The logical absurdity of reducing a budget deficit by expanding it begins to look extremely logical, in the light of Italy’s election and Britain’s credit-rating downgrade, writes Alan Shipman
Had John O’Farrell won the Eastleigh by-election, the comic novelist would have been in a similarly paradoxical situation: immersion in one of the richest reservoirs of comic material – the House of Commons – but in too serious and time-pressed a role to convert it into print. Fortunately, O’Farrell is no stranger to paradoxical situations. His novel of (non-political) partying and parenthood, The Best a Man Can Get, mines a rich seam of them, between the fleeing partners and flying nappies. Most notably, when he discovers that nature has committed a basic programming error in the design of young children. They confront some of life’s greatest internal and external threats at a time when they are not equipped to convey what’s wrong, except in inchoate burble; then they learn how to speak and relentlessly build up their articulacy, in inverse proportion to the importance of what they’ve got to say.
But there’s one paradox that even Labour’s most experienced politicians still struggle to express. So do the other parties who fared well in the Italian elections, and those in the US Congress who’ll try again in March to avert a leap off the ‘fiscal cliff’ . Whenever those now ‘rebalancing’ the economy are attacked for an over-hasty budget tightening that triggered recession, they have an easy way to dismiss the critics.
How can you bring a deficit down with policy changes that would move it up? It’s a paradox that enables David Cameron and George Osborne to fend off the fiscal brickbats from Ed Miliband and Ed Balls, even when recoiling from such obvious embarrassments as a pre-Budget downgrade from a leading credit-rating agency.
It seems obvious that the only way to tighten a national budget is to reduce public spending and/or increase taxation. Indeed, this seemed so obvious that it was almost universally agreed among economists until the 1930s. And it’s still the view of many, who periodically propose ‘balanced budget amendments’ to national constitutions (where they’re written down) to make sure governments never let spending exceed their tax revenue in the first place.
It seems obvious, yet it’s wrong. As in ballooning, so with ballooning deficits: what goes down must sometimes first go up. The realisation that a budget deficit might be closed more rapidly by initially raising it, than by immediately trying to reduce it, was the breakthrough that launched modern economics amid the 1930s Great Depression. The fact that the post-2008 ‘Great Recession’ has now gone on longer than that nominally bigger downturn – with UK national output still below its pre-downturn level, and actually falling again during 2012 – suggests that it’s overdue for rediscovery.
While the prime minister correctly observes that Britain risks more downgrades if it dares to show ‘reduced commitment to fiscal consolidation’, he is wrong to characterise his opponents’ alternative strategy this way. In practice, both the Chancellor and his Shadow have a deficit reduction strategy, aimed at capping the rise in UK public debt. Imposing immediate spending cuts and tax increases is one approach. Postponing such action, and even reversing it, is another. As it turns out, the effort to cut the deficit immediately has had the opposite effect, and UK borrowing will be higher in 2012/13 than in 2011/12 (). Running a wider deficit two years ago might have led to a lower deficit now – as the US (after a post-recession ‘fiscal stimulus plan’) will continue to demonstrate, if it avoids a springtime reversion to sudden budget cuts.
The ability of a wider deficit now to generate a narrower deficit later arises from the ‘paradox of thrift’, a centuries-old observation that economists periodically rediscover when times get bad. If one person tries to save more, their savings go up. But if everyone tries to save more, their savings go down, because the lack of demand in the economy reduces production and shrinks their income (or throws them out of work). Similarly, if a government tries to reduce its deficit, and pay down debt, it can cause the economy to shrink, reducing its revenue and raising its spending obligations until the deficit actually widens. If it raises the deficit, resultant economic growth may create the conditions for later deficits to fall.
Public finances are not household finances writ large – they are fundamentally different, because of their impact on the macro-economy. But explaining the difference takes several chapters of an economics textbook (not quite as entertaining as a John O’Farrell novel). So the advocates of ‘expanding the deficit in order to shrink it’ can never quite win the argument, on the floor of the Commons or Congress, over the advocates of ‘expansionary contraction’. Perhaps, in the month a new Pope is chosen, Europe’s self-defeated budget cutters would do well to recall St Augustine’s wiser strategy: “Lord, please make me virtuous, but not just yet”.
Alan Shipman 4 March 2013
Alan Shipman is a lecturer in Economics at the Open University. He is responsible for the modules You and your money:personal finance in context and Personal investment in an uncertain world, part of the foundation degree in Financial Services.
The views expressed in this post, as in all posts on Society Matters, are the views of the author, not The Open University.
Cartoon by Catherine Pain
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