Forget the deficit?

Despite his denials, I suspect that Ed Miliband "forgot" to mention the deficit in his speech yesterday for the same reason schoolboys forget their homework - because they don't care about it.

If I'm right, he has an excellent antecedent. Back in 1933, Maynard Keynes said:

Look after the unemployment, and the Budget will look after itself.

But is Keynes' saying still relevant? My chart shows the result of a simple test. It shows the regression of public sector net borrowing as a share of GDP upon the unemployment rate, plus lagged unemployment over the past 10 quarters.

I'm defining unemployment as the officially unemployed, plus the inactive who want a job: ONS data on this began in 1993, so the lags mean our data starts in 1996. And I'm using lags of unemployment because some taxes (such as corporation tax) only flow to the Treasury with a long lag.

My chart shows three things.

First, that there's a close relationship between the two: the R-squared is 75%, implying that Keynes was three-quarters right*.

Secondly, pretty much all the rise in the deficit between 2007 and 2010 is explicable by unemployment. In this sense, the deficit was cyclical.

Thirdly, in the last two years the deficit has been higher than unemployment would predict. You could interpret this as a sign of a "structural" deficit. But if you do, it's one that has emerged only since 2012. And it's no bigger than the "structural" deficit of 2005 - and you'll remember the great fiscal crisis of that year. Not.  

In fact, I suspect there's a simple reason for this gap. It's simply that the drop in unemployment overstates the health of the economy. Joblessness has declined not just because the economy has grown buty because productivity has stagnated. This means we have not seen the rises in wages and profits we usually see when joblessness declines, and so tax revenues haven't risen as much as they should have.

In this sense, we might rephrase Keynes: look after unemployment and productivity, and the Budget will look after itself.

Now, I'll concede that I might be wrong here. Maybe there is indeed a "structural" deficit that requires significant fiscal tightening. But I'll need better evidence than estimates which are based upon the mumbo-jumbo idea of an output gap. And in the absence of such evidence, we should at least entertain the possibility that the deficit doesn't matter. Maybe therefore Miliband was right to forget it, as there are much higher priorities.

* I suppose one might argue that the relationship is the other way round, and deficits cause unemployment 18 months previously. Feel free to provide empirical evidence that this is the case.

Comments

[Luis Enrique]

I am assuming that everybody has their knickers in a twist because sensible types like the IFS forecast that absent fiscal tightening the deficit would stay worrying large for a long time.

Which raises the question, are they forecasting high unemployment for a long time, or don't their forecasts reflect the relationship between unemployment and the deficit that you report here? And if not, why not?

[chris]

@ Luis - I suspect it's because they expect productivity to stay low - that there's been a permanent reduction in the sustainable level of output. This might be right, or not. But politicians can be forgiven perhaps for not wanting to sacrifice real people's jobs to a forecast, however reasonable.

[Liam]

I'd love to see how Keynes would do on the Daily Politics if he was alive today, trying to convince the utterly impartial Andrew Neil or Nick Robinson that deficits aren't as important as unemployment.

Did the very serious people in the 1930s think all unemployment was structural and nothing could be done? Did they change their minds 10 years later when teenagers were flying warplanes and women were working in munitions factories, and admit that government spending could play a useful role in reducing unemployment?

[Neil Wilson]

The next question is why is the deficit 'worrying' - given that it is just the excess saving of the non-government sector.

If they stop saving in Sterling, then by definition they are spending Sterling on something, which is taxed, which reduces the deficit. Sterling is non-convertible.

The reason for worrying over the deficit is that it tells you that the economy is suffering from an excess of safe saving - which means that there isn't anything more interesting to invest in!

It's the lack of anything interesting to invest in that's the problem - particularly when you are paying no interest to people doing the saving.

Both unemployment and private sector productivity could be addressed by offering a full alternative job guarantee from the public sector at the living wage. Then the private sector is always forced to compete for the labour it requires, which increases the incentive to replace the jobs with machines, or better processes.

And the labour 'nobody requires' produces non-competing public goods for us all to enjoy.

[Alex]

The obvious, and unrespectable answer: unemployment hasn't come down as much as the blue line suggests, because the figures are dodgy. What you're showing is perfectly consistent with a major shift of people from counted unemployment (i.e. jobseeking), into noncounted unemployment (i.e. drawing WTC with nugatory hours, aka bogus hairdressing).

There is an underlying improvement (the economy is actually doing better, we're not making it up), which you can see from the improvement in the budget (i.e. people are paying tax and earning-out of the tax credit regime).