Discussion: do Keynesians have a limit on deficit?

This article is really just a place for me to continue a conversation I’ve been having with @mcnalu and @spatchcockable on Twitter.  The 140 characters started off as restrictive then descended into farce.

But you may also be able to help aid my understanding of this topic so I’ll lay out some background.

There’s been a lot of talk over the last few years about public debt, deficits and austerity.  Like most people, I am not educated in economics and have to rely on reading the opinions of trained economists in newspapers and online articles.  This has led me to a general understanding of the basics, so far as a lay person would be interested in the topic.

Nothing in this post or the comments below is intended to be an argument for or against austerity or Keynesian stimulus economics.  I am simply trying to understand an aspect of the debate which hasn’t been clear to me thus far.

I understand the opposition to so-called “austerity”: that in times of recession or anaemic growth it is beneficial to increase public spending in order to replace the lost spending from a hesitant private sector; that this spending then goes on to create an economic stimulus and return the economy to growth.  No problem.  Very straight-forward.

I also understand that government debt isn’t what most people think it is (I can recommend this on that topic) and that so long as the growth rate exceeds the deficit as a percentage of GDP, then net debt as a percentage of GDP will decline. Also straight-forward.

What I don’t understand is this: there must be a limit to the level of deficit that can be accommodated in the medium and long term.  Whether that be 10%, 50% or 1000% of GDP there still has to be a level at which every economist, regardless of their view on austerity, says “enough’s enough”.  Right?   Or even in the short-term, would any sensible economist advocate a government introducing spending 200% of GDP in one year to introduce a massive surplus?  I’m using enormous figures to make the point seem ludicrous but assuming that everyone agrees that 200% isn’t sensible, doesn’t it follow that at some point between there and the “sensible” x% there is a tipping point?

So my confusion comes in what dictates that tipping point.  What is the limiting factor where anti-austerians would say that “enough’s enough”?  And how is it quantified?  Can you point at a number and say that the UK, for example, *shouldn’t* have a deficit higher than y% for 2015, despite having a sovereign currency and independent central bank?

From my lay person’s perspective, I wondered if the limiting factors may be:

  • inflation: government introduces far too much money into the country in one go, devaluing the currency and/or creating huge inflation
  • interest repayments are prohibitive, making it difficult for growth to outstrip the deficit without reducing public spending to such a degree that it causes another recession
  • market confidence
  • higher borrowing makes it more likely that the debt is held by foreign lenders, meaning that the interest payments end up removing money from the country

I’m sure that there are more complex influences which should be considered here, so anyone with better knowledge on the subject than I have would be very welcome.

And just to re-iterate, I am not making an argument for or against austerity here.  I am simply trying to understand something that I currently don’t.

So, over to you.


7 thoughts on “Discussion: do Keynesians have a limit on deficit?

  1. Hi Fraser,

    Thanks for making this space to discuss this. I should say, I am not an economist by trade but have spent the last few years trying to understand these issues like yourself.

    The way I like to understand it is to picture the economy a bit like a lake. There are inflows and outflows and if you want to keep the water level constant then the inflows and outflows need to be balanced. In this analogy, government spending and sales to foreign customers (i.e. exports) are inflows of money (or “demand”) to the domestic economy, while taxing, saving and purchases from abroad (imports) are outflows of money (or demand). A healthy economy is one where the level of domestic spending is high enough to give everyone an income (full employment) but no higher otherwise inflation will occur. So maintaining this level of spending is like keeping the level of the lake constant. If the inflows or outflows change at any point, something else has to change to compensate and keep the system stable.

    For example, if the private sector saves at a rate of 5% then this is 5% of demand lost from the domestic economy. But if the country has a trade surplus of 5% then this fills that spending gap and spending (and therefore incomes) is maintained. Effectively, the trade surplus funds the saving, leaving the same amount of money circulating through the economy.

    But if there is no trade surplus (or even a trade deficit) then the government basically has to tax less than it spends so that it is adding more money (or demand) to the economy than it is taking away and giving room for saving (and net importing). This “surplus” for the private sector is a deficit to the government sector. This happens quite automatically because, when the private sector stops spending as much (same as saving more), tax revenues drop and social security spending rise. These are called the “automatic stabilizers”. If the deficit does not rise to meet the twin losses of savings and trade deficit then incomes have to drop. In other words the economy gets smaller. So what the government does is offers the savers bonds – swap their cash for an interest bearing asset. The government gets to recycle the savings back into domestic spending and the saver gets the safest asset in town. Its the same deal for foreign savers which arise because of the trade deficit.

    The final bit of the jigsaw is economic growth. If the economy is growing it needs more money to maintain stable prices. Imagine the lake is getting bigger because of erosion at the bed – it now needs some extra inflow to keep the water level the same.

    So, the job of the government – I would argue – is to keep the economy healthy such that everyone can get an income and without causing prices to rise (too quickly). This involves compensating for any leakages which may arise (saving, importing) and accommodating any growth, but not adding too much money/demand. So the government’s deficit should be at the right level to compensate for saving and trade deficit and to accommodate economic growth but no more.

