Probability of Osborne Hitting his Surplus Target? Around 0%. Here's why.

Last month, when UK Chancellor George Osborne set out his budget, the Office for Budget Responsibility issued its outlook for the next few years. It judged that the probability of Osborne hitting his self-imposed target of achieving a budget surplus in 2020 was a little greater than 50%. Remember that Osborne not only wants to hit this target in 2020 but wants to make legislation that forces all governments to do the same in the future.

This is insane. The government must run deficits; I discuss here why we actually need to run much larger ones. And the probability of Osborne hitting that target without heavy financial engineering is, in my opinion 0% (rounded to the nearest percent).

Running a surplus is extremely rare. The reason is that for nominal GDP growth, more money must be spent every year than the year before. On top of this, the structure of our economy is such that we end up, on average, saving a small proportion of money from GDP each year, taking money out of the system. The saving needs to be replaced, and the extra demand for goods and services must come from somewhere.

On occasions this may come from high confidence leading to people spending more of their savings than the amount lost to new saving. But typically the money needed to grow the economy comes either from new private sector debt or new government debt.

The detail of my Demand Based Cash Flow model as well as my empirical findings are in my paper, which I recommend reading, but very briefly...  A 10% of GDP increase in private sector debt corresponds to around 1.5% economic growth in the year that it is taken out. Note that this multiplier is a lot lower than that commonly calculated for government debt (normally around 1), so government debt is much more stimulatory. And the bad news is that it exerts a drag on economic growth from then on. The drag is significant - maybe a 0.15% loss of  NGDP growth per year every year until it is repaid.

Private sector debt in UK, and worldwide, is now very high. This, in my opinion, is the reason for our current economic stagnation and the reason that we are at zero interest rates.

The mechanism that this works through is that the higher debt is, the more of GDP that goes to paying interest payments rather than wages. This is both by corporations and by individuals. On top of this higher debt means more demand for houses as well as lower interest rates - this leads to higher house prices and in turn higher rents.

This means even more money goes to savers/investors in an economy rather than workers. People tend to spend most of their wages but interest and dividends are often just accumulated in pension funds or other saving vehicles. So the marginal propensity to spend of workers is higher than that of savers.

For this reason, as debt has risen, demand has fallen. And the saving rate of the economy (which I define as the amount of GDP in year t that is not spent again in year t+1) has grown to around 3% of GDP each year.

Other factors contribute. The ability of corporations to achieve higher profit margins by suppressing wages is one.

And the intermediate step between both of these and lower NGDP growth is a shrinking of worker share of GDP (after rental payments).

I would like to thank Duncan Weldon for both the idea to look at this as well as the glorious spreadsheet that he directed me to with three centuries of economic data for the UK.

I made an estimate for worker share of GDP growth, following Weldon's example. The numerator is (compensation per employee x total people in employment) minus (estimated rent per property x total people in employment). The denominator is Nominal GDP minus (estimated rent per property x total people in employment). So an approximation for (wages minus rent), divided by (NGDP minus rent). The rent per property is estimated at 5% of the property value.

I plotted this worker share of GDP growth against the average government deficit for the subsequent ten years. Although in any one year the government deficit can be volatile, over a ten year period one can get an idea of how much demand needs to be replaced.

The graph looks like this:

It is not a perfect fit, but considering that it is just one factor in a complex system, it is reasonably close. I would argue that there does appear to be a strong relationship, especially if one ignores the immediate post-war period.

I also have private debt figures from 1963 onwards from BIS. The private debt level is -78% correlated to the above worker share measure. The level of private debt is also -61% correlated to the ten year average government balance. The three series appear to be linked; as predicted by my DBCF model. Also, much earlier, by Steve Keen, whose work is invaluable for more understanding of the role of debt.

From the graph it can be seen that with the current low level of worker share of GDP the economy is structurally saving considerably too much to allow the government to eliminate the deficit. Unless the worker share of GDP can be increased, and unless more money goes to people who will spend rather than save, then the economy can not bear the cost of a government surplus.

The graph actually suggests that deficits are too small. This, in my view, is the reason that NGDP growth is so much lower than trend. Higher deficits are really needed. The damage already done to the UK's productivity by Osborne's misguided policy is huge; this graph shows the sudden stop in 2008.

