Dropping the Deficit

On 16th October 2010, the Obama administration announced that America's budget deficit was at its highest level ever at a staggering $1.42 trillion - over three times higher than the previous record set at the end of the last fiscal year. By the end of the decade, the deficit is predicted to have soared to around $10 trillion. Almost all other countries in the OECD are running budget deficits. In fact, the total deficit for OECD countries went from -1.2% of total OECD GDP in 2007 to -7.9% in 2009.

To understand why this is unsustainable one must first understand that a government funds a deficit by selling bonds - promissory notes to pay the bearer back later. The amount of bonds sold makes up the difference between the governments receipts and expenditure (in other words, its deficit). As the deficit widens, governments will keep on selling these bonds. Clearly, this cannot carry on to infinity - at some point people will stop buying bonds because they will think that bonds are too risky.

Governments today must take whole-hearted measures to drop this deficit sooner rather than later so that the situation outlined above when no one is willing to fund the deficit never happens. That said, this fiscal restructuring must be made in a smart way which mitigates the effects on economic growth.

Fiscal restructuring cannot solely involve reductions in government expenditure as the poor (who gain the greatest from government expenditure) will be hit the hardest. Balancing the budget cannot only consist of tax hikes either. This is because of the sheer scale of OEDC countries' deficits. If taxes rose higher and higher, eventually the fabled Laffer Curve would kick in and the government would actually experience negative marginal revenue. Therefore, dropping the deficit must take into account both tax raises and spending cuts.

Tax increases do not necessarily have to cripple weak recovery that is underway. In fact, aggregate demand could actually increase if tax hikes for the upper decile in an economy are countered by slight tax reliefs for the poorer people. This is because the rich 'leak' more money out of the economy than the poor do - mainly in the form of imports. Hence taking money away from the rich and giving it to the poor would help stimulate growth through the formation of a positive multiplier effect.

Governments should strive to achieve higher tax revenues and greater economic efficiency simultaneously. This can be done through the imposition of carbon taxes and higher taxes on harmful goods like cigarettes and alcohol. Taxing these demerit goods would reduce externalities in the economy (and hence increase efficiency) while increasing government tax receipts at the same time.

Keynesian economists believe in counter-cyclical expenditure where the government borrows and spends during recessions and pays back its debts during times of growth. By that model and given the fragile state of the global recovery, Keynesians are in support of huge increases in government spending (in many countries through bouts of quantitative easing) in order to make up for a shortfall in aggregate demand due to reduced consumption. However good this may sound in theory, this model isn't practical as, unfortunately, political cycles and economic cycles don't coincide. Governments don't usually repay their debts right before elections as such moves are not popular. Also, such huge rounds of Keynesian government spending crowd out consumers and therefore may have the opposite effect than that intended.

I believe that it is important when restructuring government spending to try and incentivize people to work. Minimum wages and other welfare benefits should not be so high that it doesn't make sense for people to work at all. Reducing spending in a way that encourages people to work should also go some way to helping increase tax revenues for the government. Cutting back government training and re-training schemes and instead giving firms some financial reliefs if they train their own workers can also improve the efficiency with which the quality of labour is increased.

This said, certain areas of government expenditure should be preserved. Education and healthcare systems are fundamental to the long-term health of the economy and so I don't think they should suffer from spending cuts. Of course, education and healthcare account for a sizable proportion of government expenditure - hence the effectiveness of spending cuts as a means of dropping the deficit is reduced.

With the baby boomers retiring over the next decade, governments are set to face the double-whammy of lower tax receipts and higher welfare payments. As The Economist notes (16th October 2010 edition) the 'median advanced country will be spending 27% of GDP on age-related items' by 2050. The only solution to this dawning predicament is to raise the retirement ages and cut the benefits. Such upward movements in retirement ages make sense - life expectancy has increased in all countries and by as much as 10 years in Europe. However, governments who try to raise retirement ages will inevitably come up against fierce resistance - evidence of which we are seeing in the form of violent protests in France. This is a measure that is easier said than done.

Another measure governments could take is to unpeg its spending from inflation rates. In other words, spending should be decided in nominal sums rather than real sums. While this may seem a little bit sneaky, it does mean that when times are bad and there is inflation, public finances will actually benefit (as real expenditure will reduce), enabling the government to spend money to boost the economy. An automatic reduction in real spending during times of inflation will also help reduce demand-pull inflation. Similar 'unpegging' has been successful in the fiscal restructuring of several countries including in Sweden.

