Wednesday, August 12, 2009

Where the record deficit comes from

The public finances are in a mess. Here’s a history (and Budget 2009 projections) of public sector net borrowing:

To see how we got to this soaring deficit, we need to look at two periods: BC (Before Crunch) and AD (Anno Debiti, in the year of our debt).

1: Before Crunch

For the six years from 2002 to 2008, Gordon Brown ran annual deficits in the range of 2.2 to 3.3% of GDP (average 2.8%). Not huge numbers, and indeed this period followed three years of surplus and one of balance. Brown can also truly say that the deficit in every single year of his chancellorship was lower than in every single year from 1991 to 1996.

But to run a modest deficit year after year during a period of decent growth and high employment – as the period before was not – is risky. You can get away with it for a while, especially if you’ve previously paid down a good chunk of the national debt, but it’s risky to let it go on. The economy might run into trouble.

Why did we have these deficits?

The Treasury forecasts of GDP growth during 2002-08 were a little optimistic, but not hugely so, and forecasts of government spending tended to be pretty good; the problem arose on the revenue side.

This graph shows government revenues relative to GDP (thick black line) compared with a series of Brown’s Budget forecasts (dotted coloured lines):

Year after year, Brown predicted the Treasury’s income was about to rise to 40% of GDP and above; in reality, it never even reached 39%. If revenues had come in as forecast, there would have been pretty much no deficit at all over this period. But when it became clear that the money persistently wasn’t appearing as expected, Brown should have raised taxes and/or rethought his spending plans to deal with the emerging structural deficit.

A couple of other points about the BC period bear notice.

First, there was a boom in the taxes coming from housing and finance, as Budget 2009 explains:

In 2002-03, financial and housing sector receipts were equivalent to 3 per cent of GDP. By 2007-08, these receipts had increased to 4¼ per cent of GDP. The rise in housing and financial sector receipts from 2002-03 to 2007-08 accounted for half of the increase in total current receipts over this period.

These revenues were of course most welcome, but this situation left the public finances more vulnerable to a financial and housing market crash – should there be such a thing.

Second, while the Treasury generally judged GDP growth not too badly, it seems to have overestimated the economy’s trend rate of sustainable growth – the speed the economy can grow without risking inflation. Indeed, on the standard measures, inflation was impressively low. Asset prices, however, were quietly bubbling up.

Robert Chote of the Institute for Fiscal Studies argues that the Treasury mistakenly raised its estimate of the trend rate under Brown, and thus failed to notice a widening output gap. Giles Wilkes of the CentreForum think-tank takes a similar view, although he notes: “This analysis benefits from considerable hindsight.”

True enough: back BC, other organisations took a similar view. As the National Audit Office judged in 2006:

The Treasury’s revised underlying growth rate assumption… is below the range of external forecasts of the long-term growth rate. It is also at or below the average of external forecasters’ medium term growth projections. On this basis the revised assumption is reasonable and cautious.

So, a common error. Wilkes observes:

In this way the Treasury’s mistake was remarkably similar to that made by the financial sector as a whole: to disregard high levels of debt as a potential limit on future growth. Had the government been aware of this limit, it might have recognised that the economy had grown faster than its sustainable rate, and that it needed a smaller budget deficit to be assured of balance over the cycle.

2: Anno Debiti

Looking at the explosion in public borrowing that has followed the recession, many have concluded that the bulk of this rise is due to what a paper by the Policy Exchange think-tank calls a “second surge in spending”. This graph, showing the Budget 2008 projections of government spending and revenue compared with the 2009 projections, seems to bear that view out:

There’s a significant but not massive fall in revenue, while the rise in spending truly is massive.

However, that graph misses one key fact: because its figures are as percentages of GDP, it overlooks the collapse in GDP. My next graph controls for this, giving the actual amounts spent and received (in constant 2007/08 prices):

(Cash numbers from Budget reports adjusted by GDP deflator.)

Quite a different picture. The rise in spending relative to the 2008 projections, while sizeable, is far exceeded by the fall in tax revenues.

Why is there such an apparent surge in spending as a share of GDP? Why is this happening to a far greater extent than during previous recessions? The short answer, as Wilkes says, is: “This is the first serious recession since inflation was defeated.”

GDP growth figures are normally given in real terms, controlling for inflation. But when you calculate something (debt, spending) as a share of GDP, you divide by nominal GDP – the cash value of the economy, which can go up due to genuine growth or to mere inflation. Roughly speaking, if economic activity stagnates but the price of everything rises 2%, then you have zero real growth even while nominal GDP rises 2%. Likewise, if a recession is accompanied by high inflation, nominal GDP can rise even as the economy contracts.

From 1979 Q2 to 1981 Q2, real GDP dropped by 5.9%. But because of the high inflation of the time, nominal GDP rose by 29%. From 1990 Q2 to 1992 Q2, real GDP fell by 2.5% but nominal GDP rose by 9%. There was government borrowing during both recessions, but when worked out as a share of GDP (still nominally increasing), it didn’t end up looking that bad.

In this recession, where inflation is very low bordering on the negative, nominal GDP is taking its first sustained fall in living memory. The result is that the rise in spending, borrowing and overall national debt as a share of GDP is magnified.

We should not be wishing we had high inflation, though. While it’s true it would be making the new debt smaller relative to GDP, it would also be making it more expensive to pay. High inflation makes the bond markets demand higher interest rates on government debt. Wilkes again:

a government that borrows when real rates are 6 per cent, as they were during Margaret Thatcher’s administration, requires a very good reason for doing so.
Conditions are now very different. The bond market lets the government borrow at a real cost of 2 per cent or less. The public debt amassed during this recession might well leave a smaller interest burden than that paid by the Thatcher government. It is far more rational to allow the fiscal deficit to take the strain during a recession when real rates are 2 per cent than when they are three times that level.

He argues that “collapsing nominal GDP” means that, to keep spending and borrowing down as a share of GDP “would have required unprecedented fiscal austerity through the slump”, which would have “prolonged the period of falling GDP, ultimately making the debt problem worse”.

3: The future

So what to do once the recovery is underway? Inflating your way out of debt is short-sighted folly; growing your way out of debt is a better strategy. There’s no denying that tax rises and spending cuts will both be needed, but if these are too soon or too big then they’ll risk stifling the recovery. It’s a delicate balance and I don’t envy the people who’ll have to strike it. I fear, though, the view that treats zealous fiscal tightening as a symbol of toughness.

I’ve quoted Giles Wilkes’s paper a few times – I highly recommend it, as it’s strong on analysis, even-handed on criticism and lucidly written. Probably the best thing I’ve read about the public finances, although I like to think my charts are prettier than his. I’ll finish by noting his dissection of the national debt in 2012/13.

Wilkes breaks down the projected increase in the national debt into different categories. Based on his calculations, almost 90% of the extra debt (not counting whatever the financial rescue packages end up costing) is due to a loss of tax revenues and only 10% to higher spending. Of the 90%, about a quarter is down to the loss of “volatile ‘bubble’ revenues” (e.g. from housing and finance), on which the Treasury had become over-reliant, and the rest to lower taxes from the rest of the ailing economy.

Furthermore, while 54% of the total debt in 2012/13 will simply be debt that there would have been anyway without the recession, Wilkes judges that three-tenths of this will be due to the structural deficit: while its origins were definitely BC, it’s still there and still pushing up borrowing. So a bit over a quarter of the total debt, he reckons, will be due to bad government policy and the rest the ‘ordinary’ effects of the recession.