Thursday, 3 December 2009

Why Has a Huge Hole Appeared In UK Public Finances? - By Michael Burke

Ever since the Tory Party conference it has been clear that there there are plans for a ferocious attack on public sector pay and social welfare benefits after the next general election. The main media outlets greeted the pronouncements from David Cameron and George Osborne with almost universal acclaim, although opinion polls suggest the public is far less enthusiastic. Quite why the poor and the lowly paid are in line to pay for the disastrous decisions of the extremely rich is never explained. It seems that the culprit for the credit crunch in Britain is now identified, it was the unemployed, low-paid and pensioners, in league with fat cat nurses, doctors and teachers. As Nick Clegg summed it up, they are all in line for “savage cuts”.

However, less frenzied commentary would show that not only is reducing the benefits of the most vulnerable and cutting the pay of the lowest paid morally indefensible. It is also economically illiterate. A savage attack on public sector pay and the provisions of the welfare state fails to address the underlying causes of the enormous rise in government deficits and debt precisely because there is no crisis of government spending. At the same time, a sharp reduction in government spending in these areas will threaten any nascent recovery and could have the effect of inducing a ’double-dip’ or ’W-shaped’ recession. Finally, it is also possible to confidently state that the proposed cuts will not yield any significant narrowing of the UK government deficits.

Sudden Impact

It is important to gauge both government spending and revenue in relation to GDP. The UK’s level of spending and revenues would seem pitifully small, say, in relation to the size of the US economy but would be utterly gargantuan relative to Monaco‘s GDP. In addition, as the cost of running a hospital will tend to rise both with population growth (more treatments) and inflation (the cost of those treatments), it makes sense to speak of both sides of the public sector accounts in their relation to GDP, to gauge real change.

Using this measure, for the last financial year (which ended in at the beginning of April 2009), there was no obvious crisis of public sector finances. As shown in the UK Treasury databank, public sector current spending was 39.4% of GDP in Financial Year (FY) 2008/09, up from 37.8% of GDP in the prior FY. This compares to a high of 42.2% and a low of 34.4% over the last 25 years [1]. Therefore, in the two most recent FYs public sector current spending has been in line with medium-term parameters and averages.

The chart below shows the trend in net public sector debt as a proportion of GDP. This includes all levels of UK government debt, not just central government. The chart shows that debt levels were stable until the beginning of 2008, when they began to climb rapidly.

Chart 1

Government finances were in reasonable health until very recently. It is also clear that it is the recession and the financial crisis that have produced the huge deterioration in them. Chart 2 below pinpoints the effect of the recession on government finances. The debt level as a proportion of GDP is shown versus the quarterly percentage change in GDP. Government finances began to slump at precisely the time the economy began to contract, at the beginning of 2008.

Chart 2

It is clear that the deterioration in government finances is recession-related. This is to be expected. Widening public sector deficits have occurred in every recession and under any UK government since World War II. It is the great severity of this recession that has driven the deficit wider at an unprecedented pace in peacetime.

Collapse In Revenues

A closer examination of the most recent period reveals the pace of the deterioration in the public finances, as well as beginning to identify its sources. The table below shows public sector expenditure and government sector net debt for the previous two financial years as well UK Treasury’s projections for the current FY, which we are halfway through.

Table 1. UK Public Sector Expenditure & Debt (% GDP)

There is a sharp rise projected in public sector net debt, from 36.5% to 55.4%, a rise equivalent to 18.9% of GDP in just 2 years. The projections from UK Treasury are not unreasonable ones, based in large measure on extrapolation of trends already apparent. If anything, they may be overly optimistic as we discuss below.

The ‘public sector current spending’ measure of government finances excludes some important items, which are especially significant in the current debate, as we will demonstrate below. But here it is important to note that it does include the two key items under threat of savage attack, welfare spending and public sector pay.