As Frances Coppola says, it is not the benefits to the disabled that are unaffordable but the chancellor himself. It could be argued that appropriate fiscal policy would have allowed a continuation of trend growth, in which case Osborne is responsible for a current annual loss of around 10% of UK GDP.

You may argue that a surplus has been achieved in the past so why can't it be done again? But there is a big difference here. When Gordon Brown in the UK or Bill Clinton in the US achieved budget surpluses they did so by allowing private sector debt to grow very quickly. At the time we had not hit the high levels of private sector debt and this was not too difficult. The budget surpluses were compensated for by lower interest rates and debt grew.

This is not possible now, though. Private sector debt has hit such a high level, and subsequently house prices are so high, that even zero interest rates can not stimulate enough new private sector debt to compensate for no government deficits. The current account deficit also makes it harder.

It is, of course, possible to get a surplus by simply cutting spending by enough. The problem for Osborne is that every cut makes the economy worse, leading to lower tax revenues. The target will just keep moving further and further away as he approaches it.

Now, I think that the increase in the minimum wage may make a small improvement here; only time will tell. But I also think that the benefits of this may be lost because of other budget measures that take from those with a high MPC (eg lowering tax credits) and give to those with low MPC (eg lowering inheritance and capital gains tax).

In conclusion, I think it totally impossible that Osborne reach his surplus target. I think that the Office of Budget Responsibility has models that do not properly include the feedback from lowering spending. And that what it calls budget responsibility is actually gross irresponsibility.

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Does Saving Equal Investment?

Tax policy in the UK is quite heavily skewed towards encouraging saving. Tax on capital gains is lower than that on income and ISAs and pensions give many tax advantages. The recent budget gave even more benefits to savers than they previously had. In fact, it is a stated aim of the government to encourage saving.

There are a number of reasons for this; one is that these policies tend to reward people who are more likely to vote at the expense of those less likely. A less self-serving motivation for the government is that saving is important because saving means that people will be able to fund their old age and not rely on everyone else.

This argument is, I think, fallacious. In the end, the economy of the future supports those not working, meaning non-workers will always rely on workers. This means that production will have to be high enough to give the required standard of living to everyone. Whether people have money saved up or not only determines the distribution of the future production, not the level.

My saving for my pension means one thing. It means that I will get a larger share of the work of others in the future than I would have received had I not saved. So if anything, it is the people who saved who are a larger burden on those in the future than those who did not save.

This takes us back to the ridiculous (and, time will prove, futile) attempts by the Chancellor to bring the government budget to surplus, as if government debt is an intergenerational transfer from the future to now. As I have said many times, the main ways we can take from the future is by not investing in our productive capacity now, or by damaging the environment. Other than that, all we impact is the distribution of money in the future.

And in that sense, the high house prices (and also other asset prices) due to using monetary policy rather than fiscal policy to boost the economy are a real inter-generational transfer.

In the end, as I argue here, I believe that the decisions to protect savers are very damaging to the economy as they come at the expense of workers; a group whose share of the economy has been falling rapidly over the years, and on whom the economy relies.

But when watching an old Newsnight clip on Frances Coppola's website, I was struck by the comment from the host about government policy:

We must rebalance the economy in favour of saving rather than consumption.

This suggests something virtuous and useful about saving, and Frances goes into more detail. It is the idea that savings are needed for investment.

I would not argue with the idea that the ratio of productive investment to consumption should be higher. If the argument was to rebalance from consumption to investment, I would not disagree. But the quote above is not saying the same thing. It says that we should save more money because it equates saving money with investment.

So, is saving needed in order for us to have money to invest?

I believe the idea that we need individuals to save is a fallacy and to some extent can be traced to Keynes' identity that savings must equal investment. This is true by Keynes' definition, because all production that is not consumed (or presumably just wasted) must either be on investment or an increase in inventories, which is also defined as investment.

But I would say that this is the wrong way round. Investment is, by Keynes' definition, saving. It is work done with expectation of consumption in the future rather than now. But saving money is not investment. Saving money either reduces consumption or increases inventories (which is not my definition of investment).


