Knowles needs to listen more carefully to ‘hero’ Clinton on deficit reduction

The austerity brigade is rattled. Young Daniel Knowles over at the Daily Telegraph is so worried, he has had to rise to the defence of the Treasury and Office for Budget Responsibility – and then resorts to proposing Greece’s economic strategy for the UK. Why? Because orthodox economic ideology has been challenged by none other than Daniel’s ‘hero’ that notorious womaniser, President Bill Clinton.

Bill gets it. On the deficit that is.  Thanks to Left Foot Forward and Mehdi Hasan we have all read Clinton’s  speech:

“(the) UK’s finding this out now. They adopted this big austerity budget. And there’s a good chance that economic activity will go down so much that tax revenues will be reduced even more than spending is cut and their deficit will increase.”

Daniel Knowles challenges his hero, on these grounds:

  1. “The government cannot spend so much that net revenues actually increase. By Clinton’s logic we should increase spending until our deficit goes away. ”
  2. “The Office of Budget Responsibility..using a Keynesian model, estimates that the fiscal multiplier is about .35”……that means that…overall the deficit is will be smaller than it would have been without cuts….. (Note: Knowles Update:  I actually made a mistake with that statistic – 0.35 is the estimate for the multiplier for VAT. Estimates of the fiscal multiplier overall, including those of the OBR, IMF and others, are closer to 0.)
  3. Greece: spending cuts have reduced the deficit from 15.4% of GDP in 2009 to 9.5% now.

The first two points are rightly, morphed together in Knowles’s argument. The first is to do with the impact of government spending. In a slump – which we are living through now – it is vital for the government to spend to fill the investment vacuum created by an over-indebted and extremely nervous private sector, desperately trying to de-leverage its debt. Right now the UK private sector is busily hoarding cash, because they are – rightly – worried about their levels of debt; and because they fear – rightly – that if they do invest, customers (both private and corporate) will not walk through the door – because customers too, are heavily indebted and worried about the threat of unemployment and falling house prices.

So given these circumstances of widespread fear and paralysis in the economy – what the ONS calls ‘flat-lining’ –  say the government invests £1 billion in libraries. What would happen next?

The Office for Budget Responsibility has adopted a model of the economy with a ‘multiplier’ – which is supposed to tell us how much the government would get in return for that investment. The OBR, according to Knowles, reckons the return would be a measly 0.35 on VAT, 0.0 on government spending overall. This model implies that an investment of £1billion in an investment in e.g.  libraries, would return nil to the Treasury. In other words, the multiplier delivers a negative return: a lot less than the £1 billion invested.

The OBR model, Daniel Knowles, is most definitely not Keynesian. In fact it is an insult to the work of Keynes and Richard Kahn – who developed the multiplier – to describe it as such. It is the very reverse of what Keynes and Richard Khan argued (for more see appendix 1 of ‘The Cuts Won’t Work‘)

For Keynes, the multiplier at the very least must be 1. That is, it must return, at the very least, £1 billion to the Treasury. This will happen because, for example,  private contractors will be hired to build the library. They will buy bricks from a supplier, who will pay taxes to the Treasury on the profits he makes from selling bricks. The construction company will pay taxes on the profits they make from building the library. And their employees will pay taxes on their income – generated by working on the library build. Then the employees may e.g. walk into  a home insulation company, and buy home insulation – to ensure greater energy efficiency at a time when gas prices are rising. The home insulation company will pay taxes on that – and employ more people to insulate homes – all of whom will be on PAYE (unless evading tax). They too, will use their income to walk through the doors of heavily indebted companies….and so on.

At the same time, the Treasury will stop doling out dole money to unemployed construction and home insulation workers.

So for Keynes and Kahn the multiplier could be at 2. In other words, with public works expenditures the Treasury could expect to get £2 billion back (in tax revenues and reduced unemployment benefit payments) for their investment. This explains why government spending, unlike the spending of an individual or company, could pay down the government’s monthly ‘overdraft’, the deficit, and in time pay down the government’s ‘mortgage’ – the public debt. Our paper, cited above, provides evidence from records of the national accounts that this is precisely what has happened in the past.

Now I don’t understand why the OBR has set the multiplier at 0.0 – and indeed will write to Robert Chote, head of the OBR to seek clarification. But anyone can see how helpful such a low multiplier is to the argument about austerity. An investment of £1billion that generates a negative return – i.e. costs the Treasury without any hope whatsoever of a return – explains precisely why the government can’t be bothered to invest in  libraries, or energy efficiency or de-carbonisation of the economy.  All of these investment could revive the economy….but why should the government bother to try and revive the economy, and with it the private sector – at a negative of return for government expenditure on public works? A return which does not even pay for the investment – and indeed is modelled not to pay for a return on the investment.

That’s not to deny that there are circumstances in which the multiplier may not work. If government spending goes into tax cuts – and if consumers choose not to spend those tax cuts – then returns to government may well be negative.  And if government spending – is invested in say, Siemens, Germany – it will leak out of the country, and returns on British public investment will go to the German government, not the UK government. That is a risk, and may explain why the OBR’s multiplier is negative. They don’t expect government to invest in Britain.

