The future of public expenditure.

Arestis, Philip ; Sawyer, Malcolm

The fiscal policy responses to the financial crisis and the onset of recession, starting with the Pre-Budget report in late November 2008, have so far been broadly in the right direction.

The responses can be criticised for being a little late in starting, as the storm clouds had been gathering since at least September 2007, and the recession started in the second quarter of 2008. They can also be criticised for not being large enough in the tax reductions, or more importantly in increases in expenditure, and not focused on raising incomes of the poorest. There has been insufficient discretionary increase in public expenditure, with much of the rise in the budget deficit coming from operations of the 'automatic stabilisers' in that tax revenues fall with recession. (For example, comparing the estimates of the 2008 Budget and the 2009 Budget for the budget deficit for 2009/10, around 82 per cent of the increase in the estimated budget deficit of [pounds sterling]137 billion could be ascribed to the economic slowdown and 18 per cent to discretionary changes.) The responses can also be criticised for the precise form which they took--for example, whether a temporary cut in Value Added Tax (VAT) is the most effective means of stimulating consumer demand is questionable.

But the Chancellor should be congratulated for having suspended the Code for Fiscal Stability and the operation of the 'Golden Rule', under which the government would limit borrowing over the cycle to cover investment and the public debt would be kept below 40 per cent of GDP. The avoidance of any knee-jerk reaction to try to reduce the budget deficit in the face of recession is much to be welcomed. It is though to be regretted that he did not take the further step and announce the scrapping of the 'Golden Rule' and the development of more sensible fiscal rules, which would recognise the role of fiscal policy in addressing problems of unemployment.

Maurice Chevalier once said: 'Old age is not so bad when you consider the alternatives'. The current and prospective budget deficits should be seen as 'not so bad' when the alternatives are considered. Those alternatives would be attempts to balance the budget with increases in tax rates and cuts in public expenditure, resulting in a deeper recession.

Paying the cost

The scale of the budget deficits should be seen as a measure of the extent of the recession and its effects: any regrets over the size of the budget deficit should be regrets over the scale of the recession, which has made the deficit necessary. The government should not be criticised for allowing the 'automatic stabilisers' to come into effect and for taking steps which increased the budget deficit in the face of the worst recession of the post-war era. Any criticism of the scale of the deficit should be that it is not large enough--in the face of sharp drops in output and rising unemployment, more should have been done to increase public expenditure and hence a larger budget deficit.

The basic criticism of government policy should instead be directed at its role in aiding and abetting the conditions and behaviour in the financial sector, which brought on the financial crisis and the subsequent recession. Although there is a financial crisis in many countries and a global recession, the difficulties in the UK are largely homemade. The financial institutions, which have had to be bailed out in various ways, got into difficulties through their own ill-judged decisions. The loose regulatory framework of the financial system, the splurge of borrowing secured against rising house prices, and so on, happened in the UK, though similar events were happening in USA and elsewhere.

The financial crisis has imposed many costs on the rest of the economy in terms of higher unemployment and lost output. The financial sector has itself borne few of those costs; and now there is the prospect of the rest of us being asked to bear more costs through higher taxation and lower public expenditure.

Here our focus is on the implications of the financial recession for the future of public expenditure and the budget position. Our arguments are that restraints on public expenditure would be political not economic, and that the appropriate policies are those to sustain and expand public expenditure as a means of providing more and better public services and more employment. There is a need for more, not less, public expenditure and public sector employment.

The pressure for spending cuts

There is much political talk of the need to make reductions in public expenditure in the years ahead. The pressures for strong constraints on public expenditure following the recession seem to come through three main routes.

First, there is the prospect that the public debt will to be much higher in the next few years than it has been recently, rising from the order of 40 per cent of GDP to around 100 per cent of GDP. The Budget foresees public debt rising to over 75 per cent of GDP (HM Treasury, 2009a) whereas other estimates put it closer to 100 per cent (see, for example, OECD, 2009). The projected increase in public debt arises mainly from the cumulative budget deficits incurred as tax revenues decline. There is also a significant addition to the public debt as a result of (partial or full) inclusion of rescued financial institutions--in June 2009, the public debt was [pounds sterling]798.8 billion when financial sector interventions are included, and [pounds sterling]657.5 billion when excluded (see ONS, 2009).

