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For 2011, a big debt needs a big society

by on January 20, 2011

Lawrence and Henry Gruijters take a comprehensive look at where the UK’s economy will be heading in 2011. First Published on The Graduate Times.

For 2011, a big debt needs a big society

2011 in economic terms will be be remembered for a VAT rise and the reality of the squeeze. Britain’s public debt is an eye-watering £952.8 billion (ONS) and 64% of the GDP, with interest payments rising to approximately £43 billion. Currently, 3% of Britain’s GDP goes to servicing this debt. This seems a scandalous amount, considering that this interest payment is equal to approximately 66% of total 2010 VAT tax receipts.

But figures do not tell the whole story. The reasons for running a deficit can be split-up into two groups: government investment and demand management. It could be argued that a budget deficit can be an investment. For example, higher spending on the transport infrastructure improves the supply-side capacity of the economy, promoting long-run growth.

To illustrate the second reason to run a deficit we, like Paul Krugman in his book The Return of Depression Economics, will summarise the following story by Joan and Richard Sweeney. The Sweeneys are members of a babysitting co-operative. In this co-op everybody gets coupons which entitle the bearers to one hour of babysitting. The babysitter would receive the appropriate number of coupons from the baby-sittees. In this way every couple would get as many hours of babysitting as they provided. There came times when there where simply not enough coupons in circulation, as couples accumulated coupons for the future. This ran down other couples’ reserves.

A demand crisis was born. Couples who felt that their reserves of coupons were insufficient wanted to babysit and did not want to go out. But one couple’s decision to go out was another’s opportunity to babysit. Opportunities to babysit became hard to find as everybody was supplying the service, making couples even less likely to use their coupons except for very important occasions.

The solution was simple – increase the demand for coupons by making going out cheaper, by supplying more coupons or increase demand for babysitting yourself and issue new coupons. These were sensible solution as there was no problem with babysitter production, but a lack of effective demand. The lesson for the real world – bad things can happen to good economies, making occasional government intervention not so costly. This is a case of imperfect coordination. Instead of government intervention a clever entrepreneur who could find a better way to coordinate could solve the same problem.

Do the these reasons justify the UK’s current deficit? To some extent, people are right to say we should continue spending to get us out of this mess and boost demand. It is difficult to claim that this deficit reflects investment opportunities as the large amount spent on the NHS may be deemed as an investment in the labour market, but is hardly an investment which will not also need to be made as new generations enter working life.

Give or take a financial crisis, whether you believe in Keynes or not, we have spent too much over the last decade. Nothing more expresses this problem than the answer to the following question: Do you think your children will be better off than you are? Invariably in the last 60 years the answer to this question has been an overwhelming yes! Recently the answer changed to no. Polls and the news like to attribute this to a lack of optimism. This is wrong – the situation is because we have spent the inheritance, and then some.

There has been a problem of ‘deficit bias’. Spending more and getting into debt, and then spending further more and getting in to even further debt. This may be good for the baby boomers, whose pensions we all still need to pay, and who are proportionately the most important catchment group of voters. Overspending now is giving future generations the burden of a higher debt that at some stage will need to be paid off with higher taxes. Firstly these taxes will reduce output. Secondly higher government debt will also divert savings from investment as interest rates are too high to exploit investment opportunities, which will once again reduce future growth.

The Extended Society therefore concludes that there is a dual problem. The current crisis may be due to a lack of effective demand, which calls for extra expenditure. This expenditure will slow growth, because the public acknowledge that current expenditure equates to future taxes and higher future interest rates ‘crowding out’ investment. The problem is a commitment one. We would love to commit to reducing the deficit when times are better, but judging on recent evidence this is not credible.

The way out is unclear but the European bond markets may be key. They could scare governments into a credible path towards fiscal consolidation. This is avoidable – credibility in this case is mainly a political problem, political credibility must be enforced. If markets knew that running a structural deficit when demand is sufficient spelt out political suicide, markets would trust that debt would not get too high.

The Big Society is the second solution. We do not suggest tax increases, but spending cuts and social reform giving responsibility to the people. This will include increasing labour mobility and wage flexibility to avoid unemployment. The sole motivation should not be to make the state smaller, but to make the state work better. The amount spent is a poor guide for performance. Over the past 50 years almost every sector has been transformed by innovation and technology increasing productivity. No sector has changed as little as the state. With ageing populations needing ever more state help, the left should have as much interest as the right in state matters. The great part of the big society is how it is focussed on productivity and medium to long-term savings, not short-term cuts which may stifle growth.

The Extended Society hopes that 2011 is not just known as the year in which austerity started with a tax levy, but is remembered as the year that the premature idea of the Big Society truly came of age.

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