Firstly, we do need to ask if Keynes did suggest that. There are arguments either way on this point. Keynes’ view unfolded and developed starting in the bleak 1920’s in Britain. There was no ‘roaring twenties’ for the UK economy as the government deflated the economy to try to fit the Pound back on to its pre-war Gold Standard. Keynes then did argue that governments should run deficits if private spending declined and reduce those deficits when future growth was strong enough. This has been interpreted by many that his intent was that the budget was to be more or less balanced over the business cycle. If anyone is keen to research into his thinking they might like to start with his 1924 publication A Tract on Monetary Reform.
A better approach might be to try to understand why Keynes should made a break from tradition and start to advocate that budgets should at times be unbalanced. If we consider an economy which is neither a net exporter nor a net importer and in which everyone spends what they earn within the economy, Government spending and taxation must balance. This is true regardless of the level of taxation imposed (providing it is finite) and so regardless of the level of inflation within the economy. It has to, according to the principle of sectoral balances originally developed in the 60’s and 70’s by the late Prof Wynne Godley at Cambridge University.
If the participants of the economy don’t spend all they earn, ie when private spending declines, we can have a tendency to recession. Keynesian economists would point out that prices and wages tend to be “sticky” and so don’t respond quickly to changing circumstances as more classically minded economists suggest they should. Therefore, Keynes was quite right to suggest that the Government should spend more, or tax less, to prevent recession from occurring. The government needs to borrow money from the savers and spend it on their behalf. Later, when the savers withdraw their money from the bank, or empty their piggy banks, and spend it, the Government needs to run a surplus in its budget to prevent the economy from overheating and inflation occurring. So the budget does indeed end up balanced over the cycle. It ends up being an approximately symmetrical pattern when expressed graphically.
This relatively simple model may have been adequate for the UK economy in the 1920s. However in recent times the extent of saving and desaving hasn’t been symmetrical over the business cycle. When times are good people may borrow and spend more but equally they may put more aside for their retirement. So if the spending/saving/borrowing pattern of the population isn’t symmetric over the business cycle, neither can we expect the government to run a balanced budget over the business cycle. Instead of imports and exports balancing, our economy has something like an annual 5% of GDP deficit in its current account. Our trading partners seem happy to supply more real things to us than we supply to them. They take our IOUs in the form of treasury bonds or gilts to make up the difference. In effect they are like a big net saver within the economy. As Keynes pointed out, if people are saving more, and that includes our trading partners, the Government has to be spending more or taxing less.
The ‘balanced budget over the cycle’ is really just a special case which does not apply to our own 21st century economy. If we try to force the Government budget into balance, at the same time ignoring the trading position and the willingness or otherwise of the economy’s participants to net save then we are courting economic disaster. The budget will not balance, no matter how hard we try, and we will end up like a dog chasing its own tail as the economy spirals ever deeper into recession.
* Peter Martin is not a LibDem party member but has voted LibDem in previous elections.
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17 Comments
Interesting article, but you don’t flesh out the implications of what you’re suggesting, and more crucially, the long-term consequences of the same. You appear to be saying it’s now okay for the government to run a 5% GDP deficit indefinitely. It doesn’t take a mathematical genius to work out that this would lead to our debt/GDP ratio growing perpetually, as we are never going to achieve long-term GDP growth greater than 5%. This will obviously lead to a debt-crisis when our debtors get nervous at the debt/GDP ratio (whether at 150%, or whatever). So what is your proposal for how the government should behave as the debt/GDP ratio approaches whatever trigger-point is believed to be risky? And given that the government must have to take that evasive action you specify at that point, what is so wrong with them playing safe and doing it substantially before that point?
“Instead of imports and exports balancing, our economy has something like an annual 5% of GDP deficit in its current account. Our trading partners seem happy to supply more real things to us than we supply to them. They take our IOUs in the form of treasury bonds or gilts to make up the difference. In effect they are like a big net saver within the economy. As Keynes pointed out, if people are saving more, and that includes our trading partners, the Government has to be spending more or taxing less.”
Yes but – Surely the main reason why our trading partners have accepted an imbalance in real goods is because it is counterbalanced by our trading surplus in “invisible” items? So our trading partners are not like “a big net saver”?
Perhaps it’s me who needs to learn more economics, but I’m not convinced by the line that public debt can only grow when private debt shrinks (and vice versa). What about the creation of new money by QE or by banks?