Secondly, the scale of budget deficits (likely to be 12 per cent of GDP in the current financial year) has already brought arguments that budget deficits have to be reduced, through tax increases and public expenditure reductions. Although it is the norm that governments run budget deficits, in that in the vast majority of years in the post-war period there has been a deficit, there is a constant whipping up of fears over budget deficits.

Thirdly, private sector output is likely to be lower in the future than had previously been thought. The 2009 Budget Report (HM Treasury, 2009a) suggests that the effects of financial crisis have lead to potential output (that is deemed to be the output which the economy is capable of producing without inflationary effects) being 5 per cent lower than it would have been. If that is anywhere near right, then the ratio of public expenditure to national output will tend to be higher, simply because the capacity of the private sector has shrunk. This also tends to bring calls for public expenditure to be cut.

We now want to examine these three sources of pressure to heavily constrain public expenditure.

Is the public debt unsustainable?

Does the size of public debt really matter? The discussion sometimes proceeds as though public debt above a certain level (relative to GDP) will lead to the economy falling into the abyss. When it is reported that public debt may reach 100 per cent of GDP it begins to sound as though all our income has to go to pay the debt.

Let us make some preliminary points about the debt ratio. First, it is a comparison between a stock (debt) and a flow (income). The precise number can be readily manipulated with use of monthly GDP or decade GDP: using the former the ratio become twelve times larger and with the latter one tenth of the size--a number which sounds frightening or reassuring. A figure close to 100 per cent may suggest all income needed to repay debt--but the debt is rarely repaid, and what might be of concern is the interest payments on the debt which would have to be paid for in some way. An alternative measure would be debt relative to tax revenues, as it is the tax revenues which come closest to the notion of government income, and that would put a ratio, which was 100 per cent of GDP, at 250 per cent. That could perhaps be compared with the mortgage to income ratio, which many first-time house-buyers face.

Second, the focus on the public debt forgets that the public sector owns substantial assets--roads, hospitals, schools, nuclear weapons and so on. Recent estimates for 2007/08 put the net worth of the public sector at 28.9 per cent of GDP--that is, the difference between the value of the assets which the government owns, and the public debt (HM Treasury, 2009a, Table 2.6). It would make more sense to think about the net wealth of the public sector rather than solely its liabilities.

Third, the public debt is held by individuals and financial institutions in the private sector, and it is assets for those owning the government bonds, with deposits in national savings, and so on. Much, though not all, of the debt is held within the UK. Interest payments on government debt are a significant element of the income of pension funds from which pensions are paid.

From 1918 until 1963 the ratio of public debt to GDP was always above 100 per cent, even in those periods of fiscal rectitude. By the end of World War Two it reached 252 per cent in 1946 (see DMO, 2009, for details). It was never suggested that the war should be stopped because the debt ratio was too high. The present budget deficit rising public debt should be seen as part of a fight against unemployment, and for that reason not stopped. It is also clear that many countries have survived with debt ratios considerably in excess of 100 per cent (for example Belgium at near 100 per cent, Italy over 120 per cent, and Japan close to 200 per cent; see OECD, 2009).

Any concern over debt should be on whether it is on an upward explosive path which threatens to continue in future. While the prospects are that the debt-to-GDP ratio will rise over the next few years, it is then likely to stabilise.

There is a simple sustainable relationship between the deficit and debt relationship. This is that the debt ratio equals the deficit ratio divided by the growth rate of nominal GDP. In other words, a given deficit ratio, if maintained over time, will lead to a debt ratio given by this relationship. That debt ratio may be high or low (however that is judged) but would not grow further or explode. Thus a growth rate of nominal GDP of around 5 per cent per annum (sum of trend growth of around 2 1/2 to 3 per cent, inflation of 2 to 2 1/2 per cent, for example) would give a debt ratio that is equal to 20 times the deficit ratio (1). A 5 per cent deficit ratio would then be consistent with a 100 per cent debt ratio, for example. It also means that with a starting debt ratio of 100 per cent, a deficit of less than 5 per cent would lead to reduction in the debt ratio. A higher deficit ratio would lead to a correspondingly higher debt ratio, but, significantly, one that stabilises.

