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The £100bn government deficit

Created:

11 November 2008

Written by:

Chris Dillow

The public sector finances could deteriorate even more than generally expected, even before tax cuts

Economists expect the Chancellor to use his Pre-Budget report to forecast public sector net borrowing of over £70bn in 2009-10, with the deficit shrinking thereafter.

Although this sounds big, it would be less than 5 per cent of GDP. That would be a smaller share of national income than we saw in the early 1990s, when net borrowing exceeded 7 per cent of GDP.

However, forecasts for government borrowing are subject to huge margins of error. Economists have a rule of thumb that the forecast one year out has a margin of error of 1 per cent of GDP (£15bn), that for two years out has a margin of error of 2 per cent of GDP, and so on.

The public finances, then, are much more volatile than politicians admit. One reason for this is that forecasts are often subject to an anchoring bias. The usual way of predicting borrowing is simply to forecast growth in spending and tax receipts, and then take the difference. Simple maths means that this often has the effect that forecasts resemble our current position. So, if the public finances are in surplus, as they were in 1989 and 2000, the forecasts are for continued surpluses. And if they are in small deficit, the forecast is for continued small deficits.

There is, however, an alternative perspective. This starts from an accounting identity - that across the whole economy, savings must equal investment. This means that if someone is saving more than they are investing, someone else must invest more than they save. One person's financial deficit is another's financial surplus.

Our chart shows trends in these financial balances - the gap between savings and investment - for the four main sectors of the economy. Note in particular the public sector and corporate balances. To a large extent, these are mirror images of each other. The public sector deficit in the early 1990s was accompanied by a corporate surplus; firms' retained profits exceeded their capital spending. Then as the corporate sector went into deficit in the late 1990s - as firms spent heavily on IT equipment - the public sector went into surplus. And just recently a rising corporate surplus has been accompanied by a rising public sector deficit.

Herein lies the danger for the public finances. The domestic private sector's financial balance could well rise in the next couple of years. Which means some other sector's balance must fall.

Most obviously, house buying - which is households' investment - is slumping. Corporate investment could continue to fall, too.

And insofar as the credit crunch bites, it will tend to raise the private sector's surplus. If some individuals or companies cannot borrow then, obviously, aggregate savings will rise relative to aggregate investment. And it's also possible that households will want to pay down debt, even if they don't have to. That could raise households' savings and hence the private sector's financial balance.

Now, if the private sector's financial balance rises, someone else's must fall. There are only two possibilities here. Either the government must run a bigger deficit. Or foreigners must run a smaller surplus - in other words, the UK's current account deficit (its borrowing from overseas) must fall.

You might think the latter a likely possibility. After all, if consumers save more and firms invest less, imports will fall and the current account deficit will indeed shrink.

This will happen. But not enough to stop government borrowing rising. Since 1988, a rise of one percentage point of GDP in companies' financial balance has been associated, on average, with a fall in foreigners' financial surplus of just 0.13 per cent of GDP. A rise in households' financial balance of 1 per cent of GDP has been associated with just a 0.23 percentage point rise in foreigners' financial surplus.

There are good reasons why these responses are so small.

One is simply that imports account for only a small part of our spending - 22.7 per cent last year. So a fall in spending cuts imports only a little as a share of GDP.

Also, the same recession that causes the private sector to invest less also hits our trading partners, too. That means our exports suffer, limiting the fall in the current account deficit.

With foreigners' financial balance responding only a little to moves in the private sector's financial surplus, it follows that the public sector's balance must do the bulk of the adjusting.

Let's do some simple numbers. Since 1988 each rise of 1 per cent of GDP in the corporate sector's financial balance has been associated with a fall in the public sector's balance of 0.63 per cent of GDP. So a two percentage point rise in the surplus would add 1.2 per cent of GDP to government borrowing.

And each percentage point rise in households' financial balance has been associated with a 0.55 percentage point rise in the public sector deficit. This means that, if the household sector were merely to return to financial balance, the public sector deficit would rise by 2.5 per cent of GDP.

Put these numbers together, and we can see a rise in public borrowing of 3.7 percentage points of GDP. Which means the level of borrowing could easily hit 7 per cent of GDP, the levels we saw in the early 1990s. And that means public sector net borrowing could exceed £100bn.

Of course, there are lots of uncertainties here. But the basic message is simple. The bigger the retrenchment you expect in households and corporate finances, the bigger will be the rise in government borrowing.

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