January 4, 2015 Leave a comment
There has been controversy recently over the Conservative claim that the UK deficit has `halved’, based on the observation that £91bn is not half of £153bn:
As the Conservatives correctly argue, the most natural way of considering the deficit is a proportion of the size of the economy. On this measure, they say it has indeed halved. I will offer a couple of brief arguments as to why the Conservatives are right to say this. Then I will suggest they could have gone further and argued that the problem is basically solved. (They may have chosen not to do this because they consider it will be valuable in the election as a way of harming other more spendthrift parties.)
1). The deficit as a proportion of GDP is the way the bond markets look at deficits. This is the correct perspective to take, because it is the bond markets who are funding the deficit. They look at debt to GDP (%) and the deficit is the rate of change of debt to GDP (also %). He who pays the piper calls the tune.
2). Relatedly, looking at the absolute number makes no sense. If I ask you whether a £5,000 overdraft is a problem, you will ask me what the person who has the overdraft makes in a year. If they have no income, it’s a big problem. If they make £80,000 a year, it is no problem at all.
Now I will look at what they could have said.
The UK budget balance as a % of GDP is currently estimated at -4.5% of GDP. (All of my numbers are going to come from the table on p. 96 of the 13 December 2014 issue of The Economist. They caveat their number as being either from `The Economist poll or an Economist Intelligence Unit estimate/forecast’. We do not need to worry about this as the number is about right; they are just allowing for the fact that they are making an estimate for the whole of 2014 slightly before it ends.)
We now need to know where we have come from in order to know how far we have come. The first benchmark is the Maastricht criterion. Although the UK is not looking to join the Euro, that is a relevant benchmark of UK peers. It requires the deficit to be 3% or less of GDP. (Again, note that the criterion is expressed as a % of GDP because that is the only sensible way of looking at it.)
I saw estimates before the last election that the previous administration was looking to borrow 15% of GDP p.a. That was terrifying, not least because 1.15^5 = 2.01 i.e. 15% a year doubles debt to GDP in a single parliament. That is a doubling of the national debt before you get another chance to intervene.
Now, perhaps that 15% was a politically influenced estimate. More neutrally, all sides agree that the deficit has reduced from around 10%. Let us take that number. Now consider this: you can run a deficit at the same level as your nominal GDP growth without changing your debt to GDP number. Since that is what bond markets care about, it should be what you care about as well. GDP growth for 2014 is 3.0%. So imagine we want to get from 10% to 3%, then the distance we want to travel is 7.0%. We have actually moved from 10% to 4.5% i.e. a distance of 5.5%. 5.5% divided by 7.0% = 79% i.e. we really only have another 20% of the distance to go.
Now I am the first to think we should continue to bear down on the deficit, and in particular it is a really bad idea to fund OpEx with debt rather that Capex — meaning you can borrow to fund actual investments in actual pieces of infrastructure which pay you actual GDP benefits but you cannot sensibly borrow to keep the lights on or to pay benefits — but it still the case that a lot of the work has been done. I would at this stage like to see the deficit number reduce only slightly but shift spending into sectors which will produce a GDP return.
Two ideas: the Germans lend EUR16bn a year to their famed SME sector. The Israelis generated a globally successful tech start-up industry by `pouring money into elite universities and creating a clever system to attract venture capital’ (The Economist again, p. 76).
Peston suggests that it is fashionable in the City to ignore the deficit:
I do not doubt it. The truth is always in fashion.