Government as household: if only!

Many of us economists are bald. One reason for this is that for the last 40 years we've been tearing our hair out whenever politicians liken government finances to those of a household. Although Thatcher popularized this woeful analogy (as early as 1949) it lingers on in Labour. Rachel Reeves' claims that "there's not a huge amount of money there" and (inverting Keynes) that "if we cannot afford it, we cannot do it" both appeal to it.

You all know this analogy is wrong. For one thing, households can cut their spending without cutting their income but governments sometimes cannot do so because cuts in public spending depress economic activity and hence tax revenues*. And for another, governments (in the UK if not euro zone) can print money, and so there is always "a huge amount of money there". The constraint on public spending is real resources - doctors, builders, management skill - not money.

For these reasons economists often say that the household analogy leads to bad policy.

And often they are bang right.

But not always. If the government were serious about managing the public finances as if they were a household, policy would actually improve in some ways.

I say this because of reports that Reeves is thinking of using private finance to fund the building of the Lower Thames Crossing, in exchange for which they would receive incomes from the tolls.

The problem here is simple. The government can borrow in the gilt market at a real cost of around 1% (depending on the maturity of the loan). Private financiers, however, will demand a higher cost than this; they wouldn't invest otherwise. The government will therefore in effect be borrowing at a higher cost than necessary. That's like a household choosing to take on expensive credit card debt rather than extending its mortgage at a lower rate. As Daniela Gabor has said, Reeves is in effect handing out subsidies to private financiers.

Of course, that might be her intention. But it's not something a sensible household would choose to do**.

She is doing this because of another way in which she is not running the public finances as a sensible household would. I'm referring to the fiscal rules, one of which is that "debt must be falling as a share of the economy by the fifth year of the forecast."

No sane individual would adopt such a rule, and not just because they know that one should never rely upon forecasts. It's also because what matters is the sustainability of debt over one's lifetime, not over five years. (There are only two things that can go wrong in personal finance; either you'll outlive your money or your money will outlive you).

Any fool can reduce debt in the short-term by selling their house, paying off the mortgage and renting a place. Whether you should do that depends upon whether the cost of renting is cheaper than that of borrowing, all things considered. That's a tricky calculation. But it's one that households wouldn't make if they were tied by that "non-negotiable" fiscal rule; they would just cut their mortgage and not worry about the fact that they'll have to pay the rent after five years.

This, though, is exactly what Reeves is doing in thinking of handing over future toll revenues to private financiers; she's giving up long-term income in order to meet a short-term target. As the Institute for Government has said, the fiscal rule "does little to promote fiscal sustainability." No sensible household would behave like that.

Such an absurdity is the result of another absurdity in the fiscal rules; they ignore the fact that balance sheets have two sides - assets as well as liabilities.

A sensible household would want to increase debt if in doing so it could buy an asset which yielded more than the cost of debt (adjusting for risk!) Buying a house - thereby saving on rent - or a business can be perfectly reasonable things to do.

Not so for Labour. Reeves has said that nationalizing utilities “just doesn’t stack up against our fiscal rules”. Which is drivel. Many utility companies have dividend yields well above the 1% it would cost to buy them, so nationalizing them would generate a net revenue for the government.

No household would rule out investing in a business on the basis of the level of its debt without also considering the cost of that debt relative to the income stream it is buying. But that's what Reeves is doing.

Of course, there are good arguments against nationalization, one being whether the companies would continue to yield so much under state control***. But this is exactly the question a sensible household would ask: is this business really as good as it seems? Can we manage it well? It would not rule out buying merely by saying "debt, aaarghh!"

There's another way in which the public finances would be better managed if governments took the household analogy seriously. It lies in Sir Keir's promise to raise military spending to 2.5% of GDP.

To see how daft this is, imagine a family decided that it wanted to eat more healthily. It would not be so stupid as to set a target of raising the share of its income it spends on fruit and veg. It could do that by spending £20 on a single carrot. Instead, it would buy a greater volume of fruit and veg and less of something else. It would be explicit about what it cuts from its weekly shop, and it would pay attention to value for money. Neither of these obviously sensible actions are contained in Sir Keir's target, which provokes the thought that just as Reeves wants to give handouts to financiers so Sir Keir wants to give them to military contractors.

You might object that there's a limit to my descriptions of what a sensible household would do. Sometimes, households are forced into bad decisions, such as by having to borrow at high rates if their creditworthiness is bad. But this doesn't apply to the government now. The fact that the gilt market is willing to lend to it at a real rate of just 1% tells us that the government is free to act sensibly. That it is not doing so is a policy choice.

Nor is any of this to say that Labour should run a significantly looser fiscal policy. I don't think it should, simply because there isn't enough slack in the economy to do so: boosting growth right now should be the job of supply-side reform and regional policy, not fiscal policy.

Instead, my point is simple. It's that if the government is to treat the public finances as if they were household finances it should be consistent in doing so, as this would actually lead to better policy-making.

* I say sometimes because if interest rates are high enough, monetary policy can be loosened sufficiently to offset the impact of spending cuts. This, however, was not the case with Osborne's austerity.
** In practice, however, many households do exactly this by paying too much in fees to fund managers - but few of us think they should do so.
*** There are other arguments. One is that nationalization just gives a future government something to sell off cheaply to its cronies. Another is that - given the pisspoor quality of UK management - the companies will be badly managed whoever owns them and its better than capitalists get the blame than that the government does.

Comments

[CA]

A perfect essay, but the point is really that Labour governors really want to be Conservatives and are determined to have Conservative policy all through. What a terrible Conservative party Labour has become.

[James]

This is an excellent post - worth noting that the same people who despair at government debt above (choose your number)% of GDP will often recommend a household borrows 350 to 500% of their salary to buy a house.

