How Budget Deficit Relates to Structural Deficit
Automatic Stabiliser Effects on UK Government Economic Policy
Oct 10, 2009
Labour, Liberal Democrat and Conservative Party Conferences (Sept-Oct 2009) have been dominated by how the next UK government (elections probably May, latest June 2010)) would deal with the budget deficit, and how much pain would be involved for the average voter. Ensuring voter confidence on this issue is crucial, not just for the political party that gets into power, but for the economic future of the country and the global financial system.
The key to ensuring voters’ confidence is educating the public about the budget deficit and its relationship to the automatic stabiliser effect and the structural deficit. Any budget deficit is the excess of government spending over tax revenue, and therefore how much the government needs to borrow. According to The Economist (Oct 10th 2009), Britain’s budget deficit is projected to be at least £175 billion in this financial year (to April 2010) – easily its largest ever in peace time.
The government borrows all the money it needs by selling Government Bonds (almost entirely in the form of Gilt-Edged Stock aka Gilts), mainly to financial institutions in the City of London (pension funds, insurance companies etc.) but also to overseas buyers, especially China and Japan. However, with an unusual large budget deficit, two additional difficulties are bound to arise:
Payment of Interest to Holders of Gilt-Edged Stock
- In normal circumstances any budget deficit in a particular year adds to the size of the National Debt – the accumulated total amount that the government owes.
- Interest has to be paid to holders of Gilts, and this is likely to amount to more than the UK spends each year on Defence, for example.
- When the recovery gets going, interest rates are likely to rise, so the total paid to holders of Gilts will have to rise as well.
However in the present highly unusual circumstances of quantitative easing the whole amount of the Budget Deficit will be accounted for by purchases of Gilts by the Bank of England itself, thus moving the debt around within the public sector, rather than increasing it.. For this reason there should be no rise in interest rates, at least in the near future, but instead there could be a risk of higher inflation if the Bank of England gets its timing wrong over the tightening of monetary policy as the recovery gets under way.
Maintaining Confidence of Large Financial Institutions and Overseas Holders of Gilts
This is potentially more serious than the first.
- Large financial institutions, especially overseas holders of Gilts, need to have confidence that they will receive a proper return.
- At present, UK debt has an AAA rating, but if this were to change because the rating agencies (eg Standard and Poors) came to believe that the UK government didn’t have credible plans for tackling the budget deficit, then large financial institutions and foreign overseas Gilts holders might refuse to buy Gilts.
- In that case the government would have to raise interest rates even further to encourage them to buy, and higher interest rates on the home front would delay the much needed recovery.
- While it is true that overseas holders of Gilts have been net sellers this year, when quantitative easing is over, the continuing budget deficit will mean the need to sell large quantities of Gilts to overseas customers.
Fortunately, this is where the automatic stabilizer effect comes into play.
How the Automatic Stabilizer Works to Reduce a Budget Deficit
When the Recovery starts (probably before Christmas) there will be an automatic reduction in the budget deficit, because tax revenues will rise as people earn more (increase in income tax revenue) and spend more (increase in VAT revenue). Government spending on unemployment and other benefits will also (eventually) automatically fall. This effect is known as the automatic stabilizer.
The part of the budget deficit that the automatic stabilizer does not wipe out (usually reckoned to be about 50%) is called the structural deficit.
How Britain’s Structural Deficit Could Create Difficulties for the Next UK Government
- Estimates of how much Britain’s structural deficit will be in this financial year have been increased from £45 billion (UK Treasury, April 2009) to nearer £90 billion according to The Institute of Fiscal Studies.
- In his speech of 7th Oct 2009, George Osborne, the Conservative Party Shadow Chancellor of the Exchequer, recommended ‘belt-tightening’ measures that would reduce the structural deficit by, at best, about £7 billion.
- This prompted Stephanie Flanders (BBC Economics Editor ) ironically to invoke Ronald Regan’s famously optimistic quote, ‘You ain’t seen nothing yet’.
Lessons from the Past on the Crucial Timing of Belt-Tightening Measures
Whoever wins the 2010 UK election, draconian measures will be forced on the next government just to avoid a ‘strike’ by overseas buyers of Gilts. However these can’t be introduced until the recovery is properly established.
- In 1937, when Roosevelt cut back too soon, and tipped the American economy back into depression.
- An ‘austerity budget’ introduced by Roy Jenkins was credited with losing the 1970 election for the Labour Party.
Assuming the Conservatives win the next election, as the opinion polls suggest, George Osborne (Labour Shadow Chancellor of the Exchequer) will be faced with the problem of damaging Conservative hopes for a second term by the need to introduce an austerity budget to tackle the rest of the structural deficit. Perhaps an enlightened public will be more understanding this time.
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