Seeking zero fiscal deficits is not a progressive endeavour

There was a most extraordinary Opinion piece in the British paper The Independent last weekend (June 13, 2015) – Labour should have managed the economy better when in power. It was written by the aspiring Labour spokesperson on business, innovation and skills, one Chuka Umunna, who in the days following their electoral loss advanced his name for leadership. His outlook, inasmuch at it represents where the British Labour Party is heading will render them irrelevant for years to to come (the Tories do this stuff better) and is almost indistinguishable from the growth strategy advanced by the Conservative Australian government in its most recent fiscal statement – more private debt driven by fiscal surpluses. We have been there before – it turned ugly as it always was going too. It is quite clear that comprehension of basic macroeconomics is light on the ground when it comes to Umunna and his ilk. A very sorry state.

The Australian government’s growth strategy announced in the May fiscal statement is clear – it wants to hack into public spending and exhort households and firms to make up the gap by borrowing more and putting the funds into housing.

Its as crude as that really. Last week, the Australian Treasurer claimed that property prices in Australia were not too high and, in the context of the rapidly inflating property market that (Source):

The starting point for a first homebuyer is to get a good job that pays good money. And if you’ve got a good job and pays good money and you have security in relation to that job, then you can go to the bank and you can borrow money. And that’s readily affordable, more affordable than ever to borrow money for a first home now than it’s ever been.

In defending his acerbic claims that housing was still affordable for those with the right motivations he thinks people should be out there borrowing to the hilt at a time when households are carrying record levels of debt after a decade or more prior to the GFC of credit bingeing.

It is true that interest rates have never been lower in Australia but the interest burden remains high (see graph below) because the average mortgage is now much greater than in the past. Compare the situation at the end of last year (most recent data) when the average mortgage rate was around 5.2 per cent with the situation in June 1989 when the interest rate was 17 per cent!

The other point is that with the massive debts already being carried by homebuyers, the situation will become worse when the RBA, at some point, starts pushing up rates again and house price rises start to taper.

Then things will start to get really ugly for those on the cusp of solvency already given the size of the debts they are carrying. I have also pointed out before that many younger families buying exorbitant houses on the fringes of the cities (because they cannot afford inner-city housing) rely on two incomes with the second earner being typically a casual worker (the female).

If the economy was to slow any further, the casual hours on offer will be the first line of adjustment for firms. These families, already at the limit, soon go overboard.

Any shift in interest rates upwards also has this effect.

With economic growth well below trend and unemployment high, and given that the external sector is draining spending, there is a need for Governments to be supporting private saving with increased public spending.

The obsession with cutting public spending to achieve surpluses can only mean that the government wants the private domestic sector to take on more debt than it already has to drive growth.

It is an idiotic strategy.

But it is one that presumably Mr Umunna in Britain will endorse for the Labour Party should it regain office in the future. That is the gist of his article in The Independent at the weekend (cited above) although I doubt he knows enough about macroeconomics to connect the dots properly.

He was reflecting on the reasons that British Labour lost the recent election – at a time when the Tories had delivered a poor performance over the last five years in office.

He claims that neither side of politics has “yet fully learned the lessons of the Noughties boom or the 2008-09 bust”. I agree, especially when we read on and see what he thinks it all meant.

He then wrote:

In 2007, before the crisis hit, the UK government was running a deficit. By historical standards, it was small and uncontroversial – it averaged 1.3 per cent from 1997 to 2007, compared with 3.2 per cent beforehand under 18 years of Tory rule. And yet to be running a deficit in 2007, after 15 years of economic growth, was still a mistake. My party’s failure to acknowledge that mistake compromised our ability to rebuild trust in 2010 and in 2015. If a government can’t run a surplus in the 15th year of an economic expansion, when can it run one?

Which tells all and sundry that Mr Umunna (or the economists who wrote the article for him) have no idea of how the macroeconomy really works.

What do we know about 2007-08? Well the fiscal deficit was 0.44 per cent of GDP and it accompanied an external deficit of 1.2 per cent of GDP.

In other words, the net contribution to demand from the government sector was not sufficient to offset the drain on demand from the external sector and as a consequence the private domestic sector continued to run a deficit (spending more than its income) of 0.8 per cent of GDP.

The private domestic deficit had fallen in the years leading up to 2007 but the household saving ratio (as a percent of disposable income) was still negative and had been negative since the December-quarter 2004. It only turned positive again (that is, households resumed saving) in the December-quarter 2008 as the reality of the crisis started to dawn on the excessively indebted British households.

The private investment ratio (capital formation as a percentage of GDP) had also fallen from 19.8 per cent in the second-quarter 2000 to 18.8 per cent in the December-quarter 2007.

So the dynamics of the private domestic deficit were being largely driven by household dissaving and increasing their indebtedness.

The economy was growing but in an unbalanced way – too much private debt and too small public deficits.

The statement “If a government can’t run a surplus in the 15th year of an economic expansion, when can it run one?” implies that there is something inevitable about a government running a fiscal surplus, just because there is on-going growth.

It seems to escape Mr Umunna’s grasp that the continuous growth was aided by the fiscal deficits and would have come to a crunch much earlier, given the private debt escalation, had the government tried to run a fiscal surplus.

To answer his question, a nation can safely run a fiscal surplus if the external sector is adding so much to spending in the domestic economy that the government can provide an appropriate level of services and the desires of the private domestic sector to save can be met.

Continuous growth that was associated with relatively large external deficits and unsustainable private sector credit expansion, would not suggest a fiscal surplus was appropriate, especially when there was not evidence that the British economy was operating at over-full employment (small output gaps).