One slight quibble. The marginal cost of government debt is not quite the same as the real gilt yield - were the state to borrow a few percent of GDP to nationalise utilities the increase in supply of gilts would affect the interest rate of all outstanding debt. Seems unlikely to be significant, but the relevant elasticities are interesting empirical questions.

[D]

One potential advantage of private finance/ownership - it's easier for them to do unpopular but necessary things because they don't need to worry about votes.

I do wonder sometimes if a hybrid model where you direct publicly owned companies to profit maximise could work.

Could result in "private" utility companies but with lower borrowing costs, lower exec costs, and dividends paid back to the people

Also would be good to compare with actual private utility companies. Say have some rail franchise or elec dnos publicly owned but otherwise operating as a private business and the rest private...

[Kester Pembroke]

Hi,

I believe the mainstream theory government finances spending by tax, borrow or print is wrong. In the UK all government spending works by creating money and there are unlimited intraday overdrafts at the central bank borrowing happens at the end of the day. Money can’t leak abroad it is a swap/exchange, not a conversion. If there is no saving or pay back bank loans in the spending chain you will get all government spend back as tax. Similarly, if people spend from savings or take out bank loans and spend no saving or pay back bank loans get all that money back as tax too. Government spend at Tesco get some back as VAT (taxes as ‘cashback’), Tesco pays its employees another chunk taken by government in income tax and so forth.

https://publications.parliament.uk/pa/cm200102/cmselect/cmpubacc/349/349ap02.htm

Point 20 says:

“ensure that its position is balanced at the end of each day”

Also at diagram in bottom surplus/shortfall in consolidated fund.

[rsm]

Does the idea that "the restraint on public spending is real resources" cause many of us to want to rip our hair out too?

Was the "resources" link (to a 2022 entry by our blogger) closed before I had a chance to reply to Boyo's questions?

"1. How is it prices are arbitrary?
2. Can you explain how inflation is psychological?
3. What is full indexation?"

What if prices are arbitrary because there is a psychological factor that trumps standard economic model parameters such as supply and demand?

Consider Fischer Black writing in "Noise":

"All estimates of value are noisy, so we can never know how far away price is from value.

However, we might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value. The factor of 2 is arbitrary, of course. Intuitively, though, it seems reasonable to me, in the light of sources of uncertainty about value and the strength of the forces tending to cause price to return to value. By this definition, I think almost all markets are efficient almost all of the time. “Almost all” means at least 90%."

Can you see how, if prices are noise, inflation is just noise upon noise, not any sort of signal of a real resource constraint?

Thus why isn't indexation the best answer to the psychological problem of inflation?

ChatGPT says: "Indexation in economics refers to the adjustment of wages, benefits, taxes, or other financial variables according to a predetermined index, typically an inflation index like the Consumer Price Index (CPI). Its primary goal is to maintain purchasing power by compensating for inflation or deflation."

Also see Stanley Fischer & Franco Modigliani, 1978, "Towards an understanding of the real effects and costs of inflation":

"There is no convincing account of the economic costs of inflation that justifies the typical belief - of the economist and the layman - that inflation poses a serious economic problem relative to unemployment. [...] We start by examining the real effects of anticipated inflation in an economy that has fully adapted to inflation. In particular, in this economy (1) public institutions are fully attuned to inflation (or inflation proof), (2) the same is true of private institutions, (3) current and future inflation is fully reflected in inherited contracts, and (4) future inflation is fully reflected in contracts for the future."

[Terence Callachan]

Thank you for writing this , i agree with what you say , i fear the Labour party have given up trying to reverse the madness imposed by the Conservative party and now try to cosy up to the same people and organisations that the Conservative party represent , do they do it in the hope that those people and organisations will let them issue some relief to the poorer folk in our society ? I dont think so , do they do it because the Labour party has been infiltrated by people who belong in the Conservative party ? Yes i think so , i would say this took place when true Labour politicians were ousted by these new pretend Labour politicians with the help of the english newspapers and the BBC and SKY accusing them of " antisemitism" , we dont hear much accusation of antisemitism now do we , the annihilation of arabs in Gaza by the israelis has driven those false accusations of antisemitism out of town.

[ardj]

Much to agree with, and thank you. But - off topic: are you sure about "bang right", and not getting confused with "bang to rights" ? The plain verb can of course be used for emphasis, &c. as in "it struck us bang on the stern" or "I want her to reply bang off", "Bang - went saxpence".But these notions of force or of immediate consequence do not seem to be what you mean. 'Bang' has also the sense of continued or repeated action, but that would not apply here, any more than a sudden loud noise or sudden excitement, a 'kick' does, and copulation seems unlikely. (I doubt that "left" or "right of bang" is a relevant parallel.)
Your nonce use seems more to lie in areas like 'bang on', 'bang opposite', meaning roughly "exactly": but it sounds odd when one could more conventionally say e.g. 'dead right'. But you could use the programmer's use of 'bang' to convey emphasis: !right!

[Alex]

OG PFIs were much more than just "central grant in aid vs project finance", usually being complex outsourcing contracts that involved operational functions far into the future. They tended to be design/build/transfer/operate if they weren't full on BPO, and much of the point was the supposed "risk transfer" which inherently involved a transfer of management. This was also largely what people didn't like about them.

Absent any funky twists like BPO or rights to refinance (a huge deal in original PFIs that was eventually got rid of), do you think there'd be much of a premium between e.g. a bond secured on tolls and guaranteed as a contingent liability and straight gilts? In those circumstances it just becomes a distinction between project-financing (remember that was the alternative to OG PFI!) and central grant in aid, and I am not sure anyone has much side about that.