Why Budget Deficits are Bad for the Economy and Why Sir Samuel Brittan is Wrong

Toby Baxendale exposes flaws in the economic thinking of the left, indicates the dangers of deficit spending and points to a better way to fund welfare while stimulating genuine commercial investment.

Published in the FT on Friday the 2nd of October under the title “A cool look at the current deficit hysteria”, we find an article by a respected economist saying that there is nothing to worry about running a deficit at the present and predicted size. Our predicted budget deficit of 12.4% of GDP in the current financial year, gradually declining to 5.5% in 2013-14 is no big deal. Coupled with the public sector debt itself, we see it leveling out at 76% of GDP. Sir Samuel says “Debt ratios of this size are historically far from unprecedented. In the Victorian period the ratio was nearly 200% and almost reached that level again in the early 1920s. In 1956 it was just under 150 per cent.” He goes on to add, “the debt was gradually reduced from the peaks mentioned above without any heroic gestures.” In a classic Keynesian tone, he concludes “The big error of the current discussion is to confuse the budget balance of individuals and companies with the government budget balance, which needs to be in deficit so long as attempted savings exceed perceived investment opportunities. Gordon Brown more or less understands this, and I wish he would use his talents to explain such fundamentals instead of stirring up an outdated class war.”

For our international readers, Gordon Brown’s speech to the Labour Conference 2009 was a class war-laced speech worthy of some of the most envy driven and hating sections of the Left. The full text is available here, if you want to take yourself back to the start of the last century. I presume this is what Brittan refers to in the last quote.

Also deficit spending — living beyond our means — in the language of the left is “investment.” There are 5 references to this type of activity in this speech. I recall a timely quote to remember from Ludwig Von Mises in Human Action (Scholar’s Edition), Page P.737:

At the bottom of the interventionist argument there is always the idea that the government or the state is an entity outside and above the social process of production, that it owns something which is not derived from taxing its subjects, and that it can spend this mythical something for definite purposes. This is the Santa Claus fable raised by Lord Keynes to the dignity of an economic doctrine and enthusiastically endorsed by all those who expect personal advantage from government spending. As against these popular fallacies there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.

How is Wealth Created?

As I have said on this web site before, wealth is created on the factory floors, in the boardrooms and in the offices of people making their factors of production — land, labour and capital — work better for them in satisfying the needs and requirements of their consumers. Invariably, this means those factors need to be brought together in better combinations or made more productive. The latter is the most common way and this almost always needs savings — i.e. forgone consumption — to invest in the newer, more productive processes.

Governments do not create wealth, they can only take it from A and give to B.

What does an Interest Rate do?

As I have said before on this web site:

Simply put, you value more highly present goods of the same quality and quantity than you do future goods. Furthermore, the value of future goods diminishes as the length of time necessary for their completion increases. This sets up a price differential between goods now or goods later. This price differential is called an interest rate.

In reality it is also the rate of profit in the economy, as it is these saved resources that are the only source of future funding for investment and the associated return on that investment. So it is arguable to say that this is the most important metric in the economy.

To underscore this, it is the saved resources of all the economic agents in society that produces the goods and the profits of the future. The return (interest) on the savings can only be the additional component that allows the additional investment in making the production structure — all those activities mentioned above going on in factories and offices — that will produce the new goods and services. The rate of return on these savings must in-fact be the rate of profit of that which is lent to enterprises.

How do we Fund a Deficit?

The Government Bond

If the government has taken less in tax receipts than it gives out in transfer payments i.e. it has deficit, then it will raise the difference on the whole through the selling of government bonds or “Gilts”. These are promises that the UK taxpayer will pay back the bond holder at a date in the future.

It is important to note here that the savings and investment process that ensures that saved resources are put to their most urgent investment needs, as described above, immediately becomes distorted when a government bond soaks up resources to go into the government coffers for spending and not into productive industry. In short, at the very time today when we need our best wealth creators, the owners of all the businesses in this country, to be firing on all cylinders, looking at making themselves more productive and selling goods and services more in tune with the new demands today, in this post-boom world, we have a policy of running a deficit which will starve these wealth creators of the wherewithal to start lifting us out of this mess.

Contrast this with the Corporate Bond

A wealth creator may sell a corporate bond to fund his investment activities.  Thus we must also observe that when you work producing wealth, you create a surplus.

You had capital of £X and, by the end of the year, you have capital of £X + £Y. You can give a return — coupon or interest rate — back to your investor. The merry-go-round can start all over again with a greater level of wealth accruing in society.

With the government bond, capital is taken away form the citizen and the interest is extracted via the taxation system to pay the bond holder. There is no wealth created, only at best transferred to another person and at worst totally destroyed.

When the proceeds of the government bond are issued to people on the dole (2.6m) and people on incapacity benefit (2.7m), capital is completely destroyed and the tax payer then pays interest on nothing!

A Note on Welfare Spending and the Future Funding of Welfare Provision

We currently rob Pater to pay Paul: that is, we fund a good portion of our welfare budget via the on-going issuance of public debt, the need for which has arisen as we are not prepared to live within our means as a nation i.e. less tax is taken than is spent by HMG.

The Rt Hon Ian Duncan Smith MP has produced a report here called “Dynamic Benefits: Towards Welfare That Works” that starts the process of simplifying the system for the claimant and the administrator. This is very welcome and long overdue. It also starts the reversal of the process whereby, over the last 12 years of Labour Government, benefits have become so rewarding — in the sense that if you are on welfare and you take employment, your net pay decreases — there is a great incentive never to get off them. All of this is welcome.

However, what you need to do, in the smallest local regions possible, is create an insurance scheme in a mutual or let the old Friendly Societies — see here for a brief account of their great history — take subscriptions from the people in the area to provide welfare to the people who need it when they fall on hard times. This has the effect of forcing the Society to invest in productive business activities to get a return on their investment to pay any welfare claims.

Contrast a bond paying interest on nothing (no capital) like a government bond with a corporate bond generating wealth (paying interest on capital) which the old Friendly Societies used: the latter is beneficial to the economy because investment takes place. Government spending can only ever be a redistribution.

Summary:

As Ludwig Von Mises says in the Scholar’s Edition of Human Action p770/1:

If government spending is financed by taxing the citizens or borrowing from them, the citizens’ power to spend and invest is curtailed to the same extent as that of the public treasury expands. No additional jobs are created.

So the message I am hopefully giving here, with the best clarity that I can, is that deficit spending totally undermines the wealth creation process.

If the government is urged to step in and spend where the private sector sees no opportunity, as Sir Samuel says, this will only lead to more general impoverishment. Does it need saying that only wealth creators create wealth and not wealth re-distributors, that is, the government?

This gives rise to the notion that a public debt is no burden because we owe it to ourselves. Now in fairness to Brittan, he is not saying this, he is just saying that in the absence of enough opportunities for savings to be fully utilized, then the government should spend instead. I hope in the above I have demonstrated that if funded by bonds (the majority way), then this is in fact a set-back to recovery.