Popular discussion of the public finances is stuck in the dark ages. Last week’s news of a bigger than expected surplus on the public finances in July prompted talk that Chancellor Phillip Hammond now has room to increase spending on the NHS.
From an economic point of view, this is nonsense. There has always been such room. The only constraint upon government spending (other than self-imposed ones) is inflation – which, given the Bank of England’s inflation target, means high short-term interest rates.
And in fact, this constraint might be more biting now than it was months ago. Far from having more room to increase spending, the chancellor actually has less.
I say this for a simple reason. The government can borrow at negative real interest rates – minus 1.6 per cent for 20-year loans. The public finances, then, don’t constrain spending. The reason not to increase spending is that doing so would add to aggregate demand, which might lead to inflation and hence higher interest rates.
In this sense, “better” public finance numbers actually signal that the chancellor has less room to increase spending, simply because the public finances improve as the economy grows – and history suggests that growth eventually leads to inflation as capacity constraints bite. The public finances were “good” in the early 1970s and late 1980s – just before inflation rose. They were “bad” in the mid-1990s and in 2009, when there was plenty of slack in the economy and hence little threat of inflation.
We can put this another way by remembering the simplest of facts – that every pound borrowed is a pound lent. Across all sectors of the economy (which includes foreigners) net borrowing must equal zero. Government borrowing can only fall therefore if some other sector saves less or borrows more. In recent years, this sector has been households. Between 2009 and 2017 government borrowing fell from £159.8bn to £37.7bn, a drop of £122.1bn. The main counterpart to this was a disappearance of households’ net savings. In 2009, they were net savers of £82.9bn. But last year they were net borrowers of £4.3bn.
Such net borrowing might well be a sign of excess demand; if we’re spending more than we’re earning, it is a sign that demand exceeds supply. To the extent that this is the case, “good” public finance numbers are a sign that we are closer to the inflation constraint and hence that the chancellor has less room to increase spending, not more.
Now, this is not to say that inflation is imminent. The fact that wage inflation has been stable while unemployment has fallen to its lowest rate since 1975 suggests that the trade-off between economic growth and inflation has improved. And even if raising public spending does raise inflation and hence interest rates, this alone is not a definitive case against such a rise. The choice between higher government spending and low interest rates is the sort of question that should be the heart of politics.
Instead, my point is simple – that “better” public finances do not, in themselves, mean there’s more room to increase public spending. The government is not like a household. It is a sad indictment of the state of public discourse that this needs saying.
