Parramatta defeated England in the final of the Rugby league World Sevens. As Henry Root’s daughter Doreen observed on a similar occasion “That’s not a football match, that’s a category mistake”

The news that Bush’s proposed budget includes a deficit of $300 billion (around 3 per cent of GDP) for the next two years, and smaller deficits into the indefinite future has been somewhat overshadowed by events of more immediate concern. But when Iraq is off the front pages and the Space Shuttles are flying again, the deficit will still be there. This immediately raises the question: So What ? Some economists seem to be very concerned about budget deficits at all times, some are concerned at some times and not others, and some never seem to worry. What is going on here?

The only satisfactory way to explain this involves a few equations. Since every equation is supposed to reduce readership by a factor of ten, this probably means I will only have two readers for this post, so maybe I should just get Jason and whoever else is still reading to email me. Pressing on regardless, let’s begin with the national income identity

Income = Consumption + Investment + Govt spending + Exports – Imports

This equation is an identity, which means that it’s true by virtue of the definitions of the terms, not because of any particular economic theory. The equation can be rearranged in various ways. The most useful involves taking taxation revenue into account as a transfer from households to governments. Rearranging, it’s then possible to show that the government budget deficit must be equal to the sum of:

Imports less Exports (the current account deficit); and
Private Saving (after-tax income less consumption), net of investment.

Arithmetically at least, a budget deficit must be funded by borrowing either from households or from overseas (in this context, printing money is regarded as a form of taxation, or perhaps of borrowing).

When a government increases spending or cuts taxes, leading to a higher budget deficit one or other of these must change as well since the accounts must balance. Economists’ level of discomfort with budget deficits depends on where they think the change will take place.

The most pessimistic view, called ‘crowding out’ is that investment will decline as private savings are used to fund the budget deficit. Another pessimistic view called ‘twin deficits’ is that the adjustment will take the form of more borrowing from abroad, that is, an increase in the current account deficit. In Australia, deficit hawks have pushed both theories, and some have managed to believe both simultaneously.

The neutral position, called Ricardian equivalence, is that consumption will adjust. In this story, people realise that the budget deficit will imply higher taxes in future, and start saving up now. If you find this story implausible, you can join 99 per cent of the economics profession.

The optimistic position is that income will increase, partly offsetting the original increase in the deficit as tax revenue rises and also allowing for higher private savings. There are two reasons why this might be so.

The Keynesian argument for deficits assumes that there are lots of unemployed workers, idle factories and so on (So far, so good!). The extra demand produced by tax cuts or government spending is met by hiring more workers and reopening factories, which in turn stimulates ‘multiplier’ effects. In a very simplistic model, sometimes referred to as the ‘pump-priming’ model, the growth is sufficient to wipe out the original increase in the budget deficit.

The ‘supply-side’ argument based on the(in)famous Laffer curve applies only to cuts in taxes. It’s claimed that the extra incentives will stimulate more work effort, higher investment and so on, thereby raising income and, in the extreme case, wiping out the original increase in the budget deficit as in the ‘pump-priming’ story. Religious metaphors arise naturally here. George Bush Senior called supply-side economics ‘voodoo’, but it’s gospel to Junior and to most of the US Republican Party

Most economists are Keynesian in the short run, but believe some mixture of crowding out and twin deficit models applies in the long run. This suggests the ideal policy called the ‘golden rule’, running deficits during recessions and surpluses during booms so as to achieve budget balance over the course of the cycle (this leaves open, the question of precisely what is meant by budget balance, but that’s a story for another post).

I wanted to swear off, but I can’t resist (no, not The Bill). The great Lott controversy rolls on, and has finally attracted the attention of mainstream media. You can get the increasingly bizarre details here. Unfortunately, if understandably, the stories focus on Lott’s “Mary Rosh” persona, and don’t mention the putative 1997 survey. This is a pity, since one of the stories is running in US News and World Report, which has a paid circulation of 2 million. That ought to be good for at least a dozen respondents to the survey (if it ever took place).

One of the techniques economists learn in game theory is recursion. If a given sequence of moves leads inexorably to defeat, it’s necessary to work back to the last decision point at which defeat can be avoided, and change the move at that point. Players of real games such as chess learn the same thing by experience.

Given the critical nature of Blix’s report on Iraqi compliance (not as critical as the initial reports made it out to be, but critical enough) and intense pressure from the US, my guess is that in the absence of some move from the Iraqi side, the UNSC will pass some sort of resolution in the next few weeks that will include a declaration that Iraq is in ‘material breach’. If so, a US-led invasion will ensue shortly thereafter, presumably leading to a very bad outcome for Saddam Hussein.