Whatever governments around the world do to reduce their deficits, they must do quickly and decisively in order to instill the public with confidence in their measures. The above are my views on what paths they could take. I would be interested to know your opinions - please leave a comment below.

Why Developing Countries Cannot Achieve Growth and Greater Equality of Income Simultaneously

I came about this ‘proof’ while investigating the following problem: Imagine that there are four people in a country. Three of these people earn $1 and one person earns $2. Hence, the total income in the economy is $5. As a result of economic growth, an extra unit of income enters the economy and now the situation is that two people earn $1 and two people earn $2. The question is whether the second situation is more of less equal than the first.

In order to solve this problem, we must first decide how we will measure equality. The Gini coefficient – derived from the Lorenz Curve – is a commonly used and widely accepted measure of inequality and so I will use it as my inequality measuring tool.

As mentioned, the Gini coefficient (GC) is derived from the Lorenz Curve. The Lorenz Curve is the curve that tracks how the cumulative percentage of national income (y-axis) changes as you ‘accumulate’ the total population (from poorest to richest). On the below diagram, the GC can be calculated as the proportion of area a/area a+b. Clearly, the higher the ratio, the more unequal the country is as the Lorenz Curve is further from the line of perfect equality.

Now that the definitions are out of the way, let’s get down to the problem. If we plot the Lorenz curve for scenario 1 and 2 (scenario 1 is three people $1, one person $2; scenario 2 is 2 people $1, 2 people $2) we find that the GC for scenario 1 is 0.15 and the GC for scenario 2 is 0.166. In other words, the second scenario is more unequal than the first. At first this can seem counter-intuitive as total income in the economy has increased and all the extra earnings went to someone who was formerly ‘poor’. The implications of this are that in a country where more than half the people are ‘poor’, any increase in output (which is the same as an increase in income as national income = national output) up until the point where half the people are poor and half are rich will inevitably lead to rising inequality.

If we take this problem a step further and say that, as a result of further growth, the scenario changes to the following: three people earning $2 and only one person earning $1. In this case, our intuition is right – the third scenario is more equal than the second. Indeed the GC for this situation is 0.11 which is even lower than scenario 1. Clearly scenario 3 is the best out of all three as average income is the higher and there is the least income inequality.

What these three scenarios show us (and the same effects can be seen using different numbers) is that, with no government intervention to redistribute income, if a country with more than half the population poor (most developing nations) grows, there will be an inevitable rise in inequality up until the point where half the population are poor and half are rich. Beyond this point, inequality reduces more rapidly than it rose in the first place.

This example suggests several things. Firstly, as most developing countries have a GC that they would hate to increase, having a completely free economy with no progressive tax structure is harmful as it will lead to further inequality and further social tensions. Also, the fact that equality improves after the 50:50 mark leads me to believe that developing countries should be less alarmed when they see a rising GC as the above scenarios suggest that this will fall if the poor are continually being elevated to the ranks of the ‘well off’. Finally, this example suggests that in a country where the GC is high to begin with (perhaps greater than 0.6), and government tax policies are non-existent or ineffective (maybe in a lawless or incredibly corrupt state), it may actually, in the interests of social harmony, be unwise for that country to pursue growth!

Note: A natural reaction to the situation that I have presented is to say that it is unrealistic for all of the ‘extra’ $1 of income to have gone to a formerly ‘poor’ guy. In real life a large chunk of this extra $1 goes to the ‘rich’ person who already had $2. This is very true. However, the fact that inequality initially increases even in this rosy, best-case situation is helpful in proving my point that, in real-life (which is far worse that this best-case situation) inequality will definitely rise at first.

Note on the Note: Some of you may question my calling the situation ‘best-case’ in the paragraph above. Surely the best-case situation is that the extra $1 is split evenly between the ‘poor’ people – doing this will certainly reduce the Gini coefficient. While this is correct, it is grossly unrealistic. To understand why this is true, it is important first to bear in mind that each individual in my scenarios would represent tens (or even hundreds) of millions of people in an actual economy. It is impossible for government policies to simultaneously benefit these teeming masses and to the same degree. Therefore, it would be too unrealistic to split the extra income evenly between the poor.