As an example, supposing I have £100 and my choices are either to save £10 or to buy a quantity of X for £10. The supplier of X can either a) create more of X by using 1 hour of labour, costing £8 and making £2 profit. Or b) she can increase margins on her goods, slightly increasing inflation and making a £10 profit.

In case a) my savings get passed on to the worker and business owner, in case b) my savings get passed just to the business owner. But in both cases the savings still exist. They just get transferred, but now they can be spent again by the recipients and again by the recipients of that money.

All I have done to the economy by saving money is reduced the hours worked by the worker (and future workers down the chain) and thus economic output.

Now ask yourself, who is more likely to invest in increasing future capacity? A business owner with more demand and higher profit or one with less and lower respectively? I would argue that the more people save the less productive investment gets made.

And this result can be seen across the developed world as despite a 'savings glut' we still have low levels of investment.

So where does the money come from for investment? If a company wants to invest then they can do so either with retained profit or by borrowing money. But they do not need to borrow money from savers for this.

Money creation in the modern economy does not require saving in order to produce credit. Banks and corporations are able to create debt (hence effectively new money) at will. Literally no-one needs to save for there to be investment.

Here is an example of  academic literature stating that "over the longer run, higher personal saving would lead to stronger economic growth". They point out that " a country’s saving rate and its investment rate remains large and significant". However, a country's saving rate is not the same as individuals saving. A country with a high saving rate is typically one where wages have been supressed maybe by currency manipulation, tariffs or wage agreements. This means that a higher share of the GDP goes to firms and the governmnent. And typically this policy is linked to a policy of high investment. Because investment is defined as saving then countries with high investment must also have high saving.

But I would call investment 'spending', rather than 'saving'.  And by my definition of saving, the saving rate has been rising over the last 40 years because more and more money, as a share of GDP, goes in dividends and interest payments and less on wages. And the marginal propensity to spend of savers is lower than that of workers, hence the saving rate in the economy is higher (even if the saving rate of workers is lower). By my definition, far more of GDP is saved than 40 years ago, and at the same time, investment has gone down.

For an economy to work well, money needs to keep flowing around it. Savers stop the money from flowing and consequently this lost demand needs to be replaced either with private or public sector debt. If the demand is not replaced then NGDP growth stalls.

The savers can keep the money in bank accounts, effectively removing it from the economy. But what if they invest in shares? Isn't this investment? No, it just transfers the money to other savers. Buying shares in a company is often called investment, but unless it is when the shares are first issued and the money was intended for productive investment, then all it is doing is passing money to another saver and increasing the price of the shares. Ditto for investing in already built property.

Unless money is specifically spent on investment then more saving has a negative effect on investment.

In conclusion, investment is saving but saving is not investment. The reason this can be true is that in the first part I define saving as 'consumption deferred', and in the second part it is just 'saving money'. And the point of the post is that we need to encourage investment or consumption but not saving.

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A Current Account Surplus is Obviously a Good Thing. Isn't it?

After my recent Coppola Comment post on a theoretical framework for making the Eurozone a genuinely viable currency union, I received a number of interesting comments in opposition to the idea.

There were three main ideas in the criticisms. The first is that it is politically impossible. This, I am inclined to agree with although, as Frances says, we have to try. Germany would never agree to this because it goes against their idea of economics. In fact, I would say that the Germans don't actually consider there to be any problem with the structure of the Euro, only the irresponsibility of the debtors.

I suppose really the point of the post was trying to plot out a minimum required level of cooperation for the Euro to be viable. Otherwise, the structural problems are so severe the best option for everyone would be a break-up.

The second criticism was of the blank cheque that it gives to governments within the Eurozone. Here I argue that all it gives is the same blank cheque that every other sovereign government has. And it is a 'blank cheque' that is necesary for sustainable economic growth. However, in order to avoid abuse, then any plan of this nature would probably need synchronisation of certain tax and spending policies. This may be unpalatable, but still is preferable to the alternative.

