A UK Recovery Program: Go Keynesian (Part 2)

by John Weeks

The latest statistics show that real household earnings in Britain fell by 3.5% over the last year (The Guardian24 November 2011), a decline unprecedented in peacetime.  What can be done to stop this unfolding disaster? While the private sector is dangerously in debt (“over-leveraged”), the public sector is not as I showed in my last article.  On the contrary, by any accepted financial measure, the UK government is under-indebted, the ratio of net debt to GDP, debt service capacity or marginal borrowing cost.

The solution to falling comes and the looming second recession is for the government to borrow and spend.  If that sounds like bad economics, it is only because the economics profession degenerated into free market metaphysics long ago, turning out reactionary propaganda against rational policy.

To be rational for a moment, begin with the basic policy questions: 1) how much borrowing would be necessary to fund the stimulus to revive the economy;  2) how much would the deficit increase as a result; and 3) how would the deficit subsequently be reduced?  We have been through this numerous times in many countries, notably in the United States in the 1990s.  When Bill Clinton became president at the end of a recession in 1993, the federal budget balance was a negative US$ 290 billion.  When his successor Bush II gave his inauguration address in January 2001, that negative 290 billion had become a positive US$ 236 billion  (see the statistical tables in the Economic Report of the President 2011).  The dramatic reversal was not the result of either tax increases or expenditure cuts (spending increased every year).  It resulted from eight years of growth at over four percent per year on average.

National income grows, taxes increase and deficits disappear (“structural” or otherwise), not terribly complicated to understand if one is non-ideological.  Not only do tax revenues rise with growth, some expenditures fall – on unemployment compensation and a range of family support payments.  Growth undermines the deficit (not the reverse) like the blades of scissors, cutting into it with more revenue and less expenditure.  Indeed, if the Coalition ideologues have concern for the impact of current policy on future generations, they might shed fewer tears over debt service and more on unemployment payments which are considerably larger.

How much additional borrowing would be necessary to stimulate growth depends on the growth target.  My calculations (available on request) suggest that if the Coalition had increased public expenditure by two percentage points of GDP in 2011 instead of reducing it, output would have grown at two percent rather than stagnated below 0.5 percent.  This is less than the three percent growth rate 1994-2007, thus modest by past performance.  The two percent expenditure estimate would compensate for the fall in private investment in 2010.  This is pragmatic policy – when the private sector’s expenditures and expectations are depressed, the public sector temporarily takes the lead.

The obvious initial impact of an increase in borrowing of two percentage points is to raise the deficit by the same amount.  Almost immediately the growth from the fiscal stimulus begins to generate more tax revenue and reduce recession-linked expenditures.  Estimating how much the one would rise and the other would fall requires a bit of calculation.  To keep things simple, I show my estimates in shares of national income in the chart.  Economic growth at a steady two percent per annum, starting this year, would reduce the public deficit to four percent by 2015 (when the current parliament would end if it runs its full term, heaven forbid), and come into balance before the end of the decade.

While the calculations are approximate, the central point holds generally:  with the economy is depressed it makes economic sense for the UK government to borrow for a fiscal stimulus, and thus reduce the public sector deficit through growth.  Almost any growth rate no matter how low reduces the deficit through the effect of rising income on tax revenue.  In a depressed economy, it falls to governments to provide the demand stimulus for growth, which is most effectively done through fiscal expansion.  To put it simply, the fiscal stimulus is funded by borrowing, and this borrowing is self-liquidating through the growth it generates.

The process is a quite straight-forward one, considerably easier to understand than fairy tales about cutting basic public services bringing us prosperity.  The government increases borrowing and distributes the funds between current and capital expenditures (about £30 billion in total).  The current expenditure might be to the National Health Service, state school running costs and university education.  The capital expenditure could be quickly allocated to the back-log of repair and expansion needed in health, education and transport.

The increased public expenditure creates an excess demand by households and businesses that is partly met by imports, but most of it by domestic production (about 70 percent).  The rise in household demand and the increased public investment induce private companies to invest to meet the expanding demand, tax revenue rises, unemployment and welfare benefits fall, and the recovery is underway with the public deficit falling.

Growth, less unemployment, less poverty and a lower deficit.  Of course, the Coalition could go for budget cuts, stagnation, rising unemployment, more poverty and a larger deficit.  But politicians are not that stupid, are they?

John Weeks is an economist and Professor Emeritus at SOAS, University of London. John received his PhD in economics from the University of Michigan, Ann Arbor, in 1969.

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