Was not the problem lying behind the financial crisis that of too much private debt? And this 'solution' of budget deficits to stimulate demand involves more debt. First, note that one person's debt is another person's asset--the debt of the government is held by the private sector and is an asset for the holder. Second, the problems with private debt were related to a combination of loans being made (and often mis-sold) which were unlikely to be repaid, and often based on a continuing rise in house prices. The loans were then sold on to other financial institutions under the 'originate and distribute' model, and when the loans went bad, so did the mortgage-based securities which were based on them. The government has the power (through taxation, further borrowing and the right to issue money) to ensure that its debts can always be serviced, and there is never any reason why the government should default on its debt (provided that the debt is denominated in its own currency).

Must budget deficits be reduced?

In order to appreciate the arguments advanced in respect of the role of budget deficits and why they are generally necessary, it is useful to present what is an accounting relationship that is based on national income accounting:

budget deficit = private savings - private investment (in capital equipment, buildings, etc.) + the current account position of the balance of payments

This can also be expressed as:

budget deficit = private savings - private investment (in capital equipment, buildings, etc.) + the capital account inflow of the balance of payments.

In terms of outcomes, these equations are national income accounting identities--they must always hold. The second equation tells us that the budget deficit is equal to borrowing domestic savings, net of what are used for private investment purposes, plus net borrowing from overseas.

Attitudes to fiscal policy and budget deficits can be readily illustrated by reference to these equations. There are two rather distinct schools of thought which can be identified. They have taken various forms over the past century but have been in constant conflict.

The first, which was initially known as the 'Treasury view' (expressed in the late 1920s: see, for example, Hawtrey, 1925), is essentially the idea that budget deficits will not increase output and employment and may even reduce it. Any attempt to increase public expenditure and the budget deficit, funded by private savings, 'crowds out' private expenditure, often investment. The essence of this 'Treasury view' (or 'crowding out') can be seen by re-writing the equation above as:

savings + capital account inflow = investment + budget deficit

It then appears that if there is a fixed pool of savings, for which if the budget deficit goes up, investment has to come down--that is, it is 'crowded out'. This may happen in a number of ways--suggestions vary, from the idea that interest rates rise, thereby discouraging investment; or that firms respond negatively to increased budget deficits, to lose confidence and reduce investment.

The second, which is more Keynesian and can be labelled 'functional finance' (the idea that a budget deficit should have a function--the function being the achievement of a high level of demand), is that the amount of investment and budget deficit effectively drives savings plus capital account inflow. For example, if investment expenditure goes up, then output will respond, leading income and employment upwards, and as income rises, people save more and savings rise; similarly with government expenditure. The purpose of the budget deficit is in effect to fill the gap between savings and capital account inflow and investment.

From here it is straightforward to see what has happened to budget deficit. The financial crisis led to a slump in investment, a rise in savings (with relatively little change in the current account position), which was accommodated by a rise in budget deficit.

For the future the (necessary) size of the budget deficit will depend on the scale of investment, the savings behaviour and the balance between exports and imports. In the aftermath of the financial crisis, it would seem likely that investment will be rather lower than in the recent past, held back by a less optimistic view of the future based in the experience of falls in output and the difficulties in securing loans. On the savings side, savings by households had fallen close to zero with consumer expenditure fuelled by borrowing (dis-saving) and rising household debt. For much time to come, the tendency to save is likely to be higher than it has in the recent past. Look now at the first equation above, which indicates that if investment is lower, saving is higher, then the budget deficit will be higher.

The way towards reducing budget deficits should come from some combination of a revival of investment and a reduction in savings. Unless and until events follow along those lines, the budget deficit will have to be maintained.

There will be many cries, not least from the Conservative Party, that the budget deficit must be reduced. Let us be clear what the consequences of attempts to reduce the budget deficit, through some combination of cuts in public expenditure and tax increases, would be: higher unemployment, prolonging the recession, and dangers of a 'lost decade'--we have been there before! Attempts to reduce budget deficits by expenditure cuts and increased tax rates will reduce income, savings and investment.

Is the public sector too big?