So in what sense was it a mistake for the government to be running a deficit even though there had been a long period of growth (presumably supported, in part, by the deficits)?

Presumably, the growth and high employment levels meant that the fiscal deficit that was remaining was not of a cyclical nature (that is, driven by movements in the automatic stabilisers because tax revenues were well below high employment levels).

The question then is whether the ‘structural component’ of the fiscal balance (reflecting the discretionary spending and taxation choices of government) is appropriate in relation to achieving full employment given the choices made by the private sector and the external sector.

Given the data above, it is clear that the fiscal deficit in 2007-08 was probably too small but a surplus would have been irresponsible.

Please read my blog – The full employment budget deficit condition – for more discussion on this point.

Umunna then excelled in his ignorance with this gem:

Our goal now must be to show that we have learned the lessons from this past … It starts by asserting again and again that reducing the deficit is a progressive endeavour – we seek to balance the books because it is the right thing to do.

Of course, he offers no insights as to why this is the right thing to do for Britain.

How is he going to create external surpluses that are of sufficient magnitude to meet the desires of the private domestic sector to net save, while at the same time, ensuring overall spending is sufficient to achieve full employment and allow the government sufficient spending scope to provide first-class public services and robust public infrastructure development?

Given history and the current circumstances, I would think an on-going fiscal deficit – larger than it is now – is the “right thing to do” if the well-being of the British people is to be advanced.

Britain will not generate large external surpluses in the foreseeable future, which means the only way that the private debt situation can be brought under control without driving the economy back into recession, is for the government to increase its fiscal deficits.

The rest of his article talks is full of motherhood statements about improving productivity, exports, being pro-business and all the rest of the guff.

But none of that is achievable (or sustainable) unless the British Labour Party starts to understand that they cannot rely on increasing private indebtedness to drive growth. And once they realise that, they will understand that the alternative is that fiscal deficits have to support the private sector’s debt reductions.

Umunna should read the Bank of England article – Household debt and spending – which appeared in the third-quarter 2014 edition of its Quarterly Bulletin.

The research reported was the “first study to use microdata to assess the role of debt levels in determining UK households’ spending patterns over the course of the recent recession”.

It demonstrates that:

high levels of household debt have been associated with deeper downturns and more protracted recoveries in the United Kingdom.

It traces “the build-up of household debt” in the UK before the GFC from around 100% of income in 1999 to 160 per cent in 2008. The same sort of dynamic occurred in Australia as a result of the property boom here.

It also notes that the “capital gearing” ratio, which is the “measure the stock of debt in relation to the value of assets” rose dramatically before the crisis because asset prices fell sharply.

The significant part of the Bank’s research pertains to the contention that rising household debt levels reduce household spending in aggregate. By way of theoretical motivation for the idea, they note that if:

… indebted households, who had borrowed on the expectation of higher future income, suffer adverse shocks to their future income expectations that lead them to consume less and repay debt. Even if other households experience offsetting positive shocks, they do not increase consumption by enough to fully offset the effect on aggregate spending.

What is the evidence for this contention? Even though the rise in household debt in the UK was “largely matched by a build-up in assets” the evidence is that:

… across countries, recessions preceded by large increases in household debt tend to be more severe and protracted, but there is less evidence that the level of pre-crisis debt is a good predictor of the subsequent adjustment in spending.

The UK evidence supports the international findings. The research finds that “UK households with high levels of mortgage debt made larger adjustments in spending after 2007”. The reductions “in spending were more modest for those with debt to income ratios below 2”.

Prior to the crisis, the spending by highly indebted households grew faster than for other groups. It was mostly on “durables and non-essential categories of spending” and after the crisis the spending cuts in these areas were large.

The researchers thus find that “highly indebted UK households’ spending appears to be more sensitive to economic shocks” which means that a growth strategy relying on rising household indebtedness from already elevated levels is likely to be highly unstable and lead to a deep unwinding when the cycle turns.

The reasons advanced for the large post-crisis cuts in spending by highly indebted households included:

1. “Highly indebted households were disproportionately affected by tighter credit conditions”.

2. “Highly indebted households became more concerned about their ability to make future repayments”.

3. “Highly indebted households may have made larger adjustments to future income expectations”.

The implications of the research are clear.

Once the private domestic sector becomes highly indebted relative to its income, the consequences of changes in the economic environment – for example, a downward revision of future income expectations as a result of uncertainty with respect to employment etc – will generate much larger downturns and more protracted recoveries.

The UK profile since 2008 supports this view as does the Australian experiences, both nations with highly indebted households.

Conclusion

The results thus indicate that the pursuit of fiscal surpluses which might lead to declining public debt to GDP ratios (because no new debt is issued yet GDP grows) as long as private spending is strong enough as a result of rising indebtedness, will run the significant (almost certain) risk of precipitating a major recession.

Mr Umunna appears to be blithely unaware of these dynamics and the sectoral relationships at the macroeconomic level, which dictate, as a matter of national accounting, that a government surplus must lead to a non-government deficit.

The latter must mean rising non-government indebtedness, which is eventually, unsustainable and as the Bank of England’s research shows creates larger swings and weaker recoveries the more indebted the private sector becomes.

Despite Mr Umunna’s assertions, it is not “a progressive endeavour” for a government to “seek to balance the books”. It is more like a certain recipe for entrenched unemployment and stagnant income growth.

The British Labour Party should expunge these sorts of positions from their policy platform.

That is enough for today!

(c) Copyright 2015 William Mitchell. All Rights Reserved.