For those of you who buried in the spending-tax-cuts and what-caused-the-deficit debate.

Policy Exchange have released a very stimulating document about tax options.  It takes a number of striking positions, in particular a surprise attack on VAT as an income-tax equivalent that I hope to address later today, and an analysis of the idea of taxing debt more in order to reduce economic instability.

But before I start on that I would like to query (once again) their repeated claim that the deficit exploded because of a burst of excess spending.  You can see the entire extent of their workings in Table 1.1.  Revenues as a % of GDP fell 3%; spending rose 7%.  Obvious, innit?  Well no.  Please consider this charming anecdote:

Imagine a small fishing community.  Ten fisher-people bring in $20 of fish each year.  30% of this is taxed by the ‘government’.  This $60 goes towards paying for domestic services – education, cleaning the huts, giving food to the young and old and infirm.

Now a storm comes and the boats are destroyed.  The fisher people have to throw nets into the shallows, and now only gather $10 of fish each.  With constant tax rates, the government now only has $30 of income.  But – for now – it keeps paying the home carers and old people because they need that stuff done.  (if you wonder how this can be done, there are other villages, and a ‘trade deficit’ emerges).  The government starts running a $30 deficit.

The village policy wonk comes out and sees that the deficit has gone from a safe 0% of GDP to a worrying 30% of GDP.    He pulls out a slate and works it out.

The villagers start clamouring about how they need to get the fishing started again – if they don’t, then their community is faced with ruin.  But the fixer shows them the table, and tells them that clearly the problem here is a spending splurge. 100% of the deficit increase comes from the splurge, he says.   So he convenes an immediate conference to discuss what to do about their mad spending habits.

Now it is obvious what is wrong with the way the wonk thinks.  Dividing through by GDP invents ‘funny-currency’.  In this case ‘Funny Currency’ means ‘One percent of what we gather in fish’, which by having such an elastic value distorts the picture of what has happened.  Tax revenues have in fact halved – but they haven’t if you also divide through by something which has also halved. Try retelling the story with GDP falling to $50, $10, and you see the distortion much more clearly.

What should the villagers decide in their conference?   It depends.  At one extreme, the answer might be to bring spending down to $30 – if they think the income loss is permanent (the deficit is structural).   Depending on their ability to borrow (they have assets) and the terms of trade with their neighbours, this may have to be quick or slow.

If they expect to return to $200 GDP, it may depend on how quickly they could get back up to those levels.  Even if they are confident, they may decide that in future they need to tax $60, and spend just $50, using the surplus $10 to build up a stormy-day fund in case it happens again.  Or they may realise they were not diversified enough, and need to invest in, say, irrigation in order not to be so fish-dependent.*  This involves turning some of that social spending into investment.

Many of the answers to the village’s problem lie with reducing spending – there is no question of that.  And given that we all know that storms happen from time to time, the government’s decision to spend all its income seems foolish, and has worsened the post-storm position.   Its spending plans pre-storm were badly flawed – again, not question of that.   The village elders should have anticipated fewer clear blue Mediterranean skies.

But these claims are different from claiming that the catastrophe itself was a spending issue. Some of the people in this debate are so concerned with making spending cuts a high priority that they accord sudden spending increases an unrealistically prominent part in our current difficulties.   A balancing act tried to strike this balance:  the fiscal crisis was largely about disappearing revenues; most of this is structural and so most of the answers lie in spending cuts. **


*Aditya’s Giant Panda theory, perhaps.    In Iceland, interestingly, they moved from a fish-dependent economy to one dependent on hedge-fund carry revenues.

**Not that radical; in fact, the piece which won that award would scarcely merit a mention on a US blog, so obvious is the thesis – it was only the absence of such a sensible consensus last year that gave it ‘room’


8 thoughts on “A cute little village anecdote

  1. In your tale above, it is the recession that has caused the rise in spending relative to GDP. That is, of course, a contributor to the rise in spending relative to GDP on this occasion. In 2009 GDP contracted by about 5% annual, whilst being pretty flat in 2008 and probably also 2010. Spending relative to GDP rose (depending on how you measure it) some 8-10 percentage points. To make the maths easy, let’s suppose that the economy were £1,000 billion and public spending were £400 billion, then the economy shrank by 5% to £950 billion. Then spending as a percentage of GDP would rise from 40% to just over 42% of GDP.

    So, your tale above vivifies how something of the order of one quarter to one fifth of the rise in spending can be thought of as a mathematical implications of the shrinkage in the economy.

    But what of the rest? Ah, yes. Well, that would be connected to the £125bn rise in actual money (as opposed to percentage points of GDP) by which spending rose. That is why your analogy doesn’t capture what happened.

    Now I know that because most of this rise in spending was already scheduled (rather than being scheduled after the recession began), and because previous plans had envisaged significant growth and consequent high tax revenues, you argue that we should think of the fall-off in revenues as the real driver of recession – the original plan did not envisage so large a deficit, and the main way in which matters have not turned out as expected in the plan is lower tax revenues, not higher spending.

