Rishi Maynard Sunak

In book 2 of the Wealth of Nations we get the first hints of Classical growth theory. We learn that ‘parsimony and not industry is the immediate cause of the increase of capital’. To have growth, you need capital. To have capital, you need somebody to put aside part of their income rather than consuming it. And for that, you need people to earn more than they spend. The rest is invested, and only investment leads to growth.

Think of a Ricardian corn economy: corn is the input, and corn is the output. You plant 1 unit of corn and it grows 3. If you consume 2 units and plant the other, you’ll have no growth, just replacement of the 3 units next year. If you consume only 1 and plant 2, you’ll get 6 next year. Thus parsimony increases capital.

My book, The Philosophy of Debt, was heavily criticised by economists for implying that an economy needs debt to grow. The example I just gave shows that they were right to criticise that claim. In my corn economy there is no debt, but if there is parsimony there is growth. But I don’t know where I made the claim. If I said it, I meant: in a financialised economy there is no growth without debt.

In a financialised economy, people invest money, not corn. Investing money means spending more than you earn. In ‘accrual’ accounting terms, you pay for capital investment, not out of your current income but rather out of your future income, which the investment will hopefully bring. The investment ‘pays for itself’ as it generates a return, and you deduct its cost from the return. You have to pay the cash up front, of course, so until the investment has paid for itself you’re in debt, in a sense.

In a sense. You might not have explicitly borrowed the cash. You might have paid for the investment out of your own savings, retained earnings, etc. But in accruals accounting you don’t deduct the expenditure when it’s paid. You deduct its cost later, from the returns on the investment. The effect, in accounting terms, is the same as borrowing and pledging your savings as collateral: rather than drawing down your savings when you make the purchase, you book a liability — a debt — against those savings and reduce it slowly as the returns come in from the investment.

So to have growth, you need somebody leveraging up: spending out of future income, or going into ‘debt’ in some very broadly-defined sense of ‘debt’. But of course if somebody is spending future income they are spending more currently than they earn currently. And money, unlike corn, is a closed system. If one accounting unit is spending more than it earns, another accounting unit or group of units must be earning more than they spend. The extra spending has to go somewhere. Thus when you have investment, and therefore growth, you have both leveraging up somewhere and deleveraging (saving) somewhere.

A useful diagram here is the sectoral balances for an economy. Here are the sectoral balances (in % of GDP) for the UK (h/t Neil Smith):

You can see that whenever one sector leverages up or down there is a contrary motion in another sector or sectors. If you look around 2016 you can see the corporate sector massively deleveraging — pulling back on investment: Brexit panic and the rest of it. This drives the household sector down: the blue line drops almost in step with the yellow line rising — savings are drained and debtors are driven further into debt. The red line — the public sector — was embarked on ‘austerity’ since 2010. This is now turning around due to Sunak’s ‘Keynesian’ budget.

People have very different emotional reactions to movements in these sectors. When the corporate sector leverages up, it’s a thriving, high-investment, business-friendly environment. When the public sector leverages up, it’s public profligacy, fiscal irresponsibility, leaving a burden to future generations, etc. etc. This might also be an overhang from Smith, who at one point made a Hayek-type argument that ‘statesmen’ can’t know enough to make good investments. Thus public investment will have low or negative returns, whereas the investments of capitalists — corporate investment in modern terms — will generate healthy returns on the whole.

It doesn’t do justice to Smith to reduce him to this. He was well aware that public investment in public goods is not only worthwhile but necessary for the success of the investments of capitalists. Somewhat unfairly, the rewards of public investment often show up as returns on capital investment.

Probably the thing we feel most palpably is the household-sector effect. An deleveraging household sector usually means a stressed and precarious population. At the tail-end of the graph you can see the relaxation of public austerity bringing some moderate relief to the household sector, which can now accumulate some savings.

But of course this doesn’t tell us what happens within the sector. Some people could still be falling, it’s just that others are rising faster. The old mantra — a rising tide lifts all boats — gets the metaphor wrong. The economy is more like a system of interconnected pumps: some are squeezed to puff up others. You need to know where you are in that system to know whether or not to be excited about this budget.