Four basic points on deficits


I'm (probably) going on Scotland 2015 later, to talk about Paul Krugman's views on deficits—i.e. 'do we really need to reduce the deficit?' Now there's no real reason why my economic views and arguments should be trusted over those of a Nobel prizewinner (it's a red herring that his Nobel prize was in the economics of trade; he has a widely-respected macro textbook and a number of widely-cited macro papers). But I do think my points hold water anyway. 1. Krugman is right that we didn't and don't have a debt crisis in the UK. When it comes to debt—like with many other things—I trust the markets. Markets aren't stupid; they aggregate the preferences and information of billions of people.

Look at Greece: it can only sell new debt at a high yield because markets are worried about the existing 200% of GDP they owe. The UK can sell debt very cheaply because the UK's debt level is more or less manageable and the UK has always repaid debts it's incurred, for hundreds of years.

2. Krugman is right that (extra) deficit spending can sometimes raise growth. Cutting taxes or raising productive government spending in a recession will raise growth, but only if the central bank is incompetent and (a) has let monetary-macro conditions fall below where they were expected to be; and (b) is unwilling to correct its mistake. Cutting taxes will also enhance efficiency and give the economy a supply-side boost.

3. Krugman is wrong that the UK is and has been suffering from a massive insufficiency of demand and needed to do more expansive fiscal policy. Firstly, fiscal policy is unnecessary or counterproductive when the central bank keeps the nominal economy stable with no monetary spurts or crashes.

The Bank of England lowered its policy rate to 0.5% and kept it there for over six years; it still rests there. It did a £375bn QE programme. Consumer price inflation hit 5.2% twice and stayed above target for five years. Do we really think it was willing to see inflation go even higher, but only if it came from extra fiscal policy?

In New Keynesian models a demand-driven slump is typically identified when you have low or negative growth and low or negative inflation. But we saw high inflation and low or negative growth. This suggests that there was a big supply-side problem—the 'productivity puzzle'—and that demand was not necessarily massively deficient.

4. There are reasons to reduce the deficit other than a possible debt crisis. At the zero lower bound—as Keynesians endlessly tell us—interest rates cannot fall further to induce extra borrowing to invest and consume. In fact, the zero lower bound may or may not exist (lots of European government bonds currently have negative yields). But even if it does exist, 99%+ of assets are not yet at the zero lower bound! This especially includes private firms' debts and equities, which are exactly where private investment comes from. And remember that private investment is how societies get richer.

By all means the government should borrow to fund investment projects that will produce above-market positive returns (although NB that these almost never exist except where the government has effectively outlawed private firms from investing in a given area). But bear in mind that borrowing to funding general government spending comes out of funds that could otherwise be used for private investment. It comes at a cost, even when Bank of England policy rates are near-zero and even when gilt yields are near zero.

So Krugman is right that we don't have a debt crisis (look at markets!); he's right that deficit spending can work (in weird circumstances); but he's wrong that the UK has suffered a massive demand deficit (look at inflation!); and borrowing comes at the expense of private investment (nearly no assets are at the zero lower bound & the zero lower bound may not even exist!)