Fixing the Budget. Are we looking at the problem the right way?

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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  • 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.

  • Thomas Shakespeare 19th Feb '16 - 4:31pm

    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.

  • Barry Snelson 19th Feb '16 - 5:18pm

    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 Snelson 19th Feb '16 - 6:09pm

    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 Snelson 19th Feb '16 - 7:42pm

    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 Snelson 20th Feb '16 - 12:21am

    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 Snelson 20th Feb '16 - 8:34am

    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.

  • Christopher Haigh 20th Feb '16 - 11:55am

    @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.

  • Christopher Haigh 20th Feb '16 - 8:53pm

    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.

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