    To illustrate what is wrong with this, consider the cautionary tale of the banker – let’s call him Mr A Darling – who planned to buy a Ferrari with his bonus. Unfortunately Mr Darling didn’t get his bonus, but he decided to go ahead with buying the Ferrari anyway. When asked why he was now deep in debt, Mr Darling’s answer was “Because I didn’t get my bonus.” Everyone else’s answer was “Because you bought a Ferrari.”

    You fall into a classic Mr Brown trap of taking his plans as fixed, and changes relative to those plans as cuts or increases. But the truth is this: spending rose £125bn in just three years. And it is this rise of £125bn in spending that is the main reason the deficit has risen to some £170bn. The fact that this huge spending rise was planned even before the recession does not alter the fact that it is a spending rise – and a spending rise in shiny pound coins, not simply in percentages of GDP.

    1. Hi Andrew, thanks for the comment. Quick warning: our office internet is down, so I have a ready-made excuse if a devastating answer is not posted soonish.;-)

      First point: I think one has to deal with cash estimates of NGDP in the years ahead. Cash NGDP for 2012 is about 12-15% lower than people expected it to be. That is the shock – the shock relative to the pathway. As economics and business are both forward thinking disciplines, anticipating certain pathways of cash demand and cash revenues and cash costs going foward, the logical way to address shocks is to ask how those plans change.

      Adopting the zero-cash-increase as the default line – in a world of rising cash costs, inflation, wages – is purely arbitrary. To do so is to ignore the fact that the spending was aimed at real resources, which in the case of public services become more expensive in by 4% pa. (We can hope that this becomes cheaper, as private wages are now stagnating and public sector costs should deflate too.) But in a world of generalised inflation, flat spending means real spending cuts. The plan to increase spending at 4-5% per year in cash terms were not deemed splurgeworthy at the time. And

      In my view the method of taking year 0 and the cash increases or decreases from there is even worse than the village wonk’s; it means that in inflationary recessions (like those of the 1970s), falling revenues had a negative effect on increasing the deficit, even though they would definitely have been hurt by the recession. You don’t want a method that is so variant on the choice of inflatinary regime.

      The only credible method is to look at the cash plans before the crisis, the cash plans after the crisis, and see what has changed. THis does not mean buying into a corrupt government’s mad scheme for ever increasing spending. You could have asked any independent forecaster “What do you think total government demand/government revenues/governement spending in cash terms will be in 2012?” in 2007, and again asked him in 2009, and had the very same result. He would notice that since you had asked him before, he has had to revise down his estimates for government revenues.

      You might get a very different answer if he were asked the normative question – “what should the government do?” – and then it would depend on whether he was Daniel Hannan or Martin Wolf. But this is a different question (which the Ferrari example begs).

      On the Ferrari question (apart from the perjorative implication that benefits pensions healthcare defence and education are frivolous unnecessary things, which I know is not your opinion): I think it is Nick Rowe who best explains the frustration macro-thinkers feel when micro-analogies are used. The fallacies of composition ignored …. the Ferrari is bought from a totally non-banker economy and none of it recirculates into the banker’s income by definition …

  2. Giles,

    Thanks for your full and interesting response as ever. Two quick response-responses. First the relevance of the Ferrari. You say: “the Ferrari is bought from a totally non-banker economy and none of it recirculates into the banker’s income by definition”. But the question at issue wasn’t whether it was a *good idea* to raise spending by so much – that’s a question for another day. The question at issue is whether spending rose.

    Next, you say: “Adopting the zero-cash-increase as the default line – in a world of rising cash costs, inflation, wages – is purely arbitrary.” But of course real spending increases also from 2007/8 to 2010/11 – by about £90bn in 2007/8 prices. That’s an increase of about 16% in just three years.

    Now I know you are itching to say: “And quite right too!” But, again, the question is not whether it was *right* to increase spending by this huge amount. The question is whether spending actually rose. It did.

  3. I think we will never agree with each other more than we do now …

    If asked “What has risen what has fallen in the last few years, in cash terms”, your answer is right. Spending has risen, revenues have fallen, the first by more than the second.

    If asked: “You the government had promised us 3% deficits. Now we have 13% deficits! What is the reason for your failure?” I would say the answer a government would make is that “For the first time since £X, we have had a collapse in the forward cash nominal GDP, which had been expected to yield revenues of £y but instead is due to yield revenues of £Z.”

    If then criticized for having spending plans that rose in cash terms, I might encourage the critic to go back and look at the history of 3 year TME spending increases in cash terms since the War. The AVERAGE I can find on my (unconnected) office computer from 1987 to 2007 was 19%. The lowest increase was 8% in the austerity years to 1998. Against that backdrop, to take the default level as zero percent, and anything above that as some kind of socialist grab, seems a little bizarre. No government I can think of has ever kept spending increases at zero for even 1 year, in cash terms. Ex Ante, the plans were reasonable. Ex Post they were essential, given collapsing demand. So why are those plans the problem?

    Many thanks as ever for the civil discussion. I am about to post the VAT piece …. hope you like it! It is the first time i have ever been to the Right of you!

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