There is a good deal of talk in Europe at the moment about balanced budgets and the need for public authorities to achieve these. Indeed, the need to balance the books provides the whole rationale for the current programmes of deficit reduction. What is missing from the conversation is an explanation of what a balanced budget is, and why it might be good for us. The purpose of this piece is to explore these issues.
If we were to take a very strict view of a balanced budget, public authorities would not incur any expenditure unless they had received a corresponding amount of income. This, of course, is an absurd position. The flow of income into the public coffers is episodic and anything other than smooth. For example, the self-employed in the UK pay their taxes on 31st January and 31st July each year. A strict view of a balanced budget would have it that the UK government could only spend money on those days. This is not practical. Much government expenditure is on salaries, and staff like to be paid monthly. Indeed, those authorities that have mismanaged their affairs, such as the State of California, have to resort to issuing IOUs to staff when there is insufficient cash to make the salary run, which is not a sustainable situation for any length of time. In order to smooth the peaks and troughs between income and expenditure flows, public authorities have to resort to borrowing. Indeed, most public borrowing is short term (i.e. less than three months) just for this purpose.
We might argue a less strict rule by holding that budgets need to be balanced each year. Laying to one side the issue of why a year is a convenient accounting period as opposed to, say, 9 months, or 15 months, and so on; it is worth delving into this view a bit further. Many advocates for balanced budgets take the view that expenditure should be matched to income over a single accounting period. Intuitively, this makes sense, but it can lead to some pretty untoward results. There will be good years and bad years. Years of relatively high economic activity (when the tax take is high) and periods of relatively low economic activity (when the tax take is low). If a nation were to balance its books so that expenditure matched its income in any one year, then the result would be to destabilise its economy by making the booms much higher than they otherwise would have been and the troughs much lower than they needed to be. One could argue that the last time this was tried was between the two World Wars, with the overheating of the 1920s being followed by the depression of the 1930s. Despite where we are today, we are nowhere near as badly off as we were in the 1930s.
One of the insights of Keynes was to show us that an annually balanced budget would lead to long periods of acute economic inactivity. This has led to the view that budgets should be balanced over the course of the business cycle. There is much to commend in this view, except that it doesn’t take into account the issue of investment, particularly investment in infrastructure. This has led to what has come to be known as ‘The Golden Rule’ of public finance, that states that budgets should be balanced over the business cycle, except for borrowing to pay for public infrastructure projects. In many respects, this makes sense. Public infrastructure projects, such as roads, bridges, hospitals, prisons, and so on, have a useful economic life that well exceeds the course of a single business cycle. A well placed road, or a well built building, may last for centuries.
Whilst the rule appears to make sense, it doesn’t really address the issue of when the borrowing would be paid back, and the structural surplus in the budget that would be required to do so. If an authority ducks the issue of raising the structural surplus, for which there is a major political incentive to do, then the result will be an accumulation of public sector debt, albeit structural debt. It is concerns about the accumulation of debt that lead observers to advocate balanced budgets.
The rationale for balanced budgets is that we should all live within our means. This is readily evident from the perspective of the Hausfrau, but is very different when applied to a national government. The government differs from households in three important ways. First, it can print its own money. The Hausfrau is not able to take a piece of paper, write ‘Five Euros’ (or whatever the currency is), and then compel everyone to accept that piece of paper as fair value in exchange. A government can. The electronic version of this – Quantitative Easing – is exactly what is happening today. The second difference is the power of taxation. The Hausfrau is not able to go into a shop, open the till, and take part of the shop proceeds. A government can – it’s called taxation. The third difference is that a Hausfrau is unable to manipulate the value of her obligations by controlling both the exchange rate and the internal rate of inflation. A government can manipulate the real value of its currency. It is absurd to say that a nation needs to live within its means when it has the ability to print its way out of debt, tax its way out of debt, and to inflate its way out of debt.
This is important when we consider our medium term economic futures. In many respects, both the US and the UK have worse debt positions than the Eurozone. And yet, it is the Eurozone that faces economic turmoil. This is because the US and the UK still have access to the three levers at a national level, whilst the Eurozone nations that are in trouble do not. The case of Greece is quite instructive here. The taxation of Greek society has gone to the point where any further fiscal tightening could seriously destabilise Greece as a nation. And yet there is more to do. Greece desperately needs to print money, but the ECB is prevented from functioning as a Central Bank by acting as a sovereign lender of last resort through the mutualisation of obligation. Greece urgently needs a monetary restructuring, either from an external devaluation or internal inflation, but the ECB is charged with acting to prevent this from happening. Increasingly, the solution that seems to be gaining ground is for Greece to leave the Eurozone so that the Greek government can regain control of the two levers that the ECB presently denies them. This is not a foregone conclusion though, because it is still possible for other Eurozone nations to come to the aid of Greece through the mutualisation of obligation at the ECB.
In considering Greece, we hit upon an important limiting factor to the need for a body to balance its budgets, and that is the willingness of its lenders to continue lending to it. The issue of balanced budgets is being forced upon Greece, and not the US and the UK, because its lenders are increasingly reluctant to loan further funds. If the Greek creditors were confident in making further loans, then the issue of balanced budgets would be relegated from being most pressing to being one of a number of possible strategic vulnerabilities. Perhaps that is the biggest indictment of the Greek government – not having sufficient foresight in managing its strategic vulnerabilities.
But then, I would say that wouldn’t I? After all, I am a futurist, and that is what we do.
© The European Futures Observatory 2012
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