Posts tagged “deficit”

Government money and saving
How private sector saving affects the fiscal multiplier and the government's budget

In the last post we looked at they way in which government spending and taxation interacts with the circular flow of money. In particular, we found that, in an economy with no saving, money introduced by the government is repeatedly spent creating additional income beyond that created by the initial government spending. Since the government collects an income tax on each transaction, the money introduced by the government spending is gradually withdrawn as it is re-spent. This "leakage" of money out of circulation places a limit on the total amount of spending and income that can ultimately arise. The eventual total level of aggregate income was shown to be a multiple, \(\frac {1}{\theta}\), of the initial government spend (where \(\theta\) is the tax rate). Here we'll consider what changes in this story when the population decide to save some of their income.

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The best kept secret in politics
Taxing does not funding government spending. So what is it for?

A few years ago I was on the long train journey from London back to Glasgow with my friend, Andrew. We were talking about economics, of which neither of us had any particular expertise, but both had an increasing interest. As Andrew was explaining to me what he had recently learned about John Law and the South Sea Bubble, a stranger sharing our table interjected to confirm something in the account. It turned out that this stranger knew a thing or two about economics and we ended up chatting at some length. The stranger was Chris Cook and he casually asserted two things that astonished me.

The two claims were:

  1. Banks do not lend out their customers’ money
  2. Governments do not spend taxpayers money

Obvious, eh? Well, not to me at the time. I think the first claim is probably less perplexing than the second one, as many people have some vague idea that banks somehow lend out more than they receive. In any case, I pretty quickly satisfied myself that it was true by learning how money is created by banks when loans are issued. But the second claim took a bit more work and that is what I want to focus on here.

So the government doesn’t spend its tax revenues? Then what are taxes for? And what does the government spend?

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The Deficit Puzzle
Are government's books ever balanced over the long term? And should they be?

A government “budget deficit” is the difference between government spending and tax revenue for any given time period (e.g. a year). In the UK it is officially labelled “Public Sector Net Borrowing”, because any spending deficit is covered by issuing government debt.

The deficit and debt of the government have been discussed intensively by politicians and the media in the UK over the past 5 years - particularly in the lead up to the recent general election. Most discussion of these issues revolves around the idea that large government deficits and debts are a problem as they represent the government “living beyond it’s means” and unjustly burdening the “next generation” with debt. This meme has had enormous success, with all the main parties in the UK accepting the need to reduce spending with an ultimate aim of bringing government finances into a position of surplus (tax > spending) within some stated time frame. A government budget surplus is therefore prized as an indicator of responsible management of the government finances and the economy in general.

Some data

Here’s a curious thing. The charts below show the state of the UK and US government finances through the post war period quoted relative to Gross Domestic Product (GDP). For the period 1956-2007 (omitting the Global Financial Crisis (GFC)), the UK government budget was in deficit during 174 of 208 quarters, that is, 84% of the time. On average, the government balance was not zero, but was equal to a deficit of 2.38% of GDP.

For the US government, the period 1947-2007 (omitting WWII and the GFC) experienced a budget deficit for 49 out of 60 years (80%). On average, the US government budget was in deficit equal to 1.5% of GDP for the whole time period and 2.5% of GDP since 1975. Since the US data also include absolute dollar values of the budget position, the net deficit over the period can be calculated at $8 trillion dollars (corrected to FY 2009 dollars), or $16 trillion dollars if WWII and the GFC are included.

To anyone who has been listening to the main political parties or media commentators in the UK over the past 5 years, this should be extremely puzzling. Aren’t we told that the “books” should be balanced each year, with governments only spending what is collected in tax? Yet government finances in both the UK and US have been almost entirely in deficit for six decades! A more nuanced view might agree that a budget deficit is to be expected during a recession - when tax revenues fall and social security payments rise. But in such a case, surely the temporary spending deficits are “paid for” by budget surpluses during the “good times”. In other words, the books should be balanced “over the business cycle”. But again, looking at the historical data, which spans multiple recessions, it is clear that the books are not remotely balanced over any business cycle or longer time scales.

There is a way to explain this, and it paints quite a different picture of the role of government (and government debt) in the economy to that normally offered by mainstream media and politicians. It is, however, pretty basic macroeconomics!

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