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All our major political parties say that reducing the public sector deficit is a major priority. Despite all the current government's efforts it is still running at about £100 billion a year, or close to 6 per cent of our Gross Domestic Product (GDP). Total government debt, which is already approaching 100 per cent of GDP, is rising at about 3 per cent of GDP per annum. On present trends, therefore, within a decade it is going to be about 125 per cent of GDP and rising towards still more unsustainable levels. Clearly, it needs to be brought under control. But how?

Common sense appears to tell us that the way to do it has to be some combination of cutting government expenditure and raising taxation. This is clearly the approach which any individual person would have to adopt with expenditure running well ahead of his or her income. It is, however, a major fallacy to think that what would work for a single person would also work for the economy as a whole. This is because everyone's income is someone else's expenditure and, while any individual's spending decisions make a negligible difference to the whole economy, this is not true of government receipts and spending.

The simplest way of seeing this is to consider what is likely to happen if government expenditure is cut and taxation raised. Other things being equal, demand will fall and the economy will contract. This will produce lower tax receipts and higher claims on the social security budget as unemployment rises. As a result, the deficit may not get any smaller. Indeed, it may increase.

There is also a more sophisticated way of approaching what to do about the deficit, which provides a more compelling way of seeing what the deficit problem is and how to overcome it. As an accounting identity, all borrowing in the economy has exactly to be matched by all lending and there are four major sectors involved. They are the government, business corporations, household consumers and the foreign balance of payments.

The key to reducing the government deficit is not to cut government expenditure or raise taxation because policies like these will not shift any of the other borrowing/lending sectors in the right direction. They are likely to discourage rather than increase business investment, thus leaving the corporate sector with even larger cash balances which have to be lent to the rest of the economy. Similarly, government cuts are unlikely to get the household/consumer sector to borrow more. Nor are they likely to do anything significant to contain our soaring balance of payments deficit, which can only be financed by borrowing from overseas. The government deficit, which is the balancing factor, is therefore almost certain to stay as high as it was before.

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