    I am not sure how to get good data on savings rate. Here is one measure, household savings as a percentage of disposable income (i.e. after tax, I think):


    And here’s the budget deficit and trade balance as percentages of GDP


    So the latest figures there suggest the deficit is just barely covering the leakage of the trade deficit (both around 5.5%; and the trade deficit looks like its widening). The savings rate is about 5% but that is on disposable income so we can probably halve it, which might suggest that the deficit is a couple of percent too low. I am not sure how well “household savings” characterises actual aggregate saving in the economy by households and businesses (it is saving “net of investment” that matters, which is another complication). SO that might be an over- or underestimate.

    Another consideration is unemployment. If you have unemployment, then you have spare capacity in the economy and the potential for additional growth. If the government spends more into the economy to stimulate activity so that these people can be brought into employment, then the extra money added is not inflationary as long as the extra capacity is being employed in producing more stuff, i.e. growing the economy. So as long as the economy is under capacity it can take more spending. When the economy is at capcacity, however, then additional deficit spending (i.e. spending over what is removed by tax) will not produce additional production (GDP) and will therefore cause prices to rise. This is the limit on deficit spending. For context, we’re on zero inflation at the moment (or thereabouts), when the government’s own target is 2%:


    The upshot of all this is that there is a limit on government’s deficit, and it is the trade off between unemployment and inflation. I’ve often heard people say the government should “balance the economy” rather than “balance the books”.


    1. Thanks for the detailed response!

      Most of it seems to be aimed at why the deficit should be *higher*, rather than the limit on it being too high, and are things that I already knew about but I like the analogy.

      For what I’m looking at, I guess this is the important part:

      “…When the economy is at capcacity, however, then additional deficit spending (i.e. spending over what is removed by tax) will not produce additional production (GDP) and will therefore cause prices to rise. This is the limit on deficit spending….”

      So the limiting factor is inflation. To add to your analogy, there’s a dam at both ends of the loch. As you allow water to flow into the loch to replace the lost water, there’s a danger you can let too much in and burst the dam at the other end – then causing your water to flow out and the level to drop again. Apologies if I’m stretching the analogy somewhat.

      It’s difficult to try and isolate one or two factors in such a convoluted equation. We haven’t even discussed that not all spending is “good spending” and different types of spending will lead to different levels of “return” in terms of economic growth.

      Anyway, I’m away for a long weekend so will have a think about it some more and get back to you after Monday. Thanks again.


  2. My thanks also for creating this post to discuss this. I’ll try an avoid repeating spatchcockable’s points, though I think most of what I’m saying is consistent.

    “Whether that be 10%, 50% or 1000% of GDP there still has to be a level at which every economist, regardless of their view on austerity, says “enough’s enough”. Right?”

    If we’re looking for a % of GDP beyond which the UK public sector debt is too high, we first have to define what “too high” means. Too high could mean that the debt is so high that it can never be paid back, but if you understand what UK public sector debt really is (your link to Frances Coppola’s article above) then I don’t need to tell you why what has befallen Greece cannot happen to the UK with its own currency, central bank and so trusted bonds.

    However, if you mean a public debt limit above which the UK economy cannot grow, then although a limit could theoretically be estimated in some circumstances given government plans, it’s difficult to account for bubbles and crashes economies regularly experience.

    For example, a debt-to-GDP of 80% would have been unthinkable in 2007 given what was understood at the time, but wind forward a year and tax revenues had dropped sufficiently that a UK budget deficit had opened up that pointed to such debt levels in coming years. In fact, in the immediate aftermath of the recession I don’t think economists and those in government seriously thought we’d get to 80% debt-to-GDP, and if we did many believed the doom-laden prophecies – huge bond yields, crippled economy – which haven’t come to pass, thankfully.

    “So my confusion comes in what dictates that tipping point.”

    Instead of looking for a value or a % of GDP, it’s better to look for signs of trouble looming, and these I don’t think can be rolled up into one tidy limit. Irrespective of the debt level, I’d be wary of adding to it if any of the following were true:

    (essentially the inverse of the conditions in three of my tweets):

    1. A rise in bond yields – this means that bond prices have fallen and so there is less demand for UK public debt. This is a sign that the market might be losing confidence in the bonds (although perhaps with no good reason).

    2. Rising ownership of UK bonds by non-UK entities.

    3. Raising public expenditure for no good reason when the economy is healthy and no investment is required in infrastructure. This could cause inflation and crowding out of private investment (although I confess to being unsure how that operates).

    Perhaps 1 and 2 could be rolled up into a warning index of some kind, and both of those are largely outside our our control. Point 3 is determined by what kind of state is desired, and what kind of society we want to create, which is very important, but a whole other blog post 🙂

    Currently the UK situation on these three points all indicate there’s no cause for concern at public debt levels:

    1. Bond yields remain low, despite inaccurate predictions of the effects of both QE and high debt-to-GDP levels.

    2. About 30% of bonds are held outside the UK, and so 70% in the UK. This means that bond coupons (effectively interest payments) are being paid into the UK economy. Also, bonds offer a safe asset that’s used to carry our future pensions, amongst other things. More remarkable is that 25% of bonds are held by the UK public sector itself as a consequence of QE, and that means £bns of coupon payments are going from HM treasury to the Bank of England and then being transferred back again! The bottom line is that only 30% of UK debt could possibly be harmful to the UK economy in the future.

