The chancellor George Osborne has recently announced a plan to enshrine budget surpluses in law. It is worth noting, that budget surpluses are quite rare in the past 120 years.
The argument of the chancellor is that with national debt ‘unsustainably high’ – periods of economic growth should be taken as an opportunity to pay down debt and reduce the burden for future generations.
What is the impact of a budget surplus?
1. Higher taxes / lower spending. To ensure a budget surplus, the government will have to cut spending and / or increase taxes. This could happen more than the government may like; there are certain long-term factors which work against the government’s fiscal position, such as the demographics of an ageing population. Also many tax revenue sources have been falling, (e.g. decline in use of petrol)
2. Impact on growth. If the government is forced to increase taxes / cut spending to meet a budget surplus, it could have an adverse effect on the rate of economic growth. If government spending is cut, then it will negatively affect AD and could lead to lower growth.
A budget surplus doesn’t have to cause lower growth. If the economy is booming, then a budget surplus could be compatible with strong economic growth. Also, even if the government increase taxes, the Bank of England could ease monetary policy to maintain strong growth. In fact, in a booming economy, Keynesian economics suggest that a budget surplus could help prevent excess growth and inflation.
The concern is that the government will be forced into creating a budget surplus when growth is positive, but not strong enough to absorb the deflationary fiscal policy (higher T, lower G). For example, with interest rates already at 0.5%, there is limited scope for the Bank of England to ease monetary policy further. The UK recovery is more fragile and unbalanced than we would like – it is arguably not strong enough to absorb austerity – and it is difficult to predict when it will. Targeting a budget surplus, we may still experience economic growth, but the austerity and fiscal tightening means that the economy runs below full potential and leads to higher unemployment than otherwise.
3. Impact on household debt. Austerity has a strong political appeal, because there is dislike of the idea of debt. But, a government budget surplus could ironically lead to higher household debt. In the financial crisis, household debt as % of GDP fell as consumers / firms tried to pay off debt. This led to fall in spending, which was partly offset by rise in government borrowing. However, with the ongoing real wage squeeze, the OBR predict a rise in household debt in the next five years.
- In 2008, household debt was 169% of GDP. This has fallen to 135% of GDP. However, the OBR says by 2019 this will rise to more than 173%. (Guardian)
If the government pursue tight fiscal policy – higher taxes, lower spending cuts, this will squeeze household disposable income and they may have to respond by increasing debt levels. A budget surplus takes money from elsewhere in the economy. It doesn’t create money.
4. Impact on cost of borrowing. One argument for running a budget surplus is that it will reduce levels of national debt, and push down bond yields and reduce the amount of debt interest payments future generations pay. This will make it cheaper for the government to borrow. UK debt interest payments are already set to rise.
However, as a % of GDP, debt interest payments have been more stable.
Also, bond yields in the UK are already very low. so running a budget surplus may have little impact on reducing bond yields. Though others may argue that without cutting deficit now, bond yields will rise in the future.
5. Impact on ability to survive future problems.
One argument for running budget surpluses is that it gives you more scope for meeting a future crisis. If you meet a future crisis with debt at 100% of GDP, it may be difficult to pursue expansionary fiscal policy. If debt has fallen to 50% of GDP, there is less need to panic.
However, if budget surpluses reduce the rate of economic growth, then this will damage the long-term potential of the economy. It is worth bearing in mind, that the UK began the 1950s with national debt at 200% of GDP, but it was no barrier to a golden age of economic prosperity and rising living standards. National debt doesn’t have to saddle future generations with poor prospects.
6. Impact on investment
If the government is committed to running a budget surplus, it is likely the government will need to cut back on public sector investment. – Investing in railways, roads, housing, communication, education, skills, training. These are all areas where this market failure. Private firms will not build new roads or fix potholes because they are effectively public goods. If the government cut back on investment, it could harm the long-term productive capacity of the economy.
Some feel the idea of government borrowing is very wrong. But, it should be remembered successful firms borrow for investment, households borrow to fund a mortgage. The economy can benefit from public sector investment. The rate of return on public sector works can be significantly higher than the current borrowing costs.
The real problem in the UK economy is not budget deficit, but poor productivity growth. The government can play a role in increasing productivity through investing in vocational training and dealing with transport bottlenecks. But, if the highest priority of the government is running a budget surplus, there will be limited resources to fund this.
7. Is national debt actually unsustainable?
It is much repeated that UK national debt is unsustainable, but is this actually true? For example, demographic trends will place increased pressure on government social security and NHS. These transfer payments are seen as unsustainable because it is not borrowing for investment. This is an important concern.
But, if UK debt is unsustainable – why are markets so keen to buy debt? Bond yields are very low, indicating that private firms don’t need a high interest rates to compensate for any perceived risk.
I often publish this graph to put UK debt levels into perspective. It is true that some circumstances were different in the 1950s. But, levels of debt are by no means unprecedented.
8. You don’t need a budget surplus to reduce debt to GDP ratio
The UK very rarely had a budget surplus 1950- 2013, but will still reduced debt to GDP ratio quite a lot – because economic growth reduces debt to GDP.
When growth is strong, it makes sense to improve the nations finances and reduce debt as a % of GDP. The counterpoint of expansionary fiscal policy in a recession, is that there need to be automatic stabilisers the other way.
However, the concern is that making budget surpluses a top economic priority could mean we take decisions which are not in the best interest of the economy. The value of budget surpluses is not that great, but they do come at an opportunity cost of taking money from elsewhere in the economy.
Governments and Central Banks need greater flexibility and not to be tied down with fiscal rules (which have proved so damaging in Eurozone)
Also, there is a very strong case for governments borrowing to finance public sector investment. We need investment in training, housing and transport to help long-term economic growth. It would be very short-sighted to target fiscal goals.