While it is true that public sector expenditure will rise as a proportion of GDP in that time, it is clearly not the primary source of the deterioration. Public spending is rising but this contribution is just 5.3% of GDP, compared to the aggregate rise in the debt level of 18.9%. This rise in spending is largely an automatic and inevitable rise in government expenditures under the impact of recession (for reference, during the milder Thatcher recession of the early 1980s, public sector current expenditure rose by 4.2% of GDP between 1980 and 1983). Therefore, it cannot possibly be true that “Gordon Brown’s overspending” on these areas has led to the crisis in government finances, or that, heading into the crisis, there was already a ‘structural deficit’ that the Institute for Fiscal Studies has constructed, following the UK Treasury’s lead. [2]

The slump in government finances is not caused by welfare spending or public sector pay, so there must be another cause of the unfolding crisis.

The primary source of the deterioration in government finances is the collapse in government receipts. The driving force is lower taxation receipts, as shown in the table below. Rising expenditures have played a role in the widening of the deficit, but a minor one. Partly this collapse in revenues is related to the slump in economic activity and in part it is a function of government stimulus measures which can and will be reversed. These include corporate tax holidays and the temporary VAT reduction.

Table 2. Change In Central Government Accounts 1st half Financial Year
2009/10 Compared to 1st half 2008/09 (£billion)

The most recent data on public finances highlight this precipitate decline in taxation revenues, already worse than UK Treasury projections, down 10.3% in nominal terms from the same period a year ago. [3] Taxes on income and wealth have fallen by £14.4bn in the first half of the current FY. In addition, taxes on production have fallen by £7.8bn over the same period. Taken together, these last two items account for £22.2bn of the entire fall of £25.1bn in central government receipts. In turn, this fall in taxation revenues accounts for the overwhelming bulk, two-thirds of the widening of the budget deficit over the period, which amounts to £37.8bn.

Neither excessive public sector pay nor welfare spending are the causes of the crisis of government spending, because there is no crisis of government spending. The crisis arises from the slump in receipts, which only a revival of economic activity can correct.


SEB has previously noted that two key components of GDP have recently moved in opposite directions in the UK and in most other OECD economies. Government spending has risen in response to the recession, and partly offsets it. It as an automatic rise in the form of increased welfare spending, although it should be noted that in the UK this increase in ‘net social benefits’ in the first 6 months of this financial year is just £7.4bn, compared to a total increase in central government borrowing of £40.1bn over the same period. At the same time the key component of GDP that has driven total economic activity lower is the outright collapse in investment.

Given that investment is the key determinant of future prosperity these two components of GDP cannot move in diametrically opposite directions over a sustained period. Either government spending must fall, as financial resources eventually run dry, or an increased level of investment revives economic activity and the tax base, thereby allowing government spending to be maintained at current or higher levels.

A stark policy choice is therefore posed. The prescription can be followed that cuts pay and welfare spending which will leave the economy on a long-term trajectory of lower growth, worse services and increased poverty. Or the government can rescue the economy by increasing investment where private operators fail to do so. In fact the government has made some effort to do this, but on a scale that is not commensurate with the crisis. Public sector net investment was 2.6% of GDP in the last FY, and is due to rise to 3.5% this year before falling back to 2.5% next year. [5] This does not address the severity of the crisis and is paltry by historical standards. Before Thatcherism, for the entire period 1963-1979 the average level of public sector net investment was over 5.2% of GDP per annum. [6]

The Treasury’s own macroeconomic model points the way. [7] Its empirical studies of the UK economy over time suggest that an increase government spending is by far the most effective means to revive economic activity. Of course, the reputation of statistical economic models based on current orthodoxies is not as high as before the crisis. However, it is the Treasury’s best estimate of the effects changes in fiscal policy and will inform the working assumptions of all economic policymaking, both Government and Opposition.

The model assumes that the multiplier effect from a change in UK government spending are 1.1 times in the first year and 1.4 times in both the second and third years. This is a far higher multiple than other fiscal measures as highlighted in the table below. Furthermore, the Treasury suggests that the multiplier effects are likely to be higher in periods where private access to credit is constrained, which is one of the defining features of the current crisis.

