Some readers have expressed bemusement at my claim in an earlier post that the only genuine deficit reduction policies are those which stimulate private sector investment and/or reduce their savings.I should expand.
Start from a trivial identity - that every pound someone borrows is a pound that someone else lends. This means that if one sector of the economy is a borrower, another must be a net lender - that is, its savings must exceed its investment.
My chart shows the net lending of the four sectors of the economy*. The most important point here is the negative correlation between public sector and companies' net lending. When companies were net borrowers in 1999-2001 the government ran a surplus, but corporate net lending in recent years has been associated with government borrowing.
But what's the direction of causality? Is government borrowing causing companies to be net lenders, or vice versa? In theory, government borrowing can depress firms' capital spending - and hence cause it to save more than it invests. But the mechanisms whereby it does so don't seem to operate now. For example:
- Financial crowding out. In this, government borrowing raises interest rates, which deters companies from investing. We know this hasn't happened, because index-linked gilt yields are now negative, and in fact were trending downwards ever since the early 00s when the government became a net borrower.
- Resource crowding out. It's possible that if the government is spending and borrowing heavily it is employing so many workers and materials that companies simply can't get the resouces they need to invest. It should be obvious that this isn't relevant today. And as there were four million unemployed even at the low point in 2005, I doubt it was relevant before the crisis.
- Ricardian equivalence. The idea here is that government borrowing means higher future taxes, and the private sector saves more in anticipation of that burden. This theory, though, runs into several problems, such as: why do people expect taxes to rise rather than public spending to fall? And why, before the crisis, did companies increase saving in anticipation of taxes rising for them, whilst households were saving less, presumably in anticipation of falling taxes?
Given these issues, I suspect the causality runs the other way. Before the crisis, foreigners were net savers, because they were building up FX reserves after the 1990s Asian currency crises, because oil exporters couldn't quickly reinvest oil revenues, and partly because of a lack of a welfare state in China. At the same time, a dearth of investment opportunities caused companies to save rather than invest. These savings caused interest rates to fall, helping to cause a housing boom and net borrowing by households. It also caused governments to borrow more, partly because tax revenues were weak, partly because low interest rates signaled that borrowing was cheap, and partly because weak private capital spending led to the belief that a Keynesian stimulus was necessary.
Since the crisis, though, households have joined companies and foreigners in being net lenders as the housing bubble burst. With those three sectors all being lenders, the government must be a borrower. In more conventional terms, the reluctance of foreigners, households and companies to spend has created a weak economy and hence low tax revenues and the need for counter-cyclical spending.
Which brings me to where I started. The government's deficit can only fall if the other sectors reduce their net lending.
In normal times, fiscal austerity might achieve this by reducing interest rates and thus stimulating private investment. But with interest rates already below zero in real terms, these are not normal times. Osborne thought austerity "will have a positive impact through greater certainty and confidence about the future" - that higher confidence would stimulate private investment. But this hasn't happened so far.
So what policies might reduce private sector net lending? Policies such as the Funding for Lending Scheme, aimed at boosting borrowing, are intended to do so, as is QE. I suspect that the passage of time would also do so; an easing of the euro crisis and a need to replace worn-out capital will eventually boost investment.
But my point here isn't to advocate specific policies, but to merely describe the problem. The problem is that the government has less control over its finances than politicians pretend.
* Four quarter rolling totals. Don't read much into the fall in the corporate surplus recently - it's affected by the transfer of the Royal Mail pension fund.