The third criticism is similar to the the first, but differs on a key point. It says not just that Germany won't agree, but that they should not agree to give up their victory in attaining a current account surplus. The idea is that it is not in Germany's interest to run a current account deficit for a while. On this, I disagree completely. I actually don't believe that running a current account surplus is necessarily a victory at all.

There are some circumstances when a current account surplus is a good policy. One obvious one is for producers of natural resources, who wish to both prevent their domestic economy from over-heating as well as save up for the future some of the value of the extracted resources.

Another would be for a small state to build up some kind of buffer against future uncertainty. In this case, the effect of their policy is tiny compared to the size of the economy that they are building up savings in.

But for a state with the size and level of development of Germany it really gives no advantage whatsoever, and actually many disadvantages when it affects the economic growth of its neighbours so badly as I  discuss in the Coppola Comment article.

Persistently running a current account deficit in a fixed currency regime [edited; thanks Frances (in comments)] is clearly a bad thing, and I am not saying that it is OK to have a deficit. I am saying that there is no symmetry here. For the reason for this, we need to look at what actually happens to create a surplus. The wages/purchasing power of the surplus country is artificially kept low, either by currency manipulation, tariffs or (as in Germany's case) wage agreements. This makes the saving rate in the economy artificially high. And these excess savings must be invested somewhere, and this somewhere must be abroad. The surplus country thus creates savings in the deficit country.

There is no increase in demand in the surplus country as the increase in exports is counterbalanced by a decrease in domestic demand. But there is a reduction in demand in the deficit country. The net effect is a reduction in world demand. It is a negative sum game.

It is true that Germany is building up credits with the rest of the world. The claims of Germany on future production by the rest of the world are growing every year by a large amount. But the thing about these claims is that at some point they need to be spent. If not, they are worthless tokens.

When is Germany planning to spend these tokens? If never, then why are they working so hard and forgoing consumption now to build these piles of bonds and equities. This is even ignoring the fact that the less competitive parts of the Eurozone are suffering an economic strangulation in the collateral damage of this policy.

It's all very well talking theoretically about the effects of a current account surplus. I would argue that these are accounting identities, but nevertheless, people will still claim that running a current account surplus is good for growth. So I have looked at OECD data for developed economies for the past 18 years.

Below is the result for Current Account Balance plotted against RGDP growth for 423 country years. I have excluded a few large outliers on either side by limiting the deficit to -10% and surplus to +15% (the assymmetry is because there are fewer surplus countries). I have also provided best fit lines. I have divided the graph into two halves, surpluses and deficits.

This graph very clearly shows no correlation between surpluses and RGDP growth. This is exactly as the above argument suggests it should be. Saving in a foreign currency does not help your growth at all.

This is really the main point I am trying to make - that for Germany to run a deficit will not hurt their economic growth at all, just spend some of the many claims that they have on the rest of the world.

An (I think) interesting aside 
 

You can stop reading now, unless you, like me, are interested in the interaction between the current account and both private and public sector debt.

An interesting feature of this graph is that it shows that higher deficits are correlated with  higher economic growth. This would seem counter-intuitive because a deficit means that demand is taken from the domestic economy. Here, one probably needs to look at the line of causation. A booming economy will be more likely to receive investments from abroad and will pay higher returns on that investment. This means a large current account deficit. The effect of this confidence could well outweigh the negative demand impacts.

Looking at private sector credit growth gives more explanation. Here the same is plotted but on the y-axis is the change in private sector debt year on year, divided by GDP.

 

The higher deficit countries have the highest increase in private sector debt to GDP too. This is both a symptom of the confidence in the economy (/bubble) and a cause of greater GDP growth despite the deficit.

There also appears to be higher creation of private sector debt to GDP in the large surplus countries. Here it may be something about the investment led growth model being followed, and much of the increase may be for investment rather than bubble building or consumption.

For completeness, it is also interesting to look at how the current account balance affects public sector debt to GDP.

 

On the positive side of the graph, as one would expect given a current account surplus and higher private sector debt creation, we see a declining government deficit. More interesting is the negative side, which shows that government deficit actually reduces with a higher current account deficit. This could be due to the higher confidence and higher private sector debt creation that goes hand in hand with the type of high confidence (arguably misplaced) economy that runs large current account deficits.

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