The Theoretical Underpinnings of Osborne’s Budget

The headline item in the UK 2015 Summer Budget is the ‘living wage’. That’s a nice piece of fat for the media to chew, but it’s hardly the heart of the budget.

The heart of the budget is in the section called The UK economy and public finances. The number one priority for this government is to drain your savings. Of course it sounds bad put that way, so they present it from the liability side: the priority is ‘reducing the deficit and repairing the public finances’ (1.40 – from the print version).

How is the budget going to be returned to surplus? ‘The government believes in lower taxes, and is committed to eliminating the deficit in a way that is fair to taxpayers’ (1.65). So the cuts on expenditure will have to be even bigger. Where will they fall? Sorry, no prizes for guessing correctly: ‘Consistent with the Charter for Budget Responsibility, the government is setting the welfare cap for this Parliament in this Budget’ (1.70).

One argument for doing this is that ‘High debt means a high burden of interest costs on future generations’ (1.47). As a categorical statement, that is false. High debt means a steady stream of interest payments to future generations – or actually to current generations, since a huge volume of the interest payments go to pension funds holding Treasury gilts. This only imposes a cost if the government chooses to raise taxes to offset those interest payments, which it need not do, since it can keep rolling over the debt forever, or just have the Bank of England retire the bonds. See this post.

The budget’s marshalling of evidence is very interesting. ‘Evidence suggests’, we are told ‘that at higher debt levels, the scope for fiscal policy to stabilise the economy is reduced’. A number of studies are cited, mostly conducted by the OECD. All of these studies look broadly across a number of countries, including many within the single-currency Eurozone and others that peg their currencies to a foreign currency. That would explain the next sentence in the budget:

A higher starting level of debt also increases the risk that a further shock to the public finances could increase debt to a level that the markets would view as potentially unsustainable, increasing interest rates. (1.48)

This completely ignores the fact that Treasury securities play a completely different role depending on whether the sovereign issuing them has its own central bank and doesn’t peg its currency or whether it needs to borrow in a foreign currency. In the latter case, it needs to sell securities to finance its spending, and it has to pay the interest rate the market charges. In the former case, it doesn’t need to sell securities to finance its spending at all; if it didn’t sell them, it would just end up with an overdraft at the central bank (see this post).

The UK falls, of course, into the former category. The concern of the authors of the budget that HM Treasury might be subject to ‘unsustainable, increasing interest rates’ is held in oblivion of the fact that if it didn’t like the rates, it wouldn’t have to pay them. It also ignores the fact that the Bank of England controls the rates, and could easily just keep buying Treasury gilts until the rate came down to where it wanted it to be, as with QE (see this post). It could always pay, since it buys everything on credit; its credit notices are known colloquially as the Great British Pound.

The budget also claims that: ‘The evidence suggests that negative effects of debt are likely to start to dominate with gross debt in the region of 70-90% of GDP.’ There is no footnote after that sentence, but the footnote to the sentence after cites: ‘Prudent debt targets and fiscal frameworks’, Fall, F. et al., OECD Economic Policy Paper No. 15, July 2015.

There is a lot of deception going on here.

First, the sentence quoted makes it sound as though the study finds some general margin of debt thresholds, applying to all countries. In fact the study states that ‘the optimal debt level can vary by as much as 70% of GDP’ (9), from country to country. It also notes that ‘The debt trajectory seems much more important than the level of debt itself’ (10). And: ‘Japan illustrates that some countries can have a high level of debt for a long time period without adverse market reactions’ (14). Finally we get to the statement: ‘Overall, the empirical estimates suggest a gross debt threshold range, where negative effects of debt start to dominate, of 70 to 90% of GDP for higher-income countries’ (14). But even here a footnote warns: ‘The establishment of this debt threshold range is not based on a complete meta-analysis of all studies and there is no weighting of the various links between debt and economic activity’ (14n.5). The threshold range is at best a very rough average, and the study says nothing to suggest that the UK’s threshold range should be near that average. One wonders whether the authors of the budget actually read this study.

Second, the study itself overlooks the crucial distinction mentioned above, between a sovereign with its own central bank and a sovereign borrowing in a foreign currency. Again we see the dire warning about out-of-control interest rates:

OECD Study

Except, of course, that ‘market access’ is not a concern for a government with its own central bank.

In sum: the budget draws upon empirical research that is conducted with no sensitivity to an enormous institutional difference. It misrepresents that research, for instance by treating averages as universals. It makes no attempt to understand how financing actually works for a government that spends in its own currency. The authors may not have even read the research they cite.

George Osborne announced this budget as ‘a budget for working people’. Given the amount of work that seems to have gone into researching it, I wonder if he even knows what that means.


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