We're not living beyond our means!

As a general rule I am not one for predicting what the Chancellor might say during his budget speech, but I would not be at all surprised if the phrase “living within our means” crops up at some point tomorrow. George Osborne said it ahead of the 2016 budget; Philip Hammond used the phrase at the Conservative Party conference in October and he was at it again over the weekend, telling the Sun on Sunday that we must “ensure we get back to living within our means.”

We all know that this is just another way for Chancellors to say that they intend to reduce the budget deficit further. But as a statement of economic fact, it’s nonsense. Over the years, Chancellors have told the public that “we must live within our means” as if somehow state finances are the equivalent of running a household budget or a corner shop. And the public continue to fall for it. But there is a major difference between an entity with a limited lifespan, such as a household or a one man business, and a state with a much longer lifetime – if not infinite, then close enough for the purposes of investors. Households operate under a lifetime budget constraint in which all current spending and borrowing have to be paid out of the finite lifetime income which it generates. A sovereign state such as the UK will (hopefully) still be around in 100 years’ time (notwithstanding the Scottish secession threat). There is thus a pretty strong likelihood that an entity which has never defaulted outright on its debt will still be around to pay its dues. For the UK, living within its means implies thinking over a much longer time horizon.

Let’s look at the counterfactual by supposing that “living within its means” requires the sovereign state to fund its commitments out of current income. How would we finance investment? Is it right that today’s taxpayers should provide all the funding for a long-lived project – such as a housebuilding or hospital expansion programme – without requiring future generations that benefit from them to pay anything? And while we are at it, how do governments fund wars? After all, UK government debt rose by 100 percentage points relative to GDP between 1939 and 1947 – proportionally way more than anything we have seen in the last decade. Imagine history’s reaction if Churchill’s government in 1940 had said something along the lines of “obviously, we are committed to freedom and democracy but we are not prepared to fight for it because we have to live within our means.”

So as statements of economic policy go, this is just dumb. However, I guess most Chancellors know it but since they are politicians first and foremost, they have to get the message across in ways that people understand. Of course, it is not just British politicians who are guilty of this fallacy. German finance minister Wolfgang Schäuble remains committed to maintaining budget balance despite the fact that Germany saves too much and invests too little (that, after all, is why it runs a huge current account surplus). Yet his message goes down well with an electorate that sees saving as a virtue – which it is, though not as an end in itself.

I am not as such opposed to a degree of consolidation in public finances – though as I noted on Sunday, we may be overdoing it in the UK. What I object to is the misrepresentation of the government’s budget problem as though it were managing a household budget for it gives a misleading impression of how state finances operate. We are living within our means if we can finance most current spending from current income and have to rely on a small sub from the markets for the rest. After all, markets lend to governments because they know they will be compensated – though not terribly well at present – and get their money back. Nobody is forcing them to do so. We know we are living beyond our means when markets cease to buy government debt. And despite record low interest rates, there is no sign of that happening just yet.