Reducing the government’s debt was “proving harder than anyone envisaged”, David Cameron, UK prime minister, said in a speech on Monday. He even admitted that “high levels of public and private debt are proving to be a drag on growth, which in turn makes it more difficult to deal with those debts”. Yet, if Mr Cameron had wanted to do so, he could have met many “anyones” who would have warned him of what he has now learnt, at great cost to the country. If the private sector is seeking to run down its debts, it is hard for the government to do so, too, because everybody cannot spend less than their income. That is the “paradox of thrift”. No, it is not a novel idea.
If the government wishes to cut its deficits, other sectors must save less. The questions are which and how. What the government has not admitted is that the only actors able to save less now are corporations. The government’s - not surprisingly, unstated - policy is to demolish corporate profits.
Net lending - the difference between savings and investment - of all sectors of an economy must add up to zero. If the government is running a huge financial deficit - that is, spending vastly more than its revenue - then other sectors must be spending much less than their income. And so, indeed, they are.
In the second quarter of 2011, the government ran a financial deficit of 9.3 per cent of gross domestic product. Counterpart surpluses were 1.6 per cent of GDP for foreigners (the inverse of the current account deficit), 1.7 per cent of GDP for households and as much as 6.4 per cent of GDP for corporations. The U.S. picture is similar: in the third quarter of 2011, the deficit of government was 9.1 per cent of GDP. Offsetting surpluses were 3.3 per cent of GDP for foreigners, 2.2 per cent of GDP for households, and 3.7 per cent of GDP for business.
In order to reduce huge government deficits, surpluses must fall elsewhere. But one should want that adjustment to occur via higher spending rather than via a collapse of the economy into a deeper slump.
It would surely be wonderful if the current account could move into a surplus (thereby reversing the flow of savings from abroad). But, given the crisis in the euro zone, that is highly unlikely for the UK. In Thursday’s second estimate for the third quarter, net exports made a negative contribution to growth. The household surplus is also quite low, particularly given the huge debt overhang. The government cannot wish that surplus to disappear, to offset fiscal tightening. That leaves corporations: if the public sector is to slash its deficits, corporations must also slash their huge surpluses.
The surplus of corporations is the gap between their retained earnings and investments. This can be lowered by raising investment, reducing earnings or increasing the pay-out to shareholders. What are the chances of a surge in corporate investment when households are deleveraging, the country’s export markets are in trouble, and the government is curbing spending? Negligible: not surprisingly, real fixed capital formation by business rose by a mere 0.3 per cent in the year to the third quarter of 2011.
Thus, if the corporate surplus is to shrink, to offset reductions in fiscal deficits, pay-outs must rise or retained profits fall. This is why I argued, slightly tongue in cheek, that the unstated aim of UK fiscal policy is to slash profits. Yet that would mean a still-weaker economy, since reduced profits would also lower investment. That would be a disaster, in the short and long term.
Policymakers could be rather more subtle: they should change taxation of corporations, to raise the incentives both to invest and pay out profits. At present, taxes do the opposite. I suggest that the right principle could be: “use it or lose it”.
Personally, I find the government’s program of fiscal tightening unreasonably inflexible in such an uncertain world. It would make good sense to introduce credibly temporary fiscal boosts, particularly when monetary policy seems rather ineffective, at least on its own.
One way to do that would be to cut taxes, temporarily. Yet another would be to borrow for specified investment projects, quite possibly alongside the private sector. The idea, amazingly widely accepted, that the UK cannot borrow any more seems quite absurd: at current real rates of interest, additional debt would cost just about zero. It is also perfectly possible to raise borrowing temporarily, while demonstrating a determination to control spending. Indeed, I would argue that such control would be far more credible if the economy showed signs of life.
If the government is dead set on rejecting such pleas, it has to show how the rest of the economy is to adjust to its lower deficits. That has to start with the corporate sector, where the vast bulk of the financial surpluses now reside. If profits are not to be slashed, what is to change and how? That is a serious question. The public deserves a decent answer.