Recessions clearly involve (virtually by definition) losses of output and employment. An important question is whether that loss of output during the recession is in effect ever recovered.

One answer would be that whilst there are 'busts' there are also 'booms' and the latter generate extra output and employment, which offsets the loss of output and employment during the 'bust'. However a study of the major UK recessions of the twentieth century concluded that

  in a major recession underemployment results in the deterioration and
  premature scrapping of physical equipment, and that disbandment or
  underemployment of a firm's workforce similarly results in the
  partial destruction of working practices and working relations ...
  The capital stock, physical and intangible, takes time to build up,
  and its destruction cannot be made good rapidly; in effect,
  therefore, the destruction is quasi-permanent. In this way demand
  shocks impact on supply. (Dow, 1998, 369)

In the present recession, investment has fallen considerably so that future capacity will be that much lower. In addition the effective capacity of the financial sector will drop considerably. The Treasury's projections for trend output imply

  a downward adjustment to the trend level of output of around 5
  per cent between mid-2007 and mid-2010, a period broadly consistent
  with the credit conditions assumption that underpins the economic
  forecast more generally. This judgement is subject to considerable
  uncertainty, and will be kept under review. Beyond this period of
  adjustment, trend growth is projected to continue at 2 3/4 per cent a
  year, as the capacity of the flexible and open UK economy to
  reallocate resources and grow from this reduced level of trend output
  remains intact. (HM Treasury, 2009a, 196)

In other words, the Treasury is saying that there has been a loss of output potential of around 5 per cent, and that loss continues in perpetuity. Even when growth of output resumes it will be from this lower base. If these estimates are anything like correct, it puts some perspective on the costs of the financial crisis--a recession which leads to 5 per cent lower output throughout the future than would have been the case without the financial crisis.

While we have to recognise that these projections have to be subject to a great deal of uncertainty, they chime with Dow's findings quoted above. The forecasts in Table 1, including growth of 0.75 per cent in 2008, show that GDP in 2013 would be 3.9 per cent higher than it was in 2007, whereas if growth had continued at a trend growth rate of 2.5 per cent per annum it would have been 16 per cent higher. The financial crisis leads to GDP in 2013 being about 12 per cent lower than it would have been if the pre-2007 experience had continued. The National Institute for Economic and Social Research forecasts that UK is 'not expected to recover pre-recession levels of output until late 2013' (NIESR, 2009, 7).

Table 1: Forecasts on key economic variables (May 2009; average of
independent forecasts)

                            2009     2010    2011     2012     2013

GDP growth (%)              -3.9     0.2      1.9      2.4     2.6

Claimant unemployment       1.74     2.27     2.23     2.09    1.91
(million)

Current account ([pounds   -29.0    -30.1    -33.0    -33.5   -30.9
sterling] billion

                          2009/10  2010/11  2011/12  2012/13

PSNB ([pounds sterling]    178.8    186.3    164.4    149.2
billion)

(Source: HM Treasury, 2009b)

This projected drop in trend output in effect means the overall size of the economy will be rather smaller than it would have been. Hence, without changes in the plans for public expenditure, public expenditure would constitute a larger part of the economy. With public expenditure amounting to the equivalent of around 45 per cent of trend GDP, a decline of around 5 to 6 per cent in trend GDP would raise that ratio by about 2 1/2 percentage points.

The significance of this that those concerned with the relative size of the public sector will shout for corresponding reductions in public expenditure. There will be the perverse argument that since the private sector is now capable of producing less than it was, that the public sector has also to shrink, even though there are many people seeking employment.

The coming spending squeeze

Periods of slow (including negative) growth of output and of substantial unemployment always bring forward a set of conflicting arguments with respect to the level of public expenditure.

If there were full employment, then any further expansion of public expenditure (on goods and services) would mean that resources had to be devoted to the public sector and drawn away from the private sector, and private expenditure would have to be restrained. Employing people in the public sector means that they are not employed in the private sector.

But at a time of substantial unemployment, additional public sector employment means additional employment, lower unemployment and the production of useful public services. This is a case of what economists would say is a 'Pareto improvement'--some gain (those now in employment, those benefiting from the public services), and no one loses.

