Sunday, April 4, 2010

£1bn of “efficiency savings” will not reduce the deficit by so much as £1.

At election time, political parties always spout nonsense about the tax cuts they can achieve through “efficiency savings” in the public sector. But what’s different this time (the UK general election is probably in May 2010) is that these efficiency savings can allegedly be used to reduce the deficit or pay off the national debt.

When it comes to economics, politicians can be expected to talk drivel. But economists should know better. Unfortunately some of them don’t.

Suppose efficiency improves in the public sector to the extent that £X is saved and Y employees are then surplus to requirements. That means the deficit can be cut by £X. But hang on: what about the Y former employees? They cannot just be left unemployed. So the deficit has to be expanded again to employ them. Now were up sh*t creek.

How do we escape from this conundrum? Well, the truth is that the deficit (or surplus, come to that) needs to be held at whatever level maximises employment without bringing excessive inflation. And this level of employment will not be affected one iota by any efficiency savings (or lack of them). In other words the deficit CANNOT be reduced because of efficiency savings.

What WILL reduce the deficit is the decision by the private sector that it is holding sufficient or excessive net financial assets (i.e. government debt and monetary base). This will cause the private sector to try to dissave money, which will raise demand, which means an end of any need for a deficit. Alternatively demand from the private sector may rise for some other reason, e.g. “animal spirits”. Indeed if the private sector gets sufficiently confident and “spendthrift”, the public sector can then run a surplus, i.e. reduce the deficit (and perhaps even run a surplus).

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