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Deficit reduction is still important

    The Emergency Budget in June 2010 set out the Coalition Government’s plans to cut the deficit and restore medium term fiscal sustainability. Excluding the publicly owned banks, public sector net borrowing reached 10.2% of GDP in 2009/10 which was £153.5 billion. With one of the largest budget deficits in the developed World, there was a clear need to outline a plan to bring the public finances swiftly back under control. Total Managed Expenditure (TME) i.e. public spending fell from 45.7% of GDP in 2009/10 to 40.7% of GDP in 2014/15. The budget deficit in 2014/15 was 4.9% of GDP which is a fall of more than half as a percentage of GDP; more than most other major economies.

    Despite this period of fiscal consolidation, the UK has a record high employment rate, one of the fastest growing economies in the developed World and satisfaction in the quality of public services has increased in many areas. The Government plans to continue this gradual reduction in public spending over the coming years such that TME is 36% of GDP; approximately 10 percentage points fewer than in 2010.

    Whilst discretionary consolidation measures may have had some short term effect on output in 2011 and 2012, as the OBR points out, higher than expected inflation, deteriorating export markets (especially in the Eurozone) and persistent difficulties in financial sector are more likely explanations of weaker growth in those years. Even so, as David Smith recently pointed out, non-oil growth which adjusts for sharply falling North Sea oil production was 2.7% and 1.9% in 2010/11 and 2011/12. Furthermore, the more robust economic growth of 1.7% in 2013 and 3% in 2014 as well as the record high employment rate of 73.4% both show that strong economic performance is possible alongside deficit reduction. The fact that the UK has had an independent monetary policy has also been essential in maintaining economic stability. A study carried out by the Bank for International Settlements estimated that without reform, public debt would grow from 50% of GDP to over 500% in three decades. 

    To a great extent, the Government has successfully implemented the spending cuts which it outlined in the 2010 Emergency Budget. Government departments have actually underspent relative to the limits given to them by the Treasury with total departmental spending in 2013/14 £4.6 billion less than planned and another £3.5 billion less in 2014/15. In 2015/16, the OBR forecasts another underspend of £1.1 billion.

    Nevertheless, the budget deficit has not fallen as quickly as the Government had anticipated. In June 2010, the OBR forecast that the Government would achieve a current budget balance by 2014/15 and have public sector net debt already falling at 69.4% of GDP. By the March 2015 Budget, the OBR forecast that over 2014/15 there was still a current budget deficit of 3.3% and public sector net debt of 80.4% of GDP. 

    Whilst the Government has over-achieved on spending cuts, slower than expected economic growth and the weakness of tax revenues have been the key causes of the missed deficit reduction targets. As the graph below from HSBC shows, tax revenues were expected to be 38.8% of GDP in 2014/15 compared to the actual 35.8%. Weak wage growth, compounded by poor productivity has contributed to disappointing revenues.

    Household consumption continues to accelerate growing at an annualised rate of 3.4% in Q1 2015 compared to 1.9% in Q1 2014. Business investment grew by 5.7% on an annualised basis and by 2% on the quarter to reach £46.5bn in Q1 2015 which is the highest on record except Q2 2005. The Quarterly Economic Survey from the British Chambers of Commerce suggests that confidence in the services and manufacturing sectors remains high. A continued low interest rate environment will ensure that the returns on capital expenditure stay attractive.

    Nevertheless, there are reasons to be concerned over the resilience of growth. Productivity growth remains stagnant and is a drag on real wages. Also, the seemingly perpetual turmoil in the Eurozone appears to be reaching a crescendo with the Greek Government’s default on payments to the IMF and a potential disorderly exit from the Eurozone. Whilst the direct consequences for the UK may be small, the contagion effects may be felt through greater financial sector volatility, less liquidity and reduced investment.

    If weak demand in the Eurozone persists or even worsens following a disorderly Greek exit, then it is likely that there will be negative consequences for UK export volumes. Whilst the current account deficit has fallen to 5.8% of GDP in Q1 2015 from 6.4% of GDP in Q4 2014, it is still at historically high levels. Net trade subtracted 0.6 percentage points of GDP from Q1 2015 which is quite significant given that the economy grew by 0.4% overall during the quarter. Net trade is forecast to subtract from growth in every year of the next Parliament alongside a further deterioration in the UK’s export market share. The reduction in the current account deficit forecast by the OBR may prove to be far too optimistic if there is sustained weakness in the global economy.