But if the investment goes into public works here in the UK – productive expenditure that improves our quality of life, employs people, generates income both for the private sector, the employed, but also for government – AND reduces the deficit – why on earth should it not do that?

Finally the unlikely point made by Knowles that thanks to cuts in government spending,  the deficit is falling in Greece.

Frankly, I can’t get my head around Greece’s numbers for its deficit – which are continuing to be revised up by actors such as the EU.. First of all, as is well-documented, with the help of Goldman Sachs and with officials at the EU and the ECB turning a blind eye, the previous Greek government ‘cooked the books’. They lied about their deficit – and hid parts of it in complex products invented for them by the bankers at Goldman Sachs. So before 2009 they claimed that the deficit was 5% of GDP. When finally EUROSTAT/ the EU/IMF got their act together and looked at the books, they estimated the deficit at 15%. Since then it has apparently come down to 10%. I find this all very dodgy.

Second: remember the government deficit can be compared to an overdraft. The public debt can be compared to a mortgage. (Although please: there is no way that government spending can be compared to individual or even corporate spending; that we can draw macroeconomic conclusions from microeconomic reasoning!)

But just for illumination: Greece’s ‘overdraft’ or deficit will, of course, be volatile. Large sums of money are being transferred by the ECB and other institutions into the government’s bank account to help with the crisis. At that point in time the ‘overdraft’ will look good. But it’s the ‘mortgage’ that we should worry about, and whether or not the ‘mortgage’ is being paid down or rising.

It’s the economy stupid.  The deficit will only recover, when the Greek economy recovers. And not before. If the ‘overdraft’ or deficit gets a boost from a one-off deposit – is that helping the Greek economy recover, so that government can collect tax revenues from an active private sector and pay down both the deficit and the debt?

Right now, I am not in a position to tell why the Greek deficit has apparently fallen. But to be honest, my major concern is whether the economic recovery in Greece is in place, and is sustainable over the long term.

And I suspect that even Daniel Knowles can see what I can see: Greece is going downhill….Is that really the model Britain should follow?

This article was simultaneously posted on LeftFootForward and PRIME >

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4 comments to Knowles needs to listen more carefully to ‘hero’ Clinton on deficit reduction

  • Nice rebuttal of young Knowles. I agree that, at least on the basis of economic theory, expanding public expenditure is a more certain way of creating jobs than tax cuts. But there are problems here. First a significant proportion of public sector projects take years get going, by which time the recession may be over. Second, the unemployed are relatively unskilled, and the public sector is not nearly as good as the private sector at employing such labour.

    Having said that, I certainly think it would be beneficial if the public sector had more built in flexibility. E.g. in a recession schools could be given more money to enable them to take on any local unemployed teachers or part qualified teachers, perhaps a teachers’ assistants.

    Also, can I suggest there is a “Knowles – OBR” argument which you could have demolished more effectively? This is the idea that a zero or negative return to the Treasury is some sort of problem. Money (or bonds) issued by a government in a recession are not a REAL COST. They do not involve the consumption of real resources. They are better as plastic chips issued by the umpire in a game called “economic activity”. If the government has to print and issue £1,000 to every household in order to get the latter to spend enough to create 1000 jobs, the return to the Treasury is deplorable. But the real cost of the £1,000 per household is about zero, whereas 1,000 extra jobs means plenty of extra real output.

  • ” and returns on British public investment will go to the German government, not the UK government. ”

    That’s incorrect. If the British government pays in GBP then it can only ever go into GBP savings or spending with some entity that accepts GBP in exchange for real goods. It doesn’t just disappear.

    So the evaluation is more complex than just ‘British jobs for British workers’. It might be that the GBP spent on German trains pops up in increased orders for the British ‘big yachts for rich people’ industry, or Northern Irish tourism – offset by a slight weakening in the exchange rate.

    About the best argument you can make is that buying British means that the government has a better idea whereabouts in the British economy the funds will pop up.

    Of course the worse thing that happens is if the foreign entity uses its GBP profit to purchase GBP government bonds. Then we end up paying interest on a bad decision as well. Another reason why we shouldn’t bother issuing something that is completely unnecessary in our monetary system.

    If we’re giving Germans GBP we want them to spend it, not save it.

  • I’m 100% a Keynesian. I think about Keynes all the time, but it’s hard for me to believe that in all times and all situations that domestic Government spending will ALWAYS pay itself back — at least 100% — into the Treasury. I’m willing to buy that it’s needed in a time of uncertainty. But I always pay back 100%? Usually more?

    Really?

  • zoltan Jorovic

    I find it interesting that the austerity enthusiasts are simultaneously arguing that unless their solution is pursued with enthusiasm the UK could become like Greece, while holding Greece up as an example to follow that justifies their solution. Simultaneous possession and consumption of cakes springs to mind.

    To pursue this analogy, if we think of our debt as a cake. Austerity is saying if we bolt it down, debt will disappear. Ann says we will get sick, and throw it all up again, so we still have the cake, but it is much less appetising. She suggests we layer it with something sweet, and eat it in small pieces, slowly. So although the cake increases in size initially, it goes down and stays down without making the eater seriously ill.

    Think of debt as a heavy fruit loaf, slice it up, add some butter or cream, and it will get eaten down to the last crumb. Try to swallow it unaccompanied, it will stick in your throat.

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