“Accounting identities cannot be violated”: the budget and the balance of payments.

IMG_0132 fireworksThis was said by Frances Coppola in response to a comment on twitter and as Frances is Moriarty to my Holmes I thought I would comment. The statement is perfectly correct, but many economists use this to justify ignoring imbalances on various components of the account in question, as if they do not matter, because the overall balance between two totals is zero: a really big mistake.

The two big accounting identities that always produce a zero balance are the government`s budget and the external balance of payments. However in both cases there are very significant imbalances between important components of each account which are very damaging to the economy and we ignore them at our peril. Glib references to the overall balance being zero, and therefore of no importance, is very misleading.

Firstly let us look at look at the government`s budget and its accumulating impact on the national debt. In the forthcoming budget any deficit, no matter how small, will increase the national debt. Shall we guess that a budget deficit of £70bn is planned for this coming fiscal year. Many economists will argue that this reduction from the previous year is more austerity whereas it is slightly less profligacy. Overall government spending will increase but some of this increase will be paying interest on an increasing national debt. Servicing £1.5tn of national debt will cost about £50bn in this year`s budget. In order to pay this the government will have to cut real spending on health, education, defence etc. This will be called austerity whereas it is, as it has been since 2007, a profligate increase in government spending. At this point I need to point out that I want neither profligacy nor austerity in the government`s budget. As I pointed out in another blog “A balanced budget: goodbye fiscal policy” I would like to see a legally enforced budget rule that requires the budget to be balanced over a three year term. It is a big mistake to suggest that years of budget deficits need to be offset by years of budget surpluses. This is wrong because a balanced budget can still be used to pay down the overall size of the National Debt and release funds to spend on the real economy.

Collecting this all together; if government`s yearly borrowing is above zero in real terms then this is profligacy. If the increase in borrowing is less than last year and government spending still increases, as will happen in this year`s budget, then this could be described as being less profligate, but cannot be described as austerity. The fact that the overall budget accounts produce a zero balance is hiding “The ticking time bomb” that I referred to in my blog just before the last budget.

The other big accounting identity that hides an enormous problem is the zero external balance on the UK balance of payments. The most important balance within the balance of payments is the current account. The latest figures show a yearly deficit of £97.96bn which is about 5.5% of the market value of our gross domestic product. This means that we are buying imports and not raising enough money from our sale of exports to make ends meet. Therefore the only way we can balance the books is if we have surpluses on the other two minor components of the accounts. Obviously we should show our appreciation to all the foreigners who are buying UK assets and allowing us to overspend on our current account. We should however note that selling off our wealth to finance current expenditure on imports, maintains a higher standard of  living  in the present but, is not sustainable in the longer term and eventually the fan is waiting to be hit.

Accounting identities cannot be violated, but we should not let them hide really serious problems in the UK economy.

John Hearn 4/7/15

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