Should we aim for budget surpluses?

Does it make sense to target a budget surplus in normal times within five years, as George Osborne suggested at the Mansion House last night? I’m afraid any answer to that has to first respond: define ‘target’ and ‘normal’. We do not have those details at the moment, so I’ll try and finesse them by asking whether it makes sense for the budget to be on average in balance within five years: more surpluses than deficits, but the occasional (abnormal) large deficit. [1] In this post I’ll ignore problems associated with the Zero Lower Bound for interest rates, which is a very good (irrefutable?) reason why we should not be seeing any fiscal tightening right now. Here I’ll focus on the longer term.

This question is really the same as asking what the long run target for government debt should be. I recently discussed an IMF paper which suggested that, as long as the market was happy buying the debt, there was no need for the government to reduce the level of debt from current levels (around 80% of GDP). That policy would imply running deficits of around 3% of GDP, which is a long way from a surplus. I also said that might be an extreme position. In this post I gave various paths for deficits and debt, where the other extreme was balancing the budget. A balanced budget could involve debt falling rapidly to around 40% of GDP by 2035, and by 2080 the debt to GDP ratio would be close to zero. I also gave various paths in between these two extremes.  

So which should it be: keep the debt to GDP ratio at around 80% as the IMF suggest, or get it to fall rapidly as George Osborne suggests, or something in between? Consider some popular arguments for going with George Osborne.

1) It provides scope to respond to another Great Recession without running out of what the IMF call fiscal space.

This is right in principle, but the numbers do not imply we need to get debt down that fast, unless we are expecting the equivalent of Great Recessions to happen in the future much more often than in the past. The IMF paper has some calculations on this (pages 12 and 13), and I looked at a particular experiment here.

2) We need to reduce the debt burden for future generations.

Under the assumptions in the IMF paper, the costs of getting debt down now exceed the future benefits. Again, that might be too extreme, but it would be very hard to justify a quick Osborne like reduction in debt on distributional grounds. That would mean that the costs of reducing debt would largely fall on the same generation that suffered as a result of the Great Recession, which would seem perverse.

3) Any individual would always want to pay back their debts quickly

Bad analogy. Here a country is more like a firm. Firms typically plan to live with permanent debt, because it has paid for its capital. The state has plenty of productive capital. To put the point in distributional terms, if we paid back most government debt within a generation, we would be giving that capital to later generations without them making any contribution towards it.

So it is hard to justify aiming for budget surpluses within the next five years. But I want to make one final point. How quickly you should reduce debt involves difficult technical issues. While I’m reasonably sure that the extremes of keeping debt at 80% of GDP or going for surpluses within the next five years are not optimal, that leaves a wide range of possibilities in between, and neither theory nor evidence gives us much guidance at the moment. This really is an area where more research is needed [2], and it would be good if the Treasury - the main interested party - was promoting that research. What we get instead are jokes about reactivating the Commissioners for the Reduction of the National Debt. (It was a joke, surely?) Sign of the times, I’m afraid. 

 

[1] It makes no sense to target any deficit/surplus number on an annual basis. The budget deficit should be a shock absorber, to prevent volatility in things that matter, like tax rates and spending decisions. (Shocks can be cyclical, but they can arise from other sources, so cyclical correction - even if it could be done well - does not negate this point; see Portes and Wren-Lewis.) That is why the coalition originally had a target for the deficit in five years time, which makes sense because it allows the deficit to be a shock absorber.

[2] Yes I know this is what academics always say, but on this issue it is absolutely true. Compared to the oceans of work on monetary policy, work on optimal government debt amounts to a puddle. One reason may be that central banks are good at encouraging and utilising academic research, whereas finance ministries are less so.