The FT reports that the UK’s structural budget deficit is £12bn greater than officially estimated.
The gilt market, however, doesn’t care. Prices have risen today, which means that 10 year yields, at under 2.6 per cent, are at a near record low. The government can therefore finance this deficit at near-record low rates.
And, frankly, I’m not alarmed either.
This is not because I don’t believe the story. Chris Giles’ thinking is straightforward and – subject to a caveat I’ll come to - plausible.
The structural deficit is the deficit that the government would run if the economy were operating at its potential level – that is, if there were no output gap. But it looks as if this output gap is smaller than the OBR estimated a few months ago; a big reason for thinking this is that inflation has been higher than expected. It follows, therefore, that a higher proportion of current borrowing is structural and a lower proportion is cyclical. In other words, we cannot rely upon economic growth alone to greatly reduce government borrowing.
So, why am I not bothered?
Quite simply, because a structural deficit is the lesser of two evils. The economy is just not strong enough to withstand the extra fiscal tightening necessary to eliminate this larger structural deficit. This tightening is more than £12bn (0.8 per cent of GDP) because higher taxes or lower public spending would weaken the economy and thus reduce tax revenues; as Greece is showing, austerity alone cannot greatly improve the public finances.
What’s more, such a tightening would cause real misery in order to address what might not be a problem at all.
As Duncan Weldon says, estimating structural deficits is notoriously difficult. This is because they depend upon three things, all of which are uncertain: the size of the output gap; the responsiveness of public spending to economic growth; and the response of tax revenues thereto. Small and reasonable differences in estimates of these factors can produce large differences in your estimate of the structural deficit.
There is, though, another reason why I say the structural deficit is the lesser of two evils.
There are two key facts about the economy. One is that UK companies are loath to invest. Their capital spending has fallen short of their retained profits for years. They’ve been running a financial surplus. The other is that the world has a savings glut, or if you prefer investment dearth. It too has been running a surplus, saving more than its investing.
Now, across all sectors of the economy, the financial surpluses must sum to zero. It follows that if two sectors – companies and foreigners – are running surpluses, some other sector must run a deficit. This sector can only be households or the government. But households are unable or unwilling to borrow much. It follows, then, that the government must have a deficit – it is the borrower of last resort.
What’s more, insofar as companies and foreigners might well run surpluses even if the economy were operating at its trend level, this government deficit is “structural.”
The only way the government could run a surplus would be if the other sectors were to run deficits.
This would happen in a nice way if public spending cuts were to “crowd in” private investment. But this has not happened so far, and there’s no good reason to suppose it will soon.
More likely, it would happen in a nasty way; tax rises or spending cuts would clobber the economy, and firms and households would borrow more to see themselves through the bad times. In this way, the structural deficit could be cut only at the expense of economic activity.
So, if Mr Giles is right the least bad option is for George Osborne to postpone the date at which he envisages the structural balance returning to surplus. After all, his promise to eliminate the structural deficit by the end of the parliament was only a self-imposed rule, rather than one with compelling economic logic.