Applying standard game theory, this analysis implies that ‘Do Nothing’ is a fatal move for Saddam, and, on his past record, it seems unlikely that he will take an obviously fatal move. The options that seem potentially better from his viewpoint are
(i) backing down on the issues raised by Blix – U2 flights, scientist interviews, documentation on what happened to missing weapons etc
(ii) recanting the December declaration, admitting he has weapons and destroying them
(iii) accepting an offer of exile

I’ll look at these options in subsequent posts. For now, I’ll consider why Saddam might do nothing. Perhaps he’s confident of beating the US in a war. Alternatively, the regime may be so tightly tied to WMDs that giving them up would lead to Saddam’s immediate overthrow. Finally, he might prefer death to dishonorable defeat. In any of these cases, he’s crazy enough that the case for war is a good deal stronger.

I’m at a conference of Parliamentary Public Accounts Committees today (a wild life I lead, no?) so I’m counting on my commentators to provide some discussion until I return. Post comments on any topic (civilised discussion and no coarse language).

My suggested discussion starter – Do we care more about the Shuttle astronauts than about those killed in the recent rail crash? Should we?

England in the Age of Improvement by Asa Briggs. It’s part of the Folio History of England series, covering 1783-1867, an odd choice of periodisation meant to cover the first stage of the Industrial Revolution. Very useful for those of us who want to think seriously about economic growth in the Internet Era and its implications for things like the distribution of income.

Meanwhile, the other big news on my cultural activities is what I’m not watching any more. I’ve only ever watched two TV series on a regular basis: Doctor Who from its inception in the early 60s to sometime around 1980 and The Bill from the late 80s until now. I don’t make any claims for either, other than they had something that managed to hook lots of people including me. I can’t exactly recall when and why I stopped watching the Doctor in his endless fight against Daleks, the Master etc, but I’ll record my abandonment of The Bill as of today. It’s been becoming steadily soapier in recent years in an attempt to extend to a broader audience. At first I actually quite liked the changes, but it’s now reached the point where almost every character is engaged in sexual intrigue with some other character (even Reg had a fling a couple of series ago). And the plot credibility, never ironclad, is now non-existent.

What this means of course, is that I’m in the market for a new TV addiction, and asking for reader suggestions. I’ll be interested to see what interaction through my blog suggests to others about what I might like on the box.

Finally, declarations of this kind are frequent, and often followed by a quiet slink back to the drug of choice. Anyone want to offer odds on this?

Update Quite a lot of my regular commentators turn out to share my attitude to The Bill, and a few even shared my predilection for the Doctor. Does anyone want to offer confessions about alternative TV addictions? Is there anyone out there willing to claim they don’t have any?

Disco dream

I dreamed I went to a discotheque, and it was a dream of hell,
Cos’ when I looked about the crowd, I didn’t fell too well
They were dressed in the latest fashion clothes, and all about fourteen
They had crimson hair and vermilion hair, and every shade of green

The dance floor was about four foot square, and covered in flashing lights
The dancers looked quite picturesque in their multicolored tights
I dreamed that I got up to dance, but I couldn’t find the beat
I was elbowed and shoved, I was pushed about, and everyone stepped on my feet

I forced my way up to the bar and ordered a whisky on ice
The barman took my ten dollar note and asked for the rest of the price
I was feeling hot and sweaty then, so I called for a beer as well
It was warm and flat, and worse than that, they’d watered it all to hell

The smoke was swirling thickly now, and I was rather shocked
When I passed by the fire escape, to notice it was locked
In my hurry to get outside, kicked the bouncer in the shin
He laid me out flat, nearly broke my nose, and he took off three layers of skin

Well then an almighty blue broke, out it was on for young and old
The blood was flowing freely now, but mine was running cold
The police were battering at the door, and just as they burst through
I awoke in Darlinghurst lockup, to find it was all quite true

Tune: The Shearer’s Dream

One of my concerns about a war with Iraq is that there seems to be no real plan for postwar reconstruction from an Administration that, until now, has demonstrated a visceral aversion to ‘nation-building’. Reports of Afghan warlords killing at will are the kind of thing I mean. The US vigorously resisted any extension of peacekeeping beyond Kabul simply on the off-chance that it might get in the way of their forces chasing bin Laden. Things aren’t as bad there as might be expected, but Iraq will be a much more difficult problem.

I got Linux!. Well, at least it wasn’t Windoze. Meanwhile, I still haven’t found the time to shift from the Windoze of blogging software, which won’t even post images properly.

Virginia Postrel offers A Tool to Explain Affirmative Action. As with most discussion of this kind of problem, it’s stronger on analysis than prescription, but well worth reading.