    Those arguing for more borrowing based on the current relatively sanguine borrowing conditions are being terribly complacent. The Eurozone crisis has shattered any illusions we may once have had about the sanctity of government bonds; financial markets are fickle and confidence can evaporate overnight. A borrowing splurge now, whilst deceptively cheap, would leave the deficit at an elevated rate, damage confidence in our willingness and ability to cut borrowing over a reasonable time period and make us more vulnerable to future bond market volatility.

    Furthermore, more borrowing implies a rise in the dead-weight loss of debt interest payments. The OBR forecasts that just a 1% increase in the rate paid on gilts would lead to a cumulative £13.1 billion increase in debt interest payments over the next five years. Despite big downward forecasts on debt interest payments, in 2020, more than 8% of total government spending will be used to pay for past profligacy, more than will be spent on education and justice.

    It is true that relative to GDP, debt payments have been higher in the past. Rising debt repayments are a lagging indicator of downturns and the previous peaks of 4.3% of GDP in 1985/86 and 3.3% in 1995/96 were both indeed a few years after recessions. Yet after both of those peaks, interest payments fell quite sharply relative to GDP. This time, interest payments have increased and stayed high even after the refinancing of old debt. Deficit reduction will help to keep that figure under control. There is substantial evidence that lower debts and deficits are associated with lower long-term bond yields.

    Eliminating the budget deficit is also important because it will help to reduce public sector net debt as a proportion of GDP. As a proportion of GDP, it has more than doubled from 39% in August 2008 to reach 80.8% currently. It is essential that this debt to GDP ratio is placed on a downward trajectory because otherwise the next recession we face will see debt levels rising well above what we should deem acceptable. There is plenty of evidence such as this Bank of International Settlements paper which suggests that exceeding a certain debt threshold will begin to damage economic growth.

    Treasury analysis based on the 2014 Budget, forecast that running a 1.4% deficit every year would lead to a total public sector net debt of £500bn higher by 2035/36 compared to a 1% annual surplus. Furthermore, in its recent Fiscal Sustainability Report, the OBR conducted sensitivity analysis of net debt. Running a primary balance + 1% from 2020/21 will lead to net debt of approximately 40% of GDP in 2064/65. However, running a primary balance -1% will lead to net debt of above 130% of GDP by 2064/65.

    Bold reforms to the delivery of public services are much more forthcoming when organisations are faced with an absolute necessity to save money. Productivity gains are more likely to be delivered when big departments move from inertia to urgency. It is of course true that demand for different government services changes over time and that productivity growth varies across departments. However, if underlying costs are growing, that is an even stronger argument for big changes now to spur on productivity growth. Deloitte estimates that every 1% of the public sector workforce’s time saved through productivity gains saves £1.64 billion annually. 

    The ONS estimates that total public services productivity did not grow at all between 1997 and 2010. Healthcare productivity grew by an average annual rate of 0.5%, whereas adult social care productivity actually fell by an average annual rate of 1.7%. However, the latest ONS estimates for 2011 and 2012 are that total public service productivity grew by 2.5% and 1.2% which were both the largest positive growth rates since 1997. Public spending restraint has increased public sector productivity.

    Furthermore, ICM polling showed that despite the spending cuts, a majority of people thought that services had improved or stayed the same. The polling also shows that people who actually use the services have an even more favourable impression of the change in service quality after years of spending cuts than the public as a whole. This applies to services as varied as schools and libraries. Perhaps one of the best examples is crime and Home Office spending. Despite the many dire warnings, crime has fallen despite sharp reductions in police spending over the same period.

    If the UK is to maintain medium term fiscal credibility, reduce the dead-weight loss of higher debt interest payments and keep competitive tax rates, then deficit reduction is still essential.

     

    Adam joined the Centre for Policy Studies as Head of Economic Research in January 2014. 

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