If there was really an iron law connecting the size of the public deficit to the level of private saving, then we would hardly need to have a policy on the deficit at all. If the iron law were true, then nothing Government could do (other than altering the interest rate to encourage or discourage private saving) would be capable of affecting the deficit!
@ David Allen,
Yes your final paragraph is a very pertinent comment and perfectly true. (or very nearly so! ) We have to take a slightly broader view of the word debt to include all liabilities of Govt including the “printing of money” to see that. Suppose a country starts of a new currency from scratch. They spend 100 million units into existence and get back 70 million in taxes. The government’s deficit is 30 million. Why? Because either the population has saved some units in their wallets and purses etc or the country’s trading partners have saved them due to the country running a trade deficit.
The bit you didn’t get quite right was concerning the ability of the government to influence matters. It can be so draconian, by creating mass unemployment etc, that the population can neither afford to save nor buy net imports. That’s one very effective way to “fix ” the budget!
@Cllr Mark Wright,
Yes you’re right. However the government is concentrating on the wrong deficit. It should be looking to reduce the trade deficit (slightly but not necessarily eliminate it) and run the economy to maximise growth rather than be too concerned about its budget deficit, which will naturally come right anyway once the economy is more buoyant.
David Allen,
I’m not convinced by the line that public debt can only grow when private debt shrinks (and vice versa). What about the creation of new money by QE or by banks?
If the government give you a £100 tax rebate their debt increases by that amount, at the same time as your debt decreases. That has to be true on a penny for penny basis. Some economists would say that if the money was just created (eg by QE) it shouldn’t be counted as debt in the same way that the creation and sale of gilts ends up being counted as debt. This line of thinking may have made some sense when the monetary base was backed by gold. It doesn’t now. It’s all a liability of government and should be included. The Americans “forgot” to include coinage in their definition of National Debt ! So theoretically they can mint trillion dollar coins (you might like to Google that term) as a work-around to any debt ceiling problems.
Bank created money is an asset/liability pair so these cancel out in the economy in the short term. However bank lending does have a very significant effect and will lead to the classic boom bust cycle as lending first stimulates the economy and the accumulation of private debt then slows it. See the theory of Debt Deflation first propsed by Irving Fisher and now taken up in earnest by Prof Steve Keen.
@Peter: thank you for the reply. I’m old enough to remember the news in the early 1980s, which was always going on about the trade deficit. It is peculiar that economists stopped caring about that in the mid 90s. However, I don’t have your confidence that the “budget deficit {…} will naturally come right anyway once the economy is more buoyant”. It’s entirely possible for a government to create structural expenditure that *increases* as the economy takes off, e.g. Housing Benefit which grows in line with rents, and voters demanding better state /publicsector pensions and pay-rises when the country is doing well, etc.
@Cllr Mark Wright
As Lerner put in his Functional Finance proposal, the government should issue bonds if it believes that it is preferable for people to hold bonds. If it is not preferable for people to hold bonds (because it wants them to save in other ways) then it should issue cash.
I suspect that people have trouble with sectoral balances etc because “printing money” is supposedly such a terrible thing that will immediately lead to Weimar Zimbabwe style inflation and wheelbarrows full of banknotes.
This overlooks a number of things.
a) the government already creates (and destroys) money without issuing debt all the time;
b) issuing debt is “printing money” just as much as issuing cash is, because bonds are tradeable for cash;
c) banks create money each time they make loans;
d) if there is slack capacity in the economy, and no crisis like a foreign balance of payments spiral or something, spending is not inflationary whether it is funded by debt or by new money. An unemployed person is, definitionally, offering something on a market for which there is no demand (her labour) and as such that constitutes a supply glut which puts downward pressure on wages. And wage deflation is bad.
Assuming that we have to issue bonds presumes that we want a savings rate that high.
(see also: http://www.coppolacomment.com/2015/03/repeat-after-me-sectoral-balances-must.html)
As the economy takes off, (the recession eases) I would indeed expect people’s balance sheets to gain, just as they shrank in the recession., so you can expect deficits to be larger. People will also start spending more, some will have more to set aside, some will consider taking on more debt. Transactions will increase, generating taxes and income (so more taxes), fewer on unemployment and likely earning more (so more taxes). We have seen that it’s recessions that make the deficit larger due in large part to lost taxes and increased transfer payments.
