Readers Question: In a non-recession situation, if a government reduces it’s borrowing and thus it’s spending, how can that have a depressing effect on the economy? Wouldn’t that money be either be loaned to someone else or spent to on goods and services by the people who have it?
Yes. If an economy is growing rapidly, a reduction in government borrowing (thought government spending cuts) shouldn’t have a depressing effect on the economy. This is because if the economy is strong, a fall in government spending, is usually absorbed by the growing private sector. This is related to the principle of crowding out. – The idea that during economic growth, government spending is crowding out private sector spending. Therefore, as government spending falls, this ‘crowded out’ private sector can increase.
Example
If the economy is growing strongly, then investors will be keen to invest in private enterprise – loans to firms, buying shares on the stock market, buying commercial bonds e.t.c. This is because during an economic boom with rising incomes, investors feel that the private sector is going to give a relatively good rate of return.
Therefore, if the government wishes to borrow money in a period of economic growth, it will have to work harder to attract private investors to buy government bonds. If the private sector is giving a rate of return of say 5%, then, ceteris paribus, the bond yield on government debt will have to be at least 5% to attract borrowing.
If the government wishes to borrow more during times of economic growth, it is competing with private sector investment, and this competition to attract buyers will most likely push up bond yields.
If the government cut spending and reduce the budget deficit, then rather than buying government bonds, private investors may switch to buying commercial bonds or investing in the stock market. The point is during economic growth, this extra money is unlikely to be kept idly standing around.
Therefore, although the government is spending less, the money gets diverted into the private sector, and overall demand is maintained.
Furthermore, if the government reduce borrowing during a period of economic expansion, we are likely to see a fall in bond yields. It is easier for government to attract bonds, and therefore, interest rates can be lower. This fall in government bond yields, is likely to reduce similar bond yields in the economy. The lower interest rates on commercial bonds will also act as an incentive to increase investment.
Some point to Cananda in the 1990s as an example of an economy which cut government borrowing sharply, but maintained overall aggregate demand (helped by strong exports and looser monetary policy)
Monetary Policy
Another factor is that if the economy is growing strongly, interest rates set by the Central Bank will be relatively high. If there was a slight downturn in the economy, the Central Bank could cut base rates to stimulate demand.
This is why the best time to reduce government borrowing is during a period of economic expansion.
In a Liquidity trap everything is different
The above analysis doesn’t apply in a deep recession / liquidity trap. Basically in a recession, investors don’t want to lend to firms (who may go bankrupt). Let’s say the private sector is giving a rate of return of 0%. Therefore, there is very strong demand for government bonds, even if interest rates are very low.
Therefore, if you cut government spending in a recession, these spending cuts don’t lead to higher private sector investment and spending. Instead, we get a negative multiplier effect and an even bigger fall in demand.
Further reading
Readers Question. If the US Government, for example, borrowed $1 Trillion less, wouldn’t this money just get spent somewhere else?
It depends on the state of the economy. In a recession, that money may just be idle, sitting in bank accounts (not used).
In a boom time, savers may be encouraged to invest in stock market, lend to private business to help promote economic growth
That is, if government borrowing is actually borrowing, and not printing/creating money by another name, doesn’t the money have to already exist? Wasn’t it going to be invested somewhere?
Thanks very much for this reply. This really helps me understand things, and makes perfect sense.
I think the last paragraph above was inadvertently copied from my question, btw.