Worrying about the size of a budget deficit is missing the point

Tom Freeman has an excellent blog post Where the record deficit came from, which is particularly worth reading for his graphs on how government income never hit the levels Gordon Brown kept on predicting, and on the relative role of higher spending and lower income in creating the current massive budget deficit.

There is one comment though that doesn’t persuade me:

To run a modest deficit year after year during a period of decent growth and high employment – as the period before was not – is risky. You can get away with it for a while, especially if you’ve previously paid down a good chunk of the national debt, but it’s risky to let it go on. The economy might run into trouble.

There certainly is a symbolic value to whether the budget is in deficit or surplus, but what really matters is that in the good times you should be ensuring you are in a strong position to deal with bad times. That includes having the financial headroom to spend more and/or cut taxes when needed.

But running a small deficit in good times doesn’t necessarily run against that. The burden that comes from accumulated debt is actually dependent on three factors: how big is that debt (and yes an annual deficit makes this worse), how quickly is inflation eating away the real value of the debt (because this reduces the debt burden without any debt having to be paid off) and how quickly is the economy growing (because the bigger the economy, the easier it is to afford any particular level of debt)?

If you are running a small deficit, the combination of economic growth and inflation can mean that the overall debt burden is still coming down. It can even be coming down sharply. And, depending on the economic situation and your views of economics, you can even argue that a small deficit is fuelling growth via the multiplier effect with the overall results that the burden coming down more quickly than if the budget was in surplus.

So although the difference between having a deficit or a surplus may seem clear and important, it’s not really the whole story.

As for the current economic situation, what I’ve said above actually makes me more pessimistic than I would be otherwise. That’s because with inflation having been at such low levels, we are unlikely to see a period of high inflation which will eat away at the value of the government debts in the way that high inflation in the 1980s and then 1970s did. The deficit currently is not only massive compared to the past, but it looks like government debt will be much harder to get under control this time.

UPDATE: Tom has responded to this post over on his blog.

One response to “Worrying about the size of a budget deficit is missing the point”

  1. The worrying thing to me, which many pundits are ignoring, is not so much the budget deficit, but the prospects for our balance of trade.

    The UK’s lifestyle is built on imports of things that are either running out, or, that other people are willing to pay more for. Much of our job market is in selling these imports. An awful example is gas and electricity. Every few months there will be a cluster of door knockers trying to get us to switch to their company. In the process, they waste vast quantities of fuel and paper, which just adds to the price of our electricity. This is insane. If UK plc were really run as a plc, we’d have long ago decided to pay these salespeople to stay at home, as it would reduce our loss, and help provide value for our shareholders (i.e. citizens).

    Until we start facing up to the fact that we’re no longer the British Empire, we’re not going to get anywhere. When we do, I predict that we’ll not just be building a tidal fence/barrage/new gizmo in the Severn, but also in the Wash and the Mersey too.

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