Lib Dem Voice

Eliminating the structural deficit is aiming for the wrong target

HM Treasury. Image courtesy of http://commons.wikimedia.org/wiki/File:Treasury_Buildings_-_geograph.org.uk_-_848056.jpg - some rights reserved

There is an appealing simplicity behind the idea of having a zero structural deficit. It is the policy the government is committed to, including the Liberal Democrats. And it’s also wrong. But the idea is so widely accepted that I’ve dusted off this post from 2012 and given it a little update before republishing it.

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’.
7 comments
DeanCrofts
DeanCrofts

I agree with richard. In 2010 we started at a point where previous borrowing year on year was too high, therefore a bigger structural deficit year on year leading to low confidence from investors creating high government borrowing interest rates. This government has lowered the borrowing rate for government since 2010 by having a plan to reduce the structural deficit. When full confidence returns u can adjust your economic policy which is what we are now seeing with looking at increase in infrastructure spending. I have long believed that government do not create long term sustainable jobs only the economic environment for businesses to be created thus increasing job opportunity and therefore GDP

Richard
Richard

I am sorry Mark but this is bad economics and certainly isn't Keynesian. 


The simple example is just not workable. Economic growth at that rate is impossible in a modern economy and high growth (that means 10% not 100%) creates all sorts of problems which would derail your example.  


Sustainable growth is perhaps 3-4% at the top of the cycle. At that point in the cycle yes economic growth is out-pacing debt growth but as the economy slows and the deficit increases the GDP-debt gap narrows, interest rates rise and as the economy contracts in the recession, debt grows as a proportion of GDP.


While it could be that we exit the cycle ahead, history shows we are far more likely to exit it with debit having grown because the levels of deficit funding at the bottom of the cycle are so high.  


I could go into more detail on the other points you raise but here may not be the place!  

MarkPack
MarkPack moderator

@DeanCrofts How do you judge something is "too high" if not by reference to whether or not it is affordable? And if you judge it by whether it's affordable, we're back to looking at what the debt servicing costs are.

MarkPack
MarkPack moderator

@Richard It's worth remembering that most of the time when the deb:GDP ratio has fallen in the UK, it has fallen in years when there has been a deficit - i.e. because growth etc. have been large enough to reduce the ratio despite there being a deficit. As that's been the regular pattern in the past, what's your reason for thinking it isn't possible in the future too?

DeanCrofts
DeanCrofts

@MarkPack @DeanCrofts  Debt/Borrowing is not affordable if your income is lower than your expenditure . I agree that we then look at debt servicing costs thus resulting in higher government interest rates when borrowing because investors lack confidence in the country. Therefore reducing the deficit reduces those costs.

MarkPack
MarkPack moderator

@DeanCrofts For most of this century and the last century the government's income has been lower than its expenditure (deficits have been the norm). Yet the country hasn't gone bankrupt. So in what sense has that been "not affordable"?

DeanCrofts
DeanCrofts

@MarkPack @DeanCrofts For all of the last century, we have had tory and labour governments creating boom and bust, that is why i am a liberal. Sound economics which do not create boom and bust.