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Why the government’s austerity isn’t working

8:30 pm - August 21st 2012

by Chris Dillow    

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Yet again, government borrowing has exceeded expectations. So far this financial year, the deficit on current borrowing* has been ÂŁ42.1bn compared to ÂŁ30.9bn in the same period last year.

This puts in doubt the OBR's forecast that this deficit would fall this year, from ÂŁ98.9bn to ÂŁ95.3bn.

Duncan says this shows how austerity is self-defeating; a squeeze on spending weakens growth and thus reduces tax revenue.

I'd add that this will remain the case for as long as the private sector deleverages. This is because of a simple, basic, unavoidable identity – that for every borrower there must be a lender. Government borrowing – by definition – means that other sectors are net savers.

The problem is that there are only three other sectors, and all three have reasons to want to save or pay down debt:

– Households. Low consumer confidence means these are loath to borrow. And it might be the case that – with the debt-income ratio still high – they will continue to deleverage.

– Foreigners. The desire of Asian economies to save heavily is unlikely to cease soon. And the credit squeeze in the euro area is creating forced savers.

– Companies. Spare capacity, a dearth of investment opportunities and depressed confidence (partly thanks to the euro crisis) are all holding back investment, and encouraging firms to build up cash piles and pay off debt.Today's CBI survey found a fall in order books, consistent with a continued reluctance to invest.

Now, as long as these three sectors want to save, the government will have to borrow, simply as an accounting identity. The mechanism through which this happens is, of course, that higher private savings mean weak activity, which means weak tax revenues and higher welfare payments.

There are three implications here.

1. Government borrowing will fall when and only when the private sector saves less. The government is not in control of the public finances. Austerity works as a deficit reduction policy only insofar as it encourages the private sector to save less. Whilst this might happen sometimes – if tighter fiscal policy encourages borrowing by lowering interest rates or increasing business confidence – these mechanisms are weak here and now. 

2. The only deficit reduction strategies that make any sense at all are those which aim at reducing private sector net saving. The Funding for Lending Scheme, aimed at encouraging borrowing, is the right kind of idea,  though I doubt how practically effective it'll be.

3. An overshoot in government borrowing will not greatly raise gilt yields; although gilt prices fell today they are extraordinarily high by historic standards. This is because the same private sector savings that cause the government to borrow also create a favourable climate for gilts – namely a weak economy that causes investors to favour safer assets, and a pool of cash from which to buy assets.

* I mention this measure as it is unaffected by the transfer of the Royal Mail pension plan.

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About the author
Chris Dillow is a regular contributor and former City economist, now an economics writer. He is also the author of The End of Politics: New Labour and the Folly of Managerialism. Also at: Stumbling and Mumbling
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Reader comments


What happens – as in this evening’s news – is some Conservative MP or pundit gets wheeled out to parade a “supply-side” remedy. This evening’s notion was tax cuts (surprise!) so entrepreneurs had better incentives to create jobs.

Predictably, no mention of entrepreneurs being put off by failing sales through insufficient market demand, the reported record trade deficit or the regular news about the difficulties that small and medium sized businesses are having in raising bank loans.

I’m sorry, it really isn’t as simple as laid out in the article above.

Government borrowing can fall whilst people pay down debt or save more….it contracts the money supply by deleveraging the fractional reserve banking system.

Wasn’t the deficit ÂŁ126bn last year? and isn’t the forecast ÂŁ120bn(ish – cant remember actual figure sitting in this NHS waiting room!)

Though while the Euro remains a problem will there ever be a prospect of real recovery? The tactic in the Eurozone seems to be of kicking the can further down the road and hoping something changes. Everyone else is hesitant because they perceive the Euro as a huge risk.

Osborne can realistically say that there will be no Plan B at this time because short termism would be rash under the circumstances.

In today’s news, even the Institute of Directors is very explicit about Osborne ought to be doing something “aggressive” and the need for “a whole raft of measures” to get Britain’s economy moving again.

Readers may need to recall that the public spending cuts have only just started – which could be one of several credible reasons why those entrepreneurs and businesses are holding back on investment decisions until they are reasonably confident that an upturn in the economy will keep going.

Close followers of the news will recall that successive growth forecasts have been downgraded and little GDP growth is now predicted for next year, which isn’t the business climate that most businesses wish for when making investment decisions.

6. gastro george

If the ideologues in the IoD are against him, then Osborne really is in trouble.

Government spin managers have been putting in a lot of hard work to deflect attention from Britain’s recessed economy.

There was the Royal wedding, and then the Jubilee celebrations followed by the Olympics. In case any noticed the double-dip recession and the downgrading of the growth forecasts for the economy next year, the Eurozone was and is blamed. The instructive insight from this timely intervention by the Institute of Directors is that they haven’t been taken in.

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