Cuts Day, Part 2 – An economics lesson: what is the deficit and what is debt?

The day has finally arrived. Everyone is now expecting the biggest cuts in spending on public services in decades. The Comprehensive Spending Review (CSR) published today will set out spending plans for the next 4 or 5 years. The Government are telling us these cuts are necessary to reduce the public sector deficit and pay off the debt.

We’ve all heard the coalition ministers blaming using ‘the current economic conditions’ like some sort of catchphrase. And no doubt we’ll hear Labour talking about irresponsible gambles a lot today and in the coming weeks. Osborne et al have been telling us for long enough that the deficit is too large because Labour allowed public spending to balloon out of control.  However, evidence shows that the reason for the increase in deficit is more to do with lower Government revenues after the recession. That recession was brought about by financial markets taking too many risks and bringing on instability, not by Government spending.

What is the deficit and what is debt?

Despite what the Tories would like you to think, all administrations are ‘tax and spend governments’.  Money is raised by the government and then spent on public services. The Deficit is the amount by which income (via taxes) is below expenditure. The total of all the earlier years’ deficits is the Debt.

During recessions, people and organisations spend less, so government income drops, while simultaneously, government spending goes up as benefits claims increase. Therefore, both the deficit and the debt are expected to increase. During a recovery, this reverses. People spend more, and deficits and debts fall again.

Examining public spending over the period of the Labour Government, it’s easy to highlight the effect of the recession on spending.

Total expenditure as a percentage of GDP

  

 We all remember Chancellor Brown’s now famous economic golden rule.

“On average over the economic cycle, the Government will borrow only to invest and not to fund current spending.”

So when times are good, the Government built up a surplus in order to cope with the expected deficit in the cyclical recession. Under Labour, this golden rule was paired with a sustainable investment rule that

“net public debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level.”

That stable and prudent level was most often defined as 40% of GDP.

Brown really believed that by following his fiscal rules, that ‘there would be no return to boom and bust’. As such the practises of the last government were sensible measures. But the crisis of 2008  meant that those rules were abandoned for the remainder of the Labour Government.

There is also a measure of the presumed deficit if the cyclical factors were removed. This is cyclically adjusted public sector net borrowing. As this is a stupidly long name and the acronym would be CAPSNB, economists refer to this as the structural deficit.

George Osborne’s spinners tend to refer to the current structural deficit to prove what bad shape our ‘current economic condition’ is in. The Treasury’s official current estimate has it at 8.7% of GDP.

Structural Deficit as a percentage of GDP

 

This chart makes it very clear that the structural deficit soared right at the point when the recession started. That makes it look like, rather than the structural deficit being a measure of how bad our economy is, is purely cyclical. Following a recession, the level of the deficit will be a larger proportion of  GDP than before that recession. Although the Government are classifying a large proportion of the deficit as structural in order to point the finger at Labour, it is in fact caused by the financial crisis and recession.

Next lesson: Why the deficit is an issue

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