    3. Currently, there’s chronic public and private under-investment in the UK and so zilch inflation and no chance of crowding out, and plenty of scope for picking productivity off the floor with public investment.

    Private debt levels worry me and I think they’re pointing to another crash, but predicting exactly when that might be is very difficult.


  3. The limit to the deficit is the private sector’s propensity to save. When people want to save, the deficit needs to be higher: when they want to spend, the deficit does not need to be so large. The deficit adjusts automatically to changes in the propensity to save, or – another way of putting it — to hold money (for this purpose, government bonds can be regarded as money). Spending versus saving preferences are largely a function of perceived economic risk: in bad times, or when they think bad times are coming, people want to save, and in good times, or when they think things are getting better, people want to spend. The government’s deficit needs to adjust to these changing preferences. I’m not just inventing this: this is Keynes’s “liquidity preference” expressed in modern language.

    I don’t agree that the saving versus spending propensities of the private sector can be helpfully influenced by artificially restricting deficit spending. Making it more difficult for people to save doesn’t encourage them to do more of it, and taxing them more (or cutting their benefits) doesn’t encourage them to spend instead of saving, except for those who are forced to dis-save in order to live.

    Treating the deficit as essentially passive makes the relationship of the fiscal balance and activity in the real economy much clearer. Deficit to gdp targets are actually ridiculous. The government has no means of controlling either, let alone the ratio between the two. It is ALL about conditions in the real economy.

    Liked by 1 person

    1. Thanks very much for the comment, I appreciate you taking the time to read and respond.

      Essentially, what we’re saying is that the size of the deficit is immaterial. Governments should accommodate whatever level of deficit is required because what’s the alternative? Continued recession or anaemic growth.

      So if the Keynesian model is that public spending should be “whatever it takes” to replace the private sector money that is removed from the economy through savings, then the same people would argue that you don’t go beyond “whatever it takes” as that can generate unwelcome levels of inflation and/or disincentivise private spending?

      Because it’s the second bit that I’ve been wondering about. If the anti-austerian argument is that it needs government spending to stimulate growth (which I’m not challenging), then why not spend more than just “what is needed”?

      To put it into context. Let’s say an anti-austerity party, if one existed in the UK, had won power in May. They’d called an Emergency Budget and their economists had advised a stimulus package of £25bn was required and was the “right level” to replace the “lost” private sector money. Why not spend £50bn? Or £100bn? At some point you would be doing more harm than good, right? And so, at some point, the spending, and thereby the deficit, becomes a negative?

      I’m not trying to “find an angle” against the anti-austerity argument here, I’m just trying to fully understand it. The argument against under-spending is very clear and straight-forward but I’m trying to understand at what point and in what manner a huge deficit / huge public spending creates a negative effect; i.e. at what point a Keynesian would consider it to be “over-spending”. Because at some point it must, otherwise governments would run a 500% deficit every year and hand out free money to their citizens from government sponsored happiness booths.

      I hope that makes sense as I fear my lack of economic education is preventing me from articulating the query clearly.


  4. The limit on *any* spending – not just government spending – is the real resources that are available in the economy. If anyone tries to buy more than is for sale – or can be produced for sale – in the economy then inflation will occur. It doesn’t matter (I don’t think) whether it is government spending or private spending. For example, a credit boom puts more spending power in the hands of the private sector and enables them to try to buy more. If this exceeds what is available, it will produce inflation (too much money chasing too few goods). So when the BoE sees inflation creeping up, it increases interest rates to try to slow down the expansion of credit. So this is not just a phenomena of government spending.

    When the government spends it is purchasing real resources from the economy – nurses labour, construction materials, drugs, energy. It can only buy these things if they are capable of being produced and for sale in the economy (or imported but lets ignore that). So if the economy is operating at capacity – i.e. full employment, all capital in use – then additional government deficit spending will produce inflation in the same way any additional spending will. This is one reason why government’s tax (it is not for funding spending when you create the currency). Taxing takes spending power out of the private economy; it prevents the population from buying everything that is produced leaving enough behind for the government to consume and utilize.

    If the economy is operating under capacity though then additional spending will bring unused resources into employment and increase the productivity of the economy. To the extent that the additional money grows at the same rate as the increase in production, no inflation will occur. In other words, if the government employs unemployed people to do useful work, the extra spending will not be inflationary. Again, this is no different from money and spending power introduced to the economy by private bank lending. Which is why the BoE drop rates during a recession to try to promote more lending and spending which will promote economic growth and more employment of resources. But if the private sector aren’t doing it for some reason, then the government should.

    I’ve heard it said by several economists that unemployment queues tell you directly that the deficit is too small. I don’t know how to calculate how many billion that extra spending would be. I assume it is a bit like the Monetary Policy Committee calculating what the interest rate change should be – a matter of judgement for experts.

    Liked by 1 person

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