Table 3 Fiscal Multipliers in the UK Treasury Model -
Source UK Treasury

The Elephant In the Room

Throughout this discussion we have tended to refer to public sector current spending (which includes all levels of government), as well as government net investment. However there is one exceptional item in the public finances not included in either of these totals. In recent UK Treasury publications it is usually referred to as the costs of ’financial sector interventions’, that is the costs to the taxpayer of the bailout of bank share and bondholders. They are mind-bogglingly large and they must of course be paid for by government borrowing.

The words of the UK Treasury can speak for themselves. “At end September, the contribution to public sector net debt (PSND) from financial market interventions amounted to £142bn“.[8]. Worse this does not yet include the interventions in RBS, Lloyds and HBoS, but only includes £111bn to bail out the bondholders of Northern Rock and Bradford & Bingley, £9bn to compensate bank depositors from failed institutions as well as other items. When, later this year, the Treasury gets to grips with the large and complex losses at Royal Bank of Scotland and Lloyds Bank, the additions to this debt mountain will increase enormously. Taking these bailouts into account brings net public sector debt to 59.0% of GDP compared to 48.9% without it. This level will rise too as the other bank bailouts are finally accounted for.

Chart 3

To date, despite much gleeful anticipation in Opposition circles and widespread sections of the media, there has been no failure to fund these deficits. At the beginning of October this year UK 10-year government bonds yielded 3.22%, the same as the US and compared to 3.13% for Germany. [9] The global decline in yields characteristic of recessions allows governments to borrow and invest more cheaply. As a result of lower interest rates the UK’s net debt interest payments are actually £5bn lower in the first 6 months of this FY compared to a year ago (shown in Table 2., above). [10]

However the scale of debt and its trajectory provide no guarantee that this will continue to be the case. Global bond investors have, in effect, staged buyers’ strikes before now. In any event, the ever-increasing level of debt will provide a heavy interest burden on taxpayers for years to come, diverting tax revenues away from productive uses.

Cuts Are Not Savings

The crisis in UK government finances is not caused by either excessive public pay or welfare payments. It is caused by two factors, the collapse in business activity and the consequent slump in taxation revenues, as well as the cost of the bank bailout.

Those arguing for an effort to balance the budget via welfare and pay cuts have learnt nothing from history. They are simply what JK Galbraith has dubbed ’the custodians of bad memories,’ speaking of those who prolonged the Great Depression by welfare cuts.[11]

In fact economic history is littered with examples of governments who made swingeing cuts to socially useful public spending and public sector pay, only to find that their deficits continued to rise. This occurs because the cuts themselves depress activity and taxation receipts, in the jargon, they trigger ‘reverse multiplier effects‘. In a different context, Michael Taft details the counter-productive nature of cuts currently being enacted in Ireland, and highlights the simple but devastating truth: Cuts Are Not Savings. Those fiscal multipliers cited above also work in reverse; cuts in government spending will not lead to commensurate savings as they depress economic activity and the fiscal receipts which are generated by it. SEB will return to this topic in a future posting.

Instead, what is required is twofold: first, the government could engineer an economic recovery by a sizeable increase in the pace of its own investment. Second, the government should make an elegant exit from the huge costs incurred through the operations to support failed financial institutions, letting their share and bondholders enjoy the fruits of the free markets they have extolled for so long.

* This piece was begun under the guidance of Redmond O’Neill, who died on October 21st. All errors are mine, but the inspiration was from him. He was the finest socialist I have known.


1. UK Treasury databank, Tab B2,'C1'!A1)

2. IFS, Britain’s Fiscal Squeeze: the Choices Ahead, Briefing Note BN87,

3. ONS, Public sector finances, September monthly bulletin, table, p.13,

4. 'The Outlook for Public Finances', p.3,

5. UK Treasury databank, B2

6. UK Treasury databank, B2

7. UK Treasury, Fiscal Multipliers in Macroeconomic Models, Statistical Annex p.102,

8. ONS, public sector finances, September monthly bulletin, (p. 5, point 6), ,

9. Financial Times, October 5 2009, table p.27, Bonds-Benchmark Government

10. ONS, September, p.3

11.’The Great Crash’, JK Galbraith, Penguin, p.201

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