The perils of obsessing over deficit reduction

19 Feb 16

Continued focus on deficit reduction risks neglecting the economy’s real vulnerabilities, upon which the health of public finances depends

Last month we saw that by December 2015 the chancellor had already exceeded his deficit target for the entire fiscal year (April 2015 to March 2016). January was the month when the exchequer had the opportunity to make up ground. The deadline for self-employed tax receipts makes last month one of only two in the year when the government can expect a surplus on its budget. Indeed, today’s figures estimate that there was a January surplus of around £11bn, leaving the government with room to borrow a further £7bn this year without breaching its target.

Nonetheless, it remains almost certain that the government will overshoot. We haven’t borrowed less than £9bn in the final two months of a fiscal year since the 1990s, and given recent subdued GDP and wage growth, we’re unlikely to do so now.

Yet missed deficit reduction targets are not the core problem – even if it is the sixth overshoot in six years since the chancellor took office. A discussion paper at the International Monetary Fund has argued that the cost of reducing debt (by cutting spending or reducing taxes) actually outweighs the ill effects from debt levels remaining constant, or rising slightly, in the short term. And this week the OECD called on the largest EU economies to ease austerity in view of prevailing headwinds in the global economy.

The problem, rather, is with obsessing over a single target that fails to capture the true health, or otherwise, of an economy – like a doctor refusing to use anything besides temperature to diagnose their patient. The risks of doing this are twofold.

First, we risk missing the economy’s genuine vulnerabilities. The most accurate way to gauge the size of the deficit is not in cash terms, but as a proportion of GDP. By far the most important element of that ratio is the denominator. If GDP is not getting bigger, there is little you can do with the numerator to put things right, without significant social and economic consequences. And whether it is slow investment or rising household debt, regional imbalances or one of the largest trade deficits in the developed world, the homegrown threats to growth remain substantial and unaddressed.

Second, our choice of fiscal policy has a direct impact on our ability to use monetary policy. With fiscal policy acting as a dampener on growth over the past five years, monetary policy has needed to remain ultra-loose to compensate, and even now, six years after we exited recession, the base rate is still close to zero.

This leaves us in serious danger of lacking the policy tools we need to respond in the event of another recession – which is especially important when you consider that, all else being equal, we are now likely to be closer to the next downturn than the last. It is ironic that deficit reduction is still being sold as the means of ensuring we have the ability to respond to a future crisis when in fact continued, excessive contraction is likely to do the opposite.

Disproportionate political focus on borrowing has embedded a popular aversion to public spending. The government has created a dangerous rod for its own back and likely for that of future governments too.

Ministers have been so successful in mis-selling deficit reduction as the be-all and end-all of economic debate, that when, like now, there is growing consensus among experts that further easing up is really needed, the political costs may prevent government from doing the right thing.

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