Tuesday, 13 October 2015

Osborne, Wren-Lewis and budget deficits.

Like most people, I expect lies and drivel from politicians like George Osborne, the UK’s finance minister.

In particular, his idea about balancing the budget over the cycle is nonsense. I’ve explained the reasons several times in recent years, but it seems (for reasons set out below) that I need to  explain yet again. Here goes.

Assuming we approximately hit the 2% inflation target, the REAL VALUE of the monetary base and national debt will shrink at about 2% pa. Thus assuming the debt and base are to remain about constant relative to GDP (which is what they actually do over the very long term), then both the base and the debt have to be constantly topped up. And there is only one way of topping them up: via a deficit.

Indeed, even more “topping up” is needed thanks to economic growth. That is, if the economy expands by X% and the debt and base are to remain constant relative to GDP, the clearly the debt and base have to expand by X% as well.

To illustrate that with some not unrealistic figures, if the debt and base are say 50% of GDP, real growth is 2%pa and inflation is 2%pa, then the deficit will have to be (2+2)%x0.5=2% of GDP. That’s quite a significant deficit.

And if you don’t believe that, consider the fact that we have in practice had deficits about nine years out of ten since WWII. Plus the occasional year when there has been a surplus has nowhere near cancelled out the previous nine or so years of deficit.

(Chart thanks to The Economist)

So why am I repeating all this? Well seems that Simon Wren-Lewis (Oxford economics prof) agrees with the “balancing the budget over the cycle” idea. See his 5th para (starting “In this light…”) in particular. I suggest SW-L has slipped up there.

Having said that, I agree with him about 90% of the time and regularly read his blog posts: because they are thought provoking and interesting.

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