In a final entry about the UK Budget, here’s a little gem of a chart from the Office for Budget Responsibility (OBR). This is the agency, you’ll remember, charged with bringing back credibility to the government’s forecasts, due to its independence and academic rigour. I have already blogged on the changes to the OBR’s forecasts for UK GDP, in light of the lack of a strong economic recovery and the persistence of high public borrowing that has resulted.
Bearing in mind the Coalition Government's plans to bring down the budget deficit through savage spending cuts and large increases in taxation on some segments of the population, the UK now faces a protracted period of austerity. We brought this upon ourselves, the Coalition says, by ‘living beyond our means’ for a sustained period. We have to repair the ‘broken’ public finances and suffer a lot of pain in the process.
It’s a classic truth and consequences scenario: we have to pay for our past profligacy. We have all overspent, including the government; the national credit card is ‘maxed out’ and now’s the time to pay off all the borrowing. Except, of course, that is not how it actually works. The country does not have a credit card, like many individuals do. The government, which issues its own sovereign currency, does not have a financial constraint, like an individual or household does. What’s more, a fall in the public deficit must mean an increase in deficit in one of the other economic sectors.
The economy can be divided into three sectors: the government sector, the private domestic sector, and the foreign sector. What happens if one of these three sectors experiences a drastic shift from deficit to surplus, or vice versa? The answer is that the other sectors must take up the slack. This is due to the truism in accounting terms that the balances of the three economic sectors must sum to zero. When a government wants to cut its deficit and return to a budget surplus, at the same time as it operates an external deficit (where imports exceed exports), then there must be a private deficit. Otherwise the accounting equation does not balance.
In the past decade, we have seen a ‘boom’ of economic growth on the back of irresponsible lending by the financial sector. This imploded with the crisis of 2007 onwards, creating a ‘bust’ which nearly took out the entire banking system. As interest rates fell, in the hope that lending would help sustain growth, some individuals began to pay off their borrowing. Households sought to take advantage of historically low rates to repay debt. The OBR chart shows this process happening in 2009, when households repaid £22bn of debt.
What’s the one thing that could derail this process? Are households really wanting to start borrowing again on a credit card-fuelled stint of spending? Not in this economic climate, so why does the chart show exactly that? It’s because the government wants to cut the budget deficit. And as it does so, the other two sectors (private households and the external sector) have to pick up the tab. The UK is operating a current account (external) deficit, despite a 20%+ sterling depreciation. That means increased private indebtedness is inevitable.