But the question will be asked as to how the expenditure is to be paid for. Tax revenues are low in the face of low employment, income and output. The answer has, of course, to be through government borrowing. The effect on the budget deficit will be less than the increase in public expenditure, as those now in employment pay income tax, National Insurance and other taxes, and there is some decline in payments of unemployment benefits. There are multiplier effects where those now employed in the public sector spend their incomes, thereby generating employment. But some increase in budget deficit has to be allowed for.

Table 1 summarises forecasts on some key economic variables. Four points stand out from this table. First, unemployment on the claimant count basis remains around two million (compare with 1.56 million in June 2009), and that would correspond to unemployment on the ILO definition of around three million. Second, after recession in 2008 and 2009, anaemic growth is expected in 2010, with output only recovering its 2007 level around 2012 or 2013. Third, the current account deficit is forecast to remain fairly flat, implying that the UK will continue to need to borrow from overseas, but not at an increasing rate. Fourth, there is at most a modest decline in the budget deficit (PSNB--Public Sector Net Borrowing).

If we put those two sets of figures together, this implies (from the first equation above) that private savings exceed investment in the order of [pounds sterling]120 billion. In other words, there is little revival in either investment expenditure or dampening of savings behaviour.

Table 2 indicates the data reported in budget documents for 2009 on projected growth of public expenditure. The large increases in public expenditure in 2008/09 and 2009/10 can be ascribed to a combination of the effects of economic slowdown on unemployment and related benefits as well as discretionary increases in expenditure in response to the slowdown. Nearly 30 per cent of the increase in expenditure in 2009/10 over 2008/09 can be ascribed to increased social security payments (not all related to the effects of the recession). Combining changes in projected public expenditure for 2009/10 in the 2008 Pre-Budget Report (HM Treasury, 2008) and the 2009 Budget (HM Treasury, 2009a) suggests that around half of the increase from 2008/09 to 2009/10 can be ascribed to discretionary changes.

Table 2: Projected growth of public expenditure (real terms), percentage
change

              2007-08  2008-09  2009/10  2010-11  2011-12  2012-13

Projected
growth of
public
expenditure

2009 Budget               3.94     7.18     2.92    -0.35     0.17

2008 Budget               2.34     1.89     2.29     1.62     1.98

Public
sector net
borrowing
(as share of
GDP)

2009 Budget       2.4      6.3     12.4     11.9      9.1      7.2

2008 Budget       2.6      2.9      2.5      2.0      1.6      1.3

              2013-14  12-13  13-14
                        over   over
                       07-08  08-09

Projected
growth of
public
expenditure

2009 Budget     -0.04   14.4   10.1

2008 Budget             10.5

Public
sector net
borrowing
(as share of
GDP)

2009 Budget       5.5

2008 Budget

(Source: calculated from HM Treasury, 2009a)

It is clear that the 2009 Budget incorporated a severe slowdown in public expenditure with a decline in real terms in the three-year period beginning 2011/12. But in the 2009 Budget over the period 2008/09 to 2013/14 the growth in public expenditure in real terms averages 2.26 per cent per annum, which is somewhat above that projected in the 2008 budget for growth over the period 2008/09 to 2012/13 of 2.02 per cent per annum.

As public debt is rising over this period, interest payments could be expected to increase (even if interest rates remain low). Unemployment benefits and similar items are unlikely to decline significantly as unemployment remains high. Hence, a very tight squeeze on public expenditure occurs. Public investment takes a particularly hard hit, with net investment projected to be in 2013/14 half of the level of 2009/10. Despite this squeeze the budget deficit remains at 5 1/2 per cent of GDP in 2013/14 (and the figures in Table 1 put the budget deficits through to 2012/13 rather above the Treasury's figures). The lower half of Table 2, comparing the budget deficits projected in the 2008 and the 2009 Budgets, is an illustration of the effects of the recession on those deficits.

The case for increased public spending

Our discussion of public expenditure stresses its role in employment creation. But we do not advocate public expenditure being used as a jobs creation programme unless the jobs which are undertaken provide valuable services. It is taken as a given that there are a wide range of areas in which an expansion of public expenditure could bring large benefits--whether it is improvements in the health service, social house construction, encouragement of development of green technologies etc. The decisions on public expenditure should be firmly based on the social value of the public services provided, and not merely on its power to create employment.

