’s wage packets. No – we can’t afford HS2, a new London airport etc etc.
But enough of this.
Are there any economists out there have moved on from the ‘magic money tree’ and have thought through how we can move the UK forward without the usual, trash the currency, print money or borrow and squander miracle solutions?
I really, really want to meet with them and swap ideas.
@Barry,
Our creaking infrastructure was built by a generation which created the workshop of the world and made the money before they spent it.
You’re probably not the only one to think this. I’m not sure why. The historical record shows otherwise.
The 19th century industrial expansion was funded by large debts. See the graph (in blue) slightly more than halfway down the page.
https://en.wikipedia.org/wiki/United_Kingdom_national_debt
@Barry
You are seriously comparing us to Zimbabwe? So which productive sector have we decimated like Mugabe did to agricultural sector? If you want to bring up Weimar republic…do we owe war reperations in gold and have the French & Belgian armies walked into the country (in German’s case the Ruhr) causing a general strike.
Look the inflation equation is MV=PY (let’s overlook the original was MV is equal by identity to PY so bent out of shape anyway) you have to put some big assumptions into it to get to inflation by money ‘printing’ basically you have to assume the economy is at full employment, Velocity is stable and companies can’t expand production without putting prices up? Seriously bakers can’t bake another loaf, barbers can’t cut anymore hair?
I take it back that you were wrong, you really don’t understand,
@Barry
To put it more simply with your hoary old monetarist argument, you might not know this but what you are doing is this…
You are dividing total prices by the monetary base and claiming that is causation, it is utter nonsense.
Peter,
Your comment on 19th century debt intrigued me and not because I wasted my time following the link but it was different to some other predictable, even Pavlovian, responses I triggered.
Because I am sure that you are intelligent enough to spot the difference between debt held by the British Empire at the height of its powers and our situation today. Could you see the coin from the ‘other side’? Is it possible that you could even join the other side?!!
There are growing signs that the electorate of the Western nations are realising that their economic leaders have failed. Carney, Yellen, Draghi, Abe – all surrounded by the most prestigious economists that money can buy have, nevertheless, lost the plot.
I don’t care about the world’s economy, only ours and there is a need for a new generation of economic thinking that realises that printing money, trashing the currency and borrow and squander are manifest dead ends and absurd.
Economic revival needs lots of small questions answering not one great big magic one and trained economists would be useful in finding those marginal gains which will add up to a winning whole.
@Barry,
I’m afraid its not possible for UK to isolate itself from the ROW so you should care about the world’s economy. Most Lib Dems do.
Most Lib Dems, and me too, care particularly about the EU economy. If the EU was functioning as well as it reasonably should there would be no possibility of a Brexit. There probably wouldn’t even be a referendum on the question.
I know you won’t agree, but if the economics of Keynes was better accepted in Europe, and particularly in Germany, the EU wouldn’t be in the mess it is in.
Sorry Peter, I was mistaken. I thought for a moment that you might see the light. My bait only caught the stereotypical Keynesian fish. I’ll throw them back and cast in different waters. The ROW affects the British but can’t be controlled by them. They are in desperate need for down to earth economists who can solve their problems rather than pontificate for hours on what everybody else should do.
I rarely laugh out loud but your advice that the most successful economy in Europe should follow Keynes managed it. My long dead father who fought them would encourage them to follow his doctrine too!
Anyway, I shall continue to look for a new generation of 21st century economic thinkers who have something to say to us in our plight and are not the bearers of effort free miracle cures.
@Barry Snelson, Barry with regard to your comment about printing money. The only institution that prints money in the UK is the Bank of England. It issues money to the banks in response to demand from high street bank customers. Therefore it will issue more money in December when people are using cash leading up to Christmas, and less in January after people have spent up.
@ Barry,
From the POV of an individual at a football match with a capacity crowd, it would makesense for him to stand up to get a better view of the game. But if everyone took his advice then, of course, no-one gets a better view and at the same time they have the discomfort of standing. We have what is known as a paradox of composition.
So , yes, Germany solves its debt and unemployment problems by running a large export surplus which exports them to others. So, therefore it follows that everyone can solve their debt and unemployment problems by having…… Well, not really!
Keynes was well aware of these kinds of paradoxes of composition and is perhaps known best for his observations on the paradox of thrift. You might want to look that up. The trick is to come up with an economic system which works for all and not just for some at the expense of others.
‘Have you ever had a tax bill to repay war debts for example?’
To a small extent, we all will have in 2015-6. In autumn 2015 the Treasury repaid what started a hundred years ago as 5 per cent War Stock (austerity Chancellor Neville Chamberlain later reduced it to 3 and a half percent). The capital’s fallen a lot in value and a lot of interest has been paid out in the meanwhile.
‘The only institution that prints money in the UK is the Bank of England.’
Apart from the Scottish and Northern Irish banks which issue their own notes.
But more seriously, the money supply is increased by banks issuing credit cards and then progressively raising the credit limits of well-behaved customers.
@ Ian Sanderson,
If I borrow a bag of sugar from you, you’d consider the debt repaid when I gave you back another bag of sugar. Govt can never repay any debts on this basis. Initially they’ll give you their IOU called Pounds (which don’t carry any interest) for the sugar. Then later they might swap those Pound IOUs for bond, stock or gilt IOUs (which do carry some interest), then later still they may swap them back for their Pound IOUs, especially if the Govt thinks it is paying too much interest on the bonds. So there is really no such thing as a repayment of govt debts, unless perhaps, its taxation revenue is greater than its spending, in which case they put their excess into the shredder. (Is that really a repayment?) Otherwise, it’s always just a swap of one type of IOU for another.
Another way of looking at it is to say the real resources (food, munitions etc) purchased by the WW1 loan were consumed at the time. Whoever held that money later (bonds or cash – it doesn’t matter) in subsequent years could exchange their held IOUs for real resources too. Now the option is just cash as these particular bonds have been redeemed – but you can still buy others like NS certs for example. They are still govt IOUs so nothing much has really changed. Except the value of the IOUs in real resource terms which may, or may not, have kept pace with inflation when interest payments are included.
Yes banks can create money if you consider their IOUs to be money. But they are bank IOUs which are asset/liability pairs. Just like casino chips are asset/liability pairs issued by the casino. They aren’t the same as govt money but we’ll only accept those IOUs if we are confident they are backed up by govt money or govt IOUs.
Ian-bank loans and credit are not printing money. They are vessels that spontaneously appear when created and spontaneously disappear when repaid.
There was a time when British football refused to play anything but 4-4-2, then a time when British football considered 4-4-2 to be seriously limited and the sign of a managerial dinosaur, and now we’re entering a phase where we can see 4-4-2 can work well but you need the right personal and be able to adapt. Those preaching austerity first backed Labour’s financial policy while in opposition no matter what was happening abroad, they then believed that Labour’s policy was seriously limited and the sign of a economic fool, and now? We have a conservative party refusing to adapt from their drive to slash away from the state no matter what is happening to the people all while spending millions to make it a one team league.