Eliminating the structural deficit is aiming for the wrong target

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’.

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