Perverse economics

James Gubb, 26 November 2008

Watching the news last night, a friend asked why people are saying tax cuts at the present time may be a bad, not a good, idea. The point is this. In the long-run huge budget deficits matter, and they matter a lot. While I’m all for tax cuts in the grand scheme of things, deficit-funded tax cuts are not the way forward. They will only increase the budget deficit and multiply the problems we have.

National savings = private savings – budget deficit. Huge budget deficits mean national savings – particularly with the current low rates of saving in the UK – are likely to be low (or, worst case scenario, negative), which will tend to reduce future national income either because: a) private investment in capital is crowded out as firms compete for reduced funds (and interest rates will tend to rise); or b) firms turn to borrowing more from abroad and you end up with a current account deficit.
Now, if you whack deficit-financed tax cuts on top of this, you’re worsening the problem in the long-run, rather than making it better. In the short-run, deficit-financed tax cuts can have a modest positive direct effect on the economy, by reducing marginal tax rates and encouraging people to work or save more. But they also increase the budget deficit, lowering national savings and – through the above mechanism – have a negative effect on economic growth in the medium to long-term. (Unless of course productivity increases significantly, which, in the current climate, is unlikely.)
A further issue is where the government itself is funding the deficit from. Currently, this is coming from a) the Bank of England effectively printing money, which tends to devalue the currency and be inflationary (think about it, an orange is still an orange with the same intrinsic worth defined by scarcity, but you’ve now got two £1 coins in the economy for every £1 you used to have; you’re going to be paying more) or b) borrowing from the international community. While a state the size of the UK will always be able to borrow, rates will reflect the risk and, because of above reasoning, will tend to rise.
So, in the long-run you’ve got a problem. Investor confidence is weakened. The fear is that the government may be forced to resort to high inflation (to wipe out the value of the debt) or you have fiscal deadlock. People are already losing confidence in the UK economy because, having a huge banking sector, it is seen – along with the US – as one of the sources of the financial problems. Deficit-financing and the dilly-dallying we have seen, best represented by reports the Treasury is/was considering raising VAT to 18.5% in the future, will only worsen this. All this will serve to do damage confidence further, triggering a shift of funds away from pound-based investments (less people will be demanding pounds). Ultimately the exchange rate will depreciate and they’ll be sharply higher interest rates on UK government debt.
I don’t want to go doomsday, but the run on the pound that the Shadow Chancellor is talking about is a distinct possibility if we don’t get our house in order. As this report by the think tank Reform advises, people need to be saving, not spending.