Most western economies are facing the prospect of record peace time government debt levels.
The EU Maastrict Criteria stated that the maximum budget deficