George Osborne fails to understand that the value of lost output in Britain is vastly greater than the cost of public debt, writes George Irvin in the Guardian
MPs on the Treasury select committee have criticised George Osborne for "misleading the public" by suggesting that Britain was close to bankruptcy. Britain's budget deficit is at present equivalent to 12.7% of GDP. The national debt has been rising, as has the cost of debt service, currently running at about just over £42bn per annum or about 3% of GDP. According to George Osborne, unless drastic austerity measures are imposed as per the government spending review, the international financial markets will lose confidence in Britain. But the chancellor's argument in favour of drastic budgetary retrenchment is a mixture of fact and myth. Below are some typical myths.
Myth 1: Debt repayment is a cost to the country
About 80% of public borrowing is from the domestic market, what economists call the "non-bank public". To those who buy them – either directly or through things like pension funds – British bonds are an asset on which holders receive a payment totalling £34bn per annum. The remaining 20% is either held by government departments or is owed to foreigners. Most public borrowing appears as a liability on the government side of the ledger, but as an asset on the ledger of domestic bondholders.
Myth 2: The taxpayer pays
We are told repeatedly that the cost of servicing public debt is paid by current and future taxpayers. But anyone who believes that has grasped the wrong end of the stick. The reason the government has had to borrow ever larger amounts since 2008 is that, in a recession, tax receipts fall while transfer payments (such as jobseekers' allowance) rise. So it is the lack of tax receipts that leads to the borrowing, not excessive borrowing that leads to more taxes. As the economy recovers, tax receipts rise and borrowing falls.
A somewhat more sophisticated argument used mainly by "financial economists" (the sort who advise Osborne) is that when government debt-financed spending rises, the public cuts its consumption by an equal amount in the expectation that future taxes will rise. This is what economists call the "Ricardian equivalence" hypothesis, first proposed by David Ricardo in the early 19th century and popularised by Robert Barro and other members of the "rational expectations" school of economics which enjoyed brief credibility in the 1970s. Bluntly, there is little empirical support for this hypothesis. (See Elmendorf, DW; Mankiw, NG (1998). "Government Debt, NBER Working Paper 6470".)
The same is true of the oxymoron "expansionary fiscal contraction"; the IMF's World Economic Outlook (October 2010) could find only two episodes out of 15 of advanced economies expanding as deficits were cut.
Myth 3: The government is broke
Liam Byrne's note in May to his successor as the UK's Treasury secretary famously claimed that "there was no money left". Clearly, this was not meant seriously. Every schoolboy knows (or should know) that government cannot "go broke" like a private business. As long as Britain has its own currency, it has the power to print money. Anyone who doesn't believe this should read up on quantitative easing, the main form of printing money at present. Governments can only go broke if they have incurred debts in another currency; ie if they cannot finance their external current account deficit (which includes interest paid abroad).
Myth 4: The government must always balance its budget
While it may be sensible for a government to attempt budgetary balance over the full business cycle, it would be folly to insist that the budget must balance every year. Although we can dampen the amplitude of business cycles using "stabilisers", unless we find some way of abolishing the business cycle altogether (as Gordon Brown once claimed to have done) in any market economy there are bound to be periodic recessions. Attempting to balance the budget in a downturn, whether through stringent cuts or higher taxes, is likely to prolong the downturn since it lowers aggregate demand; ie people lose their jobs, spend less, and in turn others businesses go broke. In extremis, cutting drastically to achieve a balanced budget in a sharp downturn, far from reducing the government deficit, can make things worse – as the Irish and Greek cases show. That is why such a measure is called "pro-cyclical": it deepens the downturn.
Myth 5: Debt costs more than stimulus
The thinktank Compass recently issued a pamphlet entitled "The £100bn Gamble". The figure of £100bn is based on assuming that the average growth rate over the next five years is a Japan-style 1.3%, considerably lower than the 2.5% average assumed by Osborne; the cumulative difference between these growth assumptions adds up to roughly £100bn over the period (about 7% of GDP). Note that over five years this is equivalent to £20bn per annum, far more than the £8bn or so in annual government debt service paid abroad. In fact, this is an underestimate, since what it does not include is the increment in GDP permanently lost as a result of the 2008 credit squeeze and the subsequent recession.
Although we will get back to our real 2007 GDP level at some point, Britain has dropped to a lower trend growth line. According to Martin Wolf, up to 10% of annual potential GDP has been lost for ever. The banks are responsible for the recession that gave rise to this loss, and – one needs to repeat the point – the value of lost output in Britain is vastly greater than the cost of public debt. Osborne's "over-egged custard" will inflict a great deal more pain.