As an illustration, take the case where the rate of increase in public expenditure for the period starting 2011/12 envisaged in the 2008 Budget was decided upon, rather than that envisaged in the 2009 Budget for that period. Over a three-year period public expenditure in real terms would grow by around 6 per cent, rather than be flat. What would the consequence be?

If it were across the board, then there would be a 6 per cent increase in the real value of pensions and other social security benefits, enabling a higher level of expenditure. The effects on output and employment would depend to some degree on the structure of the increases in public expenditure. Expenditure on construction would have a direct effect on employment, and involve relatively low import content. Expenditure on transfer payments enhances the income of those receive them, but not all of those payments would be spent and there would be 'leakages' through spending on imports. There would also be 'multiplier' effects through which the public spending leads to higher incomes which in turn are spent generating more demand, output and employment.

A conservative estimate of the effects of public expenditure being 6 per cent higher would be GDP being 2 to 3 per cent higher (than otherwise) and employment higher by a similar amount, and unemployment correspondingly lower. Making some allowance for the additional tax revenue generated by the higher level of GDP would mean budget deficit increases by around 1 to 1 1/2 per cent of GDP. (It should also be noted that the reduced levels of unemployment would reduce payments on Job Seeker's Allowance and related benefits, so that the increase in public expenditure is a net figure of overall higher expenditure minus reduced payments on unemployment benefits.)

These figures are intended to be illustrative rather than definitive. There is nothing sacrosanct about the figure of a 6 per cent increase, and there would be arguments for it being rather higher. The key point is that public expenditure can bring into employment those who would otherwise be unemployed, and that there is much that needs to be done. There are no limits on public expenditure arising from the crowding out of private expenditure. What would then prevent such an increase in public expenditure taking place?

The first set of forces, which may well be uppermost in Tory minds, would be fear that the state is expanding its role. Public expenditure has been rising relative to the size of the economy, as indicated in Table 3, although that comes from the private sector shrinking as much as the public sector expanding. Even with the squeeze on public expenditure envisaged in the 2009 Budget in the years after 2011/12, the ratio of public expenditure to GDP in 2013/14 would be over 2 percentage points above the 2007/08 level.

Table 3

2009 Budget         2007/08  2008/09  2009/10  2010/11  2011/12  2012/13

revenue (% GDP)        38.6     36.9     35.1     36.2     37.3     37.7
expenditure (%
GDP)                   41.0     43.1     47.6     48.1     46.3     44.9
expenditure (%
trend) output          41.3     42.6     45.3     46.2     44.9     43.9
expenditure as %
'old' trend output     41.3     41.8     43.7     43.7     42.5     41.4

2009 Budget         2013/14

revenue (% GDP)        37.9
expenditure (%
GDP)                   43.4
expenditure (%
trend) output          42.9
 expenditure as %
'old' trend output     40.2

(Source: HM Treasury, 2009a)

The second issue would be, as strange as it may seem, the problem of the economy overheating. It sounds strange since, as indicated above, the prospects are for unemployment around the three million mark and output substantially lower than would have been anticipated prior to the financial crisis. But consider the figures in the Budget that put the output gap at 2.1 per cent in 2012/13, that is, according to this perspective, actual output would be 2.1 per cent below 'trend output'; and output above 'trend output' is supposed to signify an overheating economy and dangers of demand inflation. This would still allow for some increase in public expenditure, which would boost output to trend level, and indeed the figures used above would fit in. However, the Treasury's forecasts for future output may well be too optimistic, and pushing output past the 'trend output' would have little consequence for inflation.

The third would be the cry that the budget deficit could not be funded, with scare stories of 'national bankruptcy' and the like. Let us first be clear that the issue here is the budget deficit of the government, and not the deficit of the country, which could be said to be the current account deficit. The UK has been running a considerable current account deficit for many years, though the forecasts in Table 1 suggest if anything some improvement in the coming years. If that is so, then the need to borrow from overseas will diminish. It may well be that the UK finds it more difficult to borrow from overseas if the prospects for the UK darken, but there is a long way to go before that is contemplated, let alone happening.

