Mr Osborne Meets Mr Micawber

Philip Arestis and Malcolm Sawyer

In his budget speech of July 10, following an earlier announcement in a speech at the Mansion House, London, on June 10, UK Chancellor of the Exchequer George Osborne announced his intention to put into place a “budget surplus” rule, which would require a  surplus in “normal times.” Although a more extreme version, this new rule follows the pattern established by the European Fiscal Compact and the change to the German constitution in 2006 to require a balance in the “structural budget.” It appears without any economic rationale as to why a budget balance or surplus would be desirable or achievable.

In Charles Dickens’ David Copperfield, Mr Micawber considers that “Annual income twenty pounds, annual expenditure nineteen [pounds] nineteen [shillings] and six [pence], result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” The rationale for a “budget surplus” would appear to run along these lines.

But Mr Micawber did not have to consider the implications of his dictum. The excess of income over expenditure may bring him happiness, but is there someone to whom he can lend his sixpence?  In other words, he may wish to save but there has to be someone willing to borrow from him. He does not have to consider the effects his actions have on employment through his failure to spend. He does not have to consider whether he would have been well advised to spend more on investing for the future. The government should, of course, take into account such considerations. It should take into account the impact its spending and tax decisions have for the economy.

Everyone should know, but most politicians and commentators do not, that there is a sectoral balance relationship resulting from the observation that one person’s borrowing is another person’s lending. At the sectoral level this becomes: budget deficit equals private savings minus private investment plus capital account inflow (and hence equal to negative current account balance of exports minus imports plus net income flow). It is then simple to observe that if the budget deficit is to be zero or negative (balanced budget or surplus) then there has to be some combination of investment exceeding savings and capital account in deficit (current account in surplus). The move from a budget deficit to a budget surplus has to be associated with some combination of lower savings, higher investment, lower imports, higher exports (and net income from abroad). A change which comes from lower savings and lower imports is likely to involve lower income; a change which comes from higher investment and higher exports (and net income from abroad), higher income. Attempting to reduce a budget deficit through expenditure cuts and tax rises is likely to involve lower income; attempting to a reduce budget deficit through stimulation of investment and exports, higher income. It is clear that the achievement of a budget surplus requires some combination of a deficit of savings to investment and a current account surplus.

In the summer of 2010, the incoming Coalition government in the UK set out to virtually eliminate the inherited budget deficit by 2015-16. The discussion above indicates that in order to succeed in that there would have to be accompanying expansion of investment and net exports. The forecasts made in late 2010, which supported such an outcome, are given in the second line of Table 1. In the event, these optimistic forecasts did not materialise as can be seen from the third line of Table 1. As a result the budget deficit did not close to the degree intended.

Table 1: Comparison of November 2010 forecasts and outcomes

Source: Calculated from Office for Budget Responsibility (OBR) spread sheets

Yet to reach a small deficit would have recorded major changes in investment and export performance as compared with earlier years.

In the budget of July 2015, the UK government’s intention was expressed in terms of the elimination of the budget deficit by 2019-20. The OBR’s central forecast was for a small surplus of 0.4% of GDP in 2019-20 and 0.5% the following year. Alongside that the forecast included continuously rising household debt. This had peaked in 2008Q1 at 168.7% of income; having fallen to just over 140% in 2013-14, rises continuously (according to the forecast) to surpass the previous peak level in 2020Q2. Investment income from abroad moves investment income, which is forecast to move from a deficit of £50.7 billion in 2014-15 to a surplus of £5.7 billion in 2019-20; and the overall current account deficit of £111.9 billions in 2014-15 moves to a deficit of £63.4 billion by 2020-21. Business investment is forecast to increase by 35% between 2015-16 and 2020-21. Exports and imports are forecast to grow at much the same rate (around 23%), but the current account deficit falls sharply through a forecast rebound of investment income from abroad. GDP is forecast to grow over the period by 12.6%. These events may happen, and if they did then indeed there would be a small budget surplus. But, and even according to the OBR, there is around a 45% chance that there will not be a budget surplus. Indeed on their estimates there is a 10% chance that the deficit will be greater than 4.1% of GDP, and also a 10% chance of a surplus greater than 3.6% of GDP.

The main argument here is that setting an arbitrary budget target without consideration of whether the macroeconomic conditions of an economy are consistent with achieving that target is foolhardy and irresponsible. Building in a “budget surplus” rule (or similar) in perpetuity compounds the irresponsibility. We have illustrated this for the UK in the following ways. The attempt to have a balanced budget in the first half of the 2010s failed when investment and exports did not grow as rapidly as forecast. The attempt to balance the budget in the second half of the 2010s is based on an investment boom, rapid drop in investment income, and a rising household debt depressing savings. These may be achieved, but would not be sustainable, and hence even if a small budget surplus is achieved it could not be sustained. A minimum requirement for pursuing a budget rule such as a balanced budget or budget surplus should be to evaluate whether private sector behaviour would be consistent with the achievement of the target in a sustainable manner. Our evaluation of the UK case is that private sector behaviour would not be consistent in a sustainable manner with achieving a budget surplus.

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