There is zero evidence that cutting spending increases deficits

We can argue about how quickly we want to close the deficit. We can argue about what leads to economic growth. But can we please stop making silly claims that borrowing can be self-financing?

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The backlash against austerity has been widespread
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Ryan Bourne
On 5 July 2012 14:04

We’ve all heard it. The response to austerity from many lefties invariably goes something like this:

“By cutting too quickly, the government is putting more people out of work, lowering tax revenues and increasing benefit payments – making the deficit situation worse.”

Earlier this week, the great development economist Amartya Sen had a column on the Guardian comment is free website. He seems to buy this idea as well:

“The moral appeal of austerity is deceptively high ("if it hurts, it must be doing some good"), but its economic ineffectiveness has been clear at least since Keynes's debunking of "the remedy of austerity" in the Great Depression of the 1930s, with unemployment and idle capacity due to a lack of effective demand. It is also self-defeating in reducing public deficits, because austerity tends to depress economic growth, so reducing a government's revenue.”

Unfortunately for all those who espouse that spending more means borrowing less, this is complete twaddle.

Nevertheless, this line of economic reasoning persistently goes unchallenged in contributions to UK television debates and in Parliament.

Cast aside all your value judgements about the role of the state in affecting output or employment, and think about this for a second.

What the argument above says is that increasing government spending through borrowing can actually reduce borrowing because it has such an effect on growth that tax revenues increase hugely, and spending on welfare falls. In other words, we would have no deficit at all if we saw a huge hike in spending.

This is a ridiculous assertion.

Suppose I increased government spending by £100 to try to ‘stimulate the economy’. According to the OBR, even if I spent this on capital expenditure (which is estimated to carry the highest multiplier of 1), this would increase GDP by £100.

But the UK’s average tax rate (our tax-to-GDP ratio) is only 37 percent. So only around 37 percent of the extra £100 of GDP would be obtained in higher tax revenues for the Treasury – meaning the deficit still would have increased, overall, by £63.

In fact, the multiplier effect necessary for any additional borrowing to be self-financing and reduce the deficit in this case is 2.7, a number that even the most ardent of neo-Keynesians would find unbelievable, particularly when there’s little evidence it is even as large as 1.

The funny thing about this is, of course, that advocates of ‘stimulus’ are unwittingly making a more extreme version of the argument they dismiss when people suggest that certain tax cuts can actually increase revenues. Just last week, Labour MP Douglas Alexander had the cheek to claim Art Laffer’s warning, that high personal taxes rates were self-defeating, was ‘discredited.’

But the self-financing stimulus idea is ten times barmier. At least with tax cuts you have the positive effects on incentives, or the possibility that you might discourage tax avoidance or evasion.

Since it’s virtually impossible for spending more to reduce deficits, the corollary is, of course, that cutting spending does reduce deficits – perhaps not by as much as the original spending cut, but it cuts them nonetheless.

This is what we’re seeing all over Europe. Between 2010 and 2011 Ireland, Spain, France, Italy, Portugal, the UK and even Greece (from 10.3 percent of GDP to 9.1 percent of GDP) all saw their high deficits fall.

Now, this is not to say we shouldn’t debate the deficit reduction plan. We can and do argue about how quickly we want to close the deficit and eventually reduce the debt burden. We can argue about what leads to economic growth, and how the cuts affect employment or other outcomes.

But can we please make sure these silly claims that borrowing can be self-financing do not continually go unchallenged?

Ryan Bourne is head of economic research at the Centre for Policy Studies. Follow him on Twitter @RyanCPS

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