The proximate cause of the recession includes the reluctance of firms to invest (and their difficulties of securing loans from banks), and households and firms wanting to save more. This means that there is an inflow of savings looking for a home. For example, each week, money flows into the pension funds and those funds have to find financial assets to acquire. It is a basic proposition of Keynesian economics that increased public expenditure helps to generate higher income, and thereby higher taxes and higher savings. It is in effect (though after the event) those higher taxes (directly) and savings (indirectly through government borrowing) which fund the increases in public expenditure. There can be occasional issues of securing the funds to cover a budget deficit, as there is for any institution raising money. But there is no underlying issue of securing the necessary funds.

Conclusion

The behaviour of the financial sector and the resulting crisis have already imposed substantial costs on everyone. The focus should now be on avoiding macroeconomic policy mistakes imposing further costs. The biggest mistake which could be made is to think that the budget deficit must be eliminated by slashing public expenditure and raising taxation.

The driving force behind public expenditure should be the drive for good quality public services. There will always be debate over the appropriate role of the state and where the boundaries for public and private activity should be drawn. In this article we do not enter into that debate, but rather assert that there seems little economic reason as to why public expenditure cannot grow in line with the rest of the economy, that is of the order of 2 1/2 to 2 3/4 per cent per annum. This has then to be matched against the demands for public services--particularly those that are driven by demographic factors, such as health service requirements related to an ageing population. The debates over public expenditure and its future should not be bound by the confines of the scale of the budget deficit and public debt as a consequence of the financial crisis.

It must be accepted that while private demand remains weak, while investment expenditure has not recovered and while export demand falters, there is an urgent requirement for public expenditure. The debate should accept that the needs for public expenditure are likely to grow broadly in line with GDP--after full investigation into the evolving requirements to meet aspirations in services such as the health service, education, housing and addressing climate change, which may point to a somewhat faster growth of public expenditure. It should then ask whether, in the face of high levels of unemployment and the availability of people wanting to work, how far investment and other projects can be brought forward. For example, how quickly could unemployed building workers be utilised to construct social housing. It also has to be asked what emergency measures are required to address rising unemployment amongst the young to avoid having a 'lost generation'.

Unless and until investment, exports and consumer demand revive, a budget deficit will be necessary, and a deficit higher (relative to GDP) than has been usual. The alternative is higher and higher levels of unemployment. The choice between a high budget deficit and a high level of unemployment is surely a 'no brainer'. If exports and investment revive, then tax revenues will rise and the budget deficit will fall. The challenge is to have flexibility with public expenditure, which enables it to be higher when demand elsewhere is low (through bringing forward investment projects) and correspondingly at more normal levels when private sector demand revives.

References

DMO (2009) 'Historical National Debt Data', UK Debt Management Office, available at http://www.dmo.gov.uk

Dow, J. C. R. (1998) Major recessions: Britain and the world, 1920-1995, Oxford, Oxford University Press.

Hawtrey, R. G. (1925) 'Public expenditure and the demand for labour', Economica 5, 38-48.

HM Treasury (2008) Budget 2008: stability and opportunity: building a strong, sustainable future, London, HM Treasury.

HM Treasury (2009a) Budget 2009: Building Britain's future, London, HM Treasury.

HM Treasury (2009b) Forecasts for the UK economy: a comparison of independent forecasts, no. 265, London, HM Treasury.

NIESR (2009) National Institute Economic Review, July, London, National Institute of Economic and Social Research.

OECD (2009) Economic Outlook, June, OECD.

ONS (2009) 'Public Sector', available at http://www.statistics.gov.uk/cci/nugget.asp?id=206.

Notes

(1.) The basic relationship is that a budget deficit (relative to GDP) of d would if maintained would lead to a debt ratio of b = d/g.

(2.) The National Institute for Economic and Social Research work on a similar figure (see NIESR, 2009, 4). See, also, OECD (2009) Chapter 4 for similar estimates for a range of OECD countries.

Philip Arestis is University Director of Research for the Centre for Economic and Public Policy in the Department of Land Economy at the University of Cambridge; and Professor of Economics in the Departamento de Economia Aplicada V, Universidad del Pais Vasco, Spain.

Malcolm Sawyer is Professor of Economics at Leeds University Business School.