But the size of the deficit shouldn’t be such a worry other than it might be too small for the prevailing conditions. If the private sector increases their net savings in a given year, the deficit will increase that year too. Where the national currency in use is a fiat currency that floats and the national government has no debts in any currency but it’s own, the smart thing to do is to balance the economy, not the budget.
@John Hobgood: “But the size of the deficit shouldn’t be such a worry other than it might be too small for the prevailing conditions.”
And how did that work out for the Mediterranean countries?
@ Cllr Mark Wright
“And how did that work out for the Mediterranean countries?”
Probably best if they hadn’t joined the Euro, but yields come back down when the ECB did what it was supposed to and intervened.
This article is a applicable to sovereign issuers & the Eurozone as a whole not individual members of a currency union (note the mess the Scot indy movement got into over this subject).
@Cllr Mark Wright
This is what happens when you give up your floating currency or peg to another currency or commodity. No European country has the latitude that the UK has via Sterling. They did have it, but gave it up to the ECB, so now they’re much like a household or business in that regard. They have to balance the budget, cut gov’t spending, sell public assets, the people need to accept lower wages, export more, etc., or whatever Germany demands.
Lesson: Unless you want Germany to dictate UK policy, shun the Euro and keep Sterling as the UK currency.
“Lesson: Unless you want Germany to dictate UK policy, shun the Euro and keep Sterling as the UK currency.”
Lesson : Unless you want the German/ Brussels axis, to dictate UK policy, shun the EU in totality, keep Sterling, keep your UK sovereignty, wish the EU *inmates* well, as you wave it goodbye, and re-join the rest of the world at the WTO table, who will be more than willing to trade, if that trade is of mutual interest to both parties in the proposed trade.
Fixed it. Let’s have no more fear mongering.
It didn’t work in the Mediterranean countries because they don’t have sovereign currencies, thus they cannot institute monetary policy to battle unemployment. When the amount of money coming into the country via spending (which is limited externally by the ECB) and exports is less than the amount leaving via taxes and imports, the economy will eventually shrink. Now this can be delayed though private sector borrowing and savings depletion, but these aren’t sustainable and eventually the private sector reaches it’s threshold to carry debt and crash ensues.
In the US simply take (Federal Spending+Exports) – (Taxes+Imports). If the number is negative, the US private sector MUST respond by increasing borrowing and depleting savings. Eventually the private sector will stop borrowing and deleveraging begins. Deleveraging causes a decrease in demand, which is then picked up by the government in the form of increased spending. Private sector “recovers”, rinse and repeat.
The problem is that the cycle is so predictable and technology has advanced to the point that those with wealth have become super efficient at capitalizing on the cycle.
As long as people believe that the Government must tax in order to spend, this cycle will continue.
The solution is for the government to look at the aggregate of (FS+E) – (T+I) (from above). This is the deficit/ surplus to the private sector. This number should be what is being reported on the nightly news, not the US government deficit.
Remember that in order for the government to balance it’s budget or run a surplus, it does so at the decrease of assets from the US private sector, which will respond, predictably, by increasing it’s debt.
She sounds excellent by any standards. And, she’s a woman and isn’t shh *you know who*
@ indigo
It’s just as true for the euro using countries as anyone else that the following identity holds :
Government Deficit = Total Savings = Savings of Domestic Economy + Trade Deficit
There are two ways for countries in the EZ to balance their budgets and avoid falling foul of the Stability and Growth Pact rules, which limits any country’s budget deficit to 3%. The preferable way is to run a trade surplus rather than a deficit which does also allows some space for savings to occur withing the economy. The snag of course is that not all countries can do this. If Germany runs a 7% of GDP surplus someone else has to run a deficit.
The other is to depress the economy, creating mass unemployment, so that there is neither a capability for the population to save nor consume too many imports.
Whatever any of us may feel about the UK’s membership of the EU this cannot be a satisfactory state of affairs. Countries which don’t have the industrial muscle of Germany and Holland which shouldn’t be forced to balance their budgets by making everyone poor!
A late comment on this thread.
When Keynes put his theories forward there were capital controls.
How does the effect of free movement of capital through tax havens have an impact? Does the ability of the private sector to move “savings” outside the nation state alter the optons in the (FS+E) – (T+I) equation?
The ‘Undercover Economist’ writes in the FT with clarity. He wants to communicate. Sometimes it seems cynical to ask, are other economists deliberately complexifying so that we accept their analysis or pay extra for their services?