The debate on ‘deficit spending’: The framework for Corbynomics

There is a debate among anti-austerity economists and supporters of the Jeremy Corbyn leadership of the Labour Party on balanced budgets and related matters. The debate was prompted by Shadow Chancellor John McDonnell’s commitment to eliminating the budget deficit and was sparked into life by this SEB piece, The need to clarify the left on budget deficits- confusions of so-called ‘Keyenesianism’. It was met with this reply from PRIME economics, ‘Living within our means’: deficits and the business cycle.

The debate relates to fundamental issues of economics and economic policy. It leads to what policy framework a radical, anti-austerity party (or government) should adopt. In the course of a constructive debate we should aim to arrive at some greater clarity on this important issue.

The debate

The original SEB piece began with the argument that the main factor accounting for growth is investment. This has long been the position in classical economics from Adam Smith, who called it an ‘increase in stock’, to Marx, who used the term ‘development of the productive forces’. Keynes pointed out that the ‘General Theory’ was primarily concerned with how to regulate the investment function in order to achieve growth and prevent slumps*. Modern usage speaks of an ‘increase in productive capacity’.  However, the logic of this classic position has now been demonstrated by the highest point of modern econometric analysis, most especially through Vu Minh Khuong’s masterly study The Dynamics of Economic Growth .

All output requires inputs. Consumption is not an input and therefore cannot lead economic growth. All economic activity depends first on production (of a good or service).  It is not possible to consume that which does not already exist, either through nature’s abundance, or through the production process.

The decisive inputs for output are the level of fixed investment and the amount and quality of labour. Vu Minh Khuong’s study shows that, taken together these account for about 90% of all growth in the advanced industrialised countries, with fixed investment playing the predominant role (57% of all growth in the advanced economies).

Consumption cannot logically be input to growth. Consumption takes place only after the production process is complete, and is highly dependent for its own growth on the growth of output. It has a dependent, subordinate role in relation to output.

There are also only two ultimate destinations for output. It can either be consumed or invested. Since investment is the sole factor of these two which can raise the level of output, it follows that the greater proportion of output devoted to investment, the greater the potential growth of that output. The opposite also applies. The greater proportion of output devoted to consumption, the lower the potential growth of output. There is no such thing as ‘consumption-led growth’ (or its near cousin, ‘wage-led growth’ as wages too are a consequence of output, and the struggle between classes over its distribution).

A farmer’s crop in one year is ten bags of wheat. If she and her family consume all ten bags, there is no seed to sow for next year’s harvest. If she retains two bags to sow next year the crop will be the same. But if she can reserve 3 bags to so next year the crop will be 50% bigger, all other things being equal. By increasing the proportion of output devoted to investment, total output rises in the following year and so can the level of consumption. The increasing complexity of economic activity does not alter these fundamental relationships between investment, growth in output and consumption.

This relates to the debate on balancing the budget. If a radical, anti-austerity government simply borrows or creates money to fund consumption, it will provide no boost to long-term growth. This is merely a stimulus to spending or consumption. This may be needed when consumption has fallen dramatically but cannot be a feature of a medium-term economic policy.  If on the other hand, the same government borrows to invest in the productive capacity of the economy then the economy is capable of sustainable expansion.  This in turn can lead to economic growth and the growth in consumption. Therefore such a government or economic policy framework, which we can call Corbynomics, should aim at increasing the level of borrowing for investment and aim at eliminating borrowing for consumption in favour of borrowing for investment.

Unfortunately, the PRIME piece does not deal with this substance of the original argument. Instead, there is agreement that there is only consumption or investment, and no logically separate category of ‘government’. It agrees on the need for public investment.  It also agrees that there can be money creation to fund public spending.

But it is hopelessly confused in treating the central argument. This is that there is only consumption or investment, and of these two only the latter can contribute to growth. Instead, it accuses the original piece of containing:

This is false and somewhat foolish. Consumption and investment are different functions. ‘Money’ or more accurately output, cannot be used for both functions simultaneously.  Money is a medium of exchange used to purchase a good or service, and this can only be for consumption or investment. (Money as capital can also be, and frequently is hoarded. This is the situation currently and which is why the state must lead an investment recovery.) Furthermore, the proportions between consumption and investment are decisive for growth.

If Nominal GDP (Y ) is 100, and Consumption  (C) is 85 and Investment (I) is 15.

The ratio between the two is approximately 5.5 : 1 (This is the position in the US economy currently. In the British economy it is close to 6.5 : 1).

If Y remains at 100 but C is increased to 90, then I must fall to 10. Contrary to the assertion of the PRIME article the two must sum to 100. But the ratio between them has adversely altered in terms of subsequent growth.

The PRIME piece may be confused between proportions and levels. This is not clear but is implied in the digression on the desirability of public services such as the NHS, education and so on.  Neither SEB nor, more importantly, John McDonnell favours cuts to spending in these areas, indeed both would seek to raise them. But the PRIME piece seems to suggest that this is what is stake in the debate and this is a confusion of its own.

To clear up this confusion: C cannot add to Y. This is because, if C = Y, then I must equal zero. As a consequence Y cannot grow. Nor can C grow, because it is based on Y and follows it. But if Y is 100 and C is 75 and I is 25, then the ratio between the two changes from 4.5 or 5 to 3. And, all other things being equal  the growth in Y will increase in following years by approximately 2%, from which it would be possible to increase C and I.

No-one in this debate wants government spending on public goods and services to decline, or the pay that is necessary to provide them nor the entitlements to social protection. That is the austerity policy.

But it is only possible to launch a sustainable increase in public services if there is economic growth, and this depends on investment. The principal policy aim should instead be aimed at driving up I at the optimal sustainable rate. This is the main factor (along with improving the quality of labour via education and training) which can lead to a rise in average living standards. Therefore the requirement to increase I is the basis for all serious discussion on People’s QE, government borrowing, taxation, wasteful spending such as Trident, and so on.  The determining role of investment in creating growth and prosperity explains the role and importance of borrowing to invest.

It is not possible to shop your way to riches. Neither is it possible to borrow your way to fund consumption. This is effectively what has been encouraged in the Western economies over a prolonged period. It has led to economic slump and stagnation.

As for the current budget deficit, this was £66 billion in 2014 while the revenue form Corporation Tax was £42 billion. It would be possible, for example, to have a graduated rise in this tax rate alone to halve the current budget, while still leaving the rate below that of the US, Germany, Japan and other industrialised countries.

But the main driver of the decline in the current budget would be growth itself, which, as the PRIME piece agrees, would generate tax revenues and lower government outlays. The disagreement lies in identifying how that growth is to be generated.

 

*JM Keynes, OUP, Quarterly Journal of Economics, February 1937.