Does Government Debt Matter?

Readers Question: Does Government Debt Matter? Do high fiscal deficits threaten economic stability?

In this situation, economic stability would involve.

• Low inflation
• Positive sustainable economic growth (e.g. close to long run trend rate of growth)
• Stable bond yields (i.e. avoid rapidly rising bond yields which could create difficulty in dealing with debt.)
• Stable exchange rates

High Fiscal deficits mean the government is forced to borrow a large sum – Government spending is greater than tax revenues.

For example, in 2011/12 the UK government will have to borrow an estimated £125bn (just under 10% of GDP). Anything over 3% of GDP could be classed as a high fiscal deficit.

UK Government Borrowing

The UK ran high fiscal deficits in 1992 and 2009. In these periods we experienced:

Low inflation. Because of the recession, demand pull inflation was low. In 2011, we had some cost-push inflation, but this is likely to dissipate in 2012.

Low Government Bond Yields. Despite high levels of debt, UK bond yields did not increase in this period. UK bond yields fell between 2008-11, despite the rise in government borrowing. Bond Yields are low because:

• In a recession, investors wish to buy security of bonds rather than riskier investments like houses and shares. The low bond yields reflect a pessimistic outlook for economic recovery and future inflation.
• Bank of England buying bonds as part of quantitative easing.
• Markets convinced governments have credible plan to reduce debt levels in medium term.

Prevent even higher unemployment

The fiscal deficit counters the fall in private sector spending.

This graph shows that budget deficits have increased when there is an increase in the negative output gap (output less than potential). Thus the fiscal deficit is partly a response to recession. If the government tried to balance its budget in a recession, it would cause a more serious recession. (see: economic impact of austerity)

How Deficits Could Cause Economic instability

• Inflation. It is possible a government may respond to a high budget deficit by printing money. This could easily cause inflation. For example, Zimbabwe in 2009 and Germany in 1920s had high budget deficits and they responded by printing money. Therefore, high deficits could be potentially destabilising. In UK, quantitative easing didn’t cause inflation because there was little increase in M4 (Broad Money Supply).

• Rising Bond Yields. In the Eurozone, high fiscal deficits have raised fears over the ability of governments to repay debt. In the case of Greece, the level of budget deficit seemed unsustainable – especially given prospects for lower economic output. In other European countries, like Spain and Italy, markets are also worried that there is no Central Bank willing to step in and act as lender of last resort (like the UK could). Therefore, we have seen rapid rises in bond yields. This is destabilizing because it has forced these countries to cut spending and risk lower economic growth. This lower growth in turn makes it more difficult to reduce debt to GDP ratios.
• Fears over default could lead to fall in value of exchange rate.

Borrowing and Future Generations

• Government debt implies future taxpayers will be responsible for repaying debt.
• Note: It doesn’t necessarily mean higher tax rates. If there is economic growth of 2%, it means income tax receipts will be increasing to meet higher debt interest payment).
• However, if borrowing increases faster than real GDP, then government borrowing may require higher tax rates.
• Future generations also benefit from current government borrowing. Government debt may be funding investment and infrastructure improvements, which lead to higher growth.
• Government borrowing may help economic recovery and reduce unemployment. This will benefit future generations.
• Also, if we assume rising real incomes, government borrowing helps redistribute income from future to present. This can help smooth income over time.

Does Borrowing matter?

• It depends on levels of private sector debt. e.g. in a recession, private sector borrowing falls as the private sector save more. Public borrowing can thus offset the rise in saving and fall in spending which threatens a recession. It is important to look at overall debt. However, if there is a rise in private sector debt and government debt, this is potentially more serious and liable to cause crowding out and be unsustainable.
• It depends on whether borrowing is sustainable. Do markets feel, the government has borrowed too much? Is the debt to GDP ratio going to keep rising, making it increasing difficult to repay?
• Is the government borrowing for investment or meeting an ever-growing demand for social security? ( e.g. pensions)

• In the early 1950s, UK national debt was over 200% of GDP (in 2012, it is 63% of GDP). But, this level of debt didn’t burden the UK. It was a legacy of the Second World War and spending on the Welfare State and nationalising industries. It laid a foundation for three decades of economic prosperity.

Related

• How much can a government borrow?
• The Biggest Lie in British Politics
• UK debt
• Historical national debt