There is probably no economic fallacy that is so difficult to correct than that of Swabian hausfrau economics (you can only spend what you have -although Swabians are fanatical homeowners, most of which are financed with mortgages) having no relevance with regard to public finance.
Frank Van Lerven is currently leading New Eonomics Foundation’s work on greening central banks and monetary policy.
The single greatest masterstroke of the Cameron-Osborne era was to undercut future progressive policy by mainstreaming the idea that the government needs to manage its finances like a household. As the Budget approaches, we should remain sceptical of any claims, like those made by the prime minister, that the belt tightening of government finances is over, until the household analogy is publicly accepted for what it is: a fallacy.
The household analogy is simple: the government needs to live within its means. Like a typical household, if the government consistently spends more than it receives in income, the nation’s debt will ultimately become unsustainable, and the country will go broke.
The familiar logic of the household analogy has become so embedded into public life that spending proposals that would help tackle some of our most pressing challenges – climate change, the housing crisis, unsustainable household debt – can barely make it out of the door. All too often, such proposals are stopped in their tracks by rival politicians and the media asking where the money is going to come from.
Indeed, progressives in the UK are frequently laughed out of the room for being fiscally irresponsible and not understanding how the economy really works. But the irony is that the UK’s national debt is actually low in comparison to historical standards. We also have a globally unique method for measuring public finance which is biased against public investment. If Germany was to use our measurements, its government debt would be twice as large as ours.
The appealing logic of the household analogy has provided intellectual cover for a protracted campaign of budget cuts that has had dire consequences for many families and communities across the UK. Meanwhile, vital public services like schools, hospitals, and prisons are close to breaking point.
The truth is, the household analogy has been weaponised for purely political ends: to prevent progressive spending policy from gaining any sense of legitimacy. Its apparently instinctive argument disguises the truth – what is true for an individual household is not true for the government.
Crucially, the economic effects of government spending cuts are significantly different from when an individual household decides to cut its spending. For example, if a single family decides to cut back on spending, say by 10%, then this will have a trivial effect on the wider economy. In terms of size, a household’s spending is vanishingly small in comparison to the total amount of spending in the economy as a whole. As a result, no one will lose their job, incomes will remain almost the same, so the family’s income will remain the same as it was before. Consequently, for the family in question, cutting spending should help it to reduce its debts.
But if the government decides to reduce its spending by 10%, this will have massive implications and reverberate throughout the wider economy, and will ultimately end up reducing the income (from tax revenue) of the government. This is because government spending is a significant proportion of an economy’s total spending. As such, when the government reduces its spending, employment and wages fall in both the public sector (e.g. for nurses, teachers, and police officers) and those sectors that provide goods and services to government (e.g. construction workers).
The reduction in employment and wages means that nurses and construction workers spend less in the economy overall, harming other businesses not directly affected by the reduction in government spending. This can then lead to further falls in employment and income – the ‘multiplier effect’. Of course, the reduction in employment and incomes means a reduction in the government’s tax take. By cutting its spending the government also ends up reducing its own income. So unlike a household, government spending and income are not independent of one another.
This is why Professor Jo Michell of UWE Bristol suggests that reductions in government spending when the economy is under-performing can actually lead to higher levels of public debt and lower growth. And, new research backs this up: “Attempts to reduce debt via fiscal consolidations have very likely resulted in a higher debt to GDP ratio through their long-term negative impact on output.”
Of course, the opposite holds true as well. The significant size of the public budget means that it can also have important positive multiplier effects across the economy, in a way that a single household cannot. For example, by creating employment and increasing wages for nurses and teachers: these workers will spend more across the economy, creating new revenue for shops, retailers and other businesses. The businesses can then reinvest their revenue to hire more employees, who will in turn spend more – and so on.
The multiplier effects of government spending are important, because, as noted by Josh Ryan-Collins of the Institute for Innovation and Public Purpose, they imply that the public sector can stimulate growth at a faster rate than increases in public borrowing. That is, the government can actually boost the level of national income relative to debt. Over time, this means the debt to income ratio will fall even if government spending is financed by borrowing – making government debt more manageable.
Another important point is that, unlike a household, the government has the powerful backing of a central bank behind it. If the Treasury and the central bank cooperate, the central bank can help lower the interest rate – i.e. the borrowing costs – of the government.
For example, in Japan the central bank targets a zero percent interest rate for the government’s ten-year loans. In the UK the Bank of England has significantly helped lower government borrowing costs, a good case can be made that the government has acted irresponsibly by not taking full advantage of the fiscal potential the Bank affords it.
In effect, the government has significant influence over its own borrowing costs. Households do not have a central bank at their disposal, which can lower their rate of interest whenever they want to.
These are but a few reasons that a household’s budget is different from a government’s. But even on its own terms, the household analogy is used fallaciously. Households need to borrow to increase their standard of living. Not many people or families have the money to pay for things up front – such as a car, a house, or a university education. So we actually end up borrowing many times our income, and as Dr Mathew Bishop of Sheffield University suggests, this ends up being “far more than any country borrows, relative to its income, for anything”.
The greatest triumph of the Cameron-Osborne era was that they managed to constrain future governments because they changed the public perception of how governments should spend – by popularising the ‘household fallacy’. Claims of ending austerity ring hollow, until we do away the ‘household fallacy’ and realise that public spending can be deployed as a potent weapon against many of the challenges we face today.