Problems of Government Borrowing

April 15th, 2009 | economics -

What are the Problems of High Government Borrowing?

There are many theoretical problems of high levels of government borrowing. But, usually these problems don’t materialise under normal circumstances. However, as government borrowing as a % of GDP increases, the problems of government borrowing are exacerbated. With UK facing an annual budget deficit of over 11% of GDP, there are many potential problems.

Higher Debt Interest Payments. As borrowing increases, the cost of servicing debt rises. The government is currently helped by low interest rates, which have kept interest payments low. However, as inflation and interest rates pick up, the cost of paying interest payments will rise in future years. Currently, the UK pays approximately £35bn in interest payments.

Inflationary Pressure. It is rare for government borrowing to cause inflation. But, the combination of quantitative easing and very high levels of borrowing make inflation more likely.

If markets fail to buy enough gilts to finance the deficit, the deficit can always be financed through ‘monetisation’. i.e. creating money. This creation of money creates inflation, reduces the value of exchange rate and makes foreign investors unwilling to hold UK debt. So far quantitative easing has not caused inflation because of the falling velocity of circulation. But, the economy could swing from deflationary to inflationary pressures quite quickly.

Higher Interest rates. The government need to sell alot of gilts to finance the budget deficit. The debt management office could be trying to sell £150bn worth of gilts this year. That is a lot – and the market may not want to buy that amount. The failed gilt auction last month was a worrying signal. If the markets don’t want to buy debt, the response will be to offer higher interest rates on gilts. This tends to push up other interest rates in the economy and reduces spending and investment. (This impact of higher interest rates in reducing private sector spending is known as crowding out)

Crowing Out. A classical monetarist argument is that high levels of government borrowing cause ‘crowding out’. What they mean is that the government borrow from the private sector by selling bonds. Therefore, the private sector have less money to spend and invest. Therefore although government spending increases, private sector spending falls and there is no boost to the economy.

I think this argument is misplaced in a recession. Private sector saving is rising. The government are spending to offset the rise in private sector saving.

Higher taxes in the future. The government will need to reduce borrowing as a % of GDP. It means future budgets will need to increase taxes and / or limit spending. The danger is that if taxes are increased too early too quickly it could snuff out the recovery and cause a further downturn. If they don’t raise taxes markets may be alarmed at size of borrowing. There will be difficult choices for the future chancellors; it is a difficult situation to be in.