Thursday, January 24, 2013

The difference between deficit, debt, and borrowing

I was amused last night by the Conservative Party Political broadcast; there they were happily citing figures of much better they've made the economy. Unemployment is down, more jobs have been created etc. I'll deal with that in another entry. For this post I'll deal with their claim that they've reduced the deficit, for the record it's perfectly true, but I think there are some out there who don't quite grasp what the deficit actually is particular those shown in the broadcast. I also think it's in the best interests of all the political parties that people don't understand it either. To hopefully remedy that here's a simple explanation.

The government gets an income from taxes, it then spends that income on services. If it has more money coming in than going out it's called a surplus; if there's less money in than going out it's called a deficit.

In these simplistic terms it should be obvious that to reduce a deficit a government can either raise its income via a rise of taxes (or creation of new ones); or by reducing how much it spends. However there is one other source of income for the government - borrowing.

Our current government has been doing all three - subtly raising taxes, unsubtly cutting services and borrowing lots (and lots) of money. Unsurprisingly enough this has reduced the deficit. But is a reduced deficit the mark of good economy? Consider the implications of each of the actions that can be taken to accomplish this.

Raising taxes. People have less money to spend.
Cutting services. People have to spend money on services previously provided so again they have less money.
Borrowing. Increases the public debt which requires more money to service the interest and pushes a loss of money into the future.

All three methods take money out of the system and we're going for the trifecta. Why? Because it's the quickest method of reducing the deficit and in theory balancing the budget. A balanced budget is the holy grail of government as it means they're charging the population enough to provide the services the population require and not too much or too little.

Update - Always nice to have these things confirmed by the UK Statistics Authority.

Okay that's the basics, carry on for some more outcomes.

Sadly a balanced budget isn't always a good thing - consider a government that has only enough income to pay the salaries of its members and thus provides no other services; that would be a balanced budget, but would hardly be a popular one. Likewise a government that puts everything under state control thus providing all services, but in turn needs to take everyone's money.

What is required is a balanced balanced budget, but due to this trifecta we're edging towards the former situation of every person providing for themselves. Pretty much policy for any group that sits on so much inherited wealth.

It gets worse. Remember that borrowing? We're never going to reduce the deficit  to zero until we've paid back everything we've borrowed and as I've said elsewhere as soon as we start doing that any future borrowing will acquire a higher rate of interest. So to remove the deficit will require even more cuts, more tax rises and no borrowing at all. In essence the country would need to become self-sufficient. Sounds reasonable, except that leads to more problems.

The reason we're not self-sufficient is due to imports - money is leaving the country and not coming back (In 2011 we spent £32bn and gained £23bn); why? Because the goods we import are cheaper than the same goods produced in this country. If we started sourcing only internally the price of goods would increase, people would require more money to buy them, which in turn would increase the price of the goods those people produce. This is the main cause of inflation.

To keep prices down in this situation requires one of two main things - greater competition, or government subsidy. Competition is the free market answer. If two companies produce the same goods people will purchase whichever is cheaper. While in theory this means a lowering of profit a 're-negotiation' of wages is also likely. Again in theory this is similar to the balanced budget - provided you have enough money to purchase goods it matters not if you have more or less than before. Competition however needs to be watched less it lead to cartels or monopolies. With the just-in-time, centralised distribution centres and wider product ranges that come with efficiency (higher efficiency means lower expenses means being able to reduce product prices) informal cartels and monopolies start to form naturally. Competition is therefore good provided government keeps a close eye on its internal workings. So as the government needs to be involved anyway why not cut out the third party and switch to subsidies?

Subsidy is almost a swear word in a country that follows a free market doctrine yet every single one practices it. Hypocritically it's a case of it being fine if we do it, but not if someone else does. So as we all do it why not implement it?There's a catch. There are two ways to provide a subsidy - fixed and relative.

For a fixed subsidy the producer receives the same amount regardless of the price they've sold it for. If a product costs £5 to produce and is sold for £10 and the subsidy is £10; profit is £15. However the minimal price that the goods can be sold for is £5, the producer makes a profit equal to the subsidy. To make more profit the cost has to be reduced. This is a good thing for the consumer, but the easiest method of reducing cost is by reducing salaries. Lower prices, but also less money to spend.

This is also the case for a relative subsidy. In that the price is made up to a value. Again if cost to produce is £5 and the goods are sold for £10 with a subsidy of £10 no payment is made and profit is £5. If the goods had been sold for £7, the subsidy would make add £3 so profit is still £5. The minimal price to sell becomes zero resulting in £10 subsidy with again the only way to increase profits by reducing the cost to produce.

The latter would seem to be a good option with producers simply handing over their goods to the retailers for free who in turn can charge whatever they like for total profit. Except the producers need paying and that comes from the government. Essentially taxpayers would end up paying the retailers to sell us stuff.

Any subsidy requires the government's income to be increased. As, at this point, borrowing is out of the question the only result would be to a) increase taxes or b) reduce costs; sound familiar?

Given the current situation that banks have left us in due to laissez faire policies it seems odd to advocate for a free market doctrine, but in this instant it really wasn't the banks fault. They were doing what the government encouraged them to do (make lots of money) and the government just closed its eyes to the what they were doing in the vague hopes that it'll all turn out okay.

Oddly enough it didn't (it rarely does) yet it's the banks suffering the ire instead of the government who should have been watching them. Are we going to get more overwatch? Don't be daft that would inflict far too much red tape and "stifle" growth. Far better to just grab as much money as possible while spending as little as you can and have a vague hope that it'll all turn out okay... huh again that sounds familiar.