We need to balance the Budget over the business cycle as Keynes suggested, right?

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

  • David Allen 14th Dec '15 - 4:53pm

    “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!

  • John Hobgood 15th Dec '15 - 6:10am

    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 15th Dec '15 - 3:46pm

    @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.

  • Chris Burden 15th Dec '15 - 5:51pm

    She sounds excellent by any standards. And, she’s a woman and isn’t shh *you know who*

  • 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?

  • Richard Underhill 7th Mar '16 - 9:28am

    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?

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