One of the interesting features of the poor GDP figures for the last three months of 2010 was they occurred at a time of rapid increases in overall public spending. Total current spending is up around 7% on the previous year, and in November was up by a double figure percentage increase compared to November 2009.
Those who think the only thing wrong with the UK economy is too little public spending under the Coalition government need to answer why output fell when spending was so buoyant. No sensible analyst can claim that the problem with the UK economy in recent years has been too little public spending or borrowing.
They could learn from the poor experiences of Greece and Ireland, that if a state spends and borrows too much it can trigger much higher borrowing costs, a loss of confidence, and less economic output, not more. They could see from Japan that continuous injections of more public spending and borrowing over a 20 year period can fail to raise the growth rate, ending as it did this week in yet another sovereign debt downgrade.
Let us take a very simple model of the economy. There are 4 people in the private sector on £20,000 a year each. There is one person in the public sector, on £15,000 after taxes . There is one person unemployed, on £10,000 of benefits paying little tax.
The private sector people and their employer pay overall 40% in taxes. So they get to spend £48,000 from their income, and the state receives £32,000 from them. The state spends £25,000 on its own employee and unemployed person, and another £17,000 on other bought in goods and services. It pays for this with the £32,000 of tax from the private sector and £10,000 of borrowings.
Some say we would all be better off if the state hired the unemployed person. Let us suppose it could do so for £14,000 a year net of taxes. The figures would then become:
State spending on employment £29,000
State spending on bought in services £17,000
This would require an increase of £4000 in state borrowing, or a 40% increase from the already extremely high levels. This would take the state well into territory likely to lead to a financing crisis.
Alternatively the state could add say £2000 to the borrowing and £2000 to taxation. This would then cut private sector incomes by an further £2000, reducing demand and offsetting some of the demand increases from the extra income in the public sector. Meanwhile the private sector faces having to pay off another £2000 of debt, and in the meantime has to pay interest on it. This will have confidence and spending effects.
As we have seen, there are limits to how far a country can go in extending additional public sector employment on borrowing before there is a collapse as seen recently in various European countries. When a state is at its borrowing limits, it does not add to economic activity to borrow more – it can tip the economy over into worse performance, as in Ireland and Greece. Even if the state can borrow more, it does not add all the extra spending to output, owing to the impact of the extra spending, borrowing and taxation on the private sector. If the private sector faces tax rises, or expects later tax rises to pay off the borrowing, the effect of the extra spending is offset to a greater or lesser extent. If a country is already setting uncompetitive tax rates it can lose more of its taxable business base quite quickly. THis country badly needs more private sector jobs. That’s why there have to be limits to the rate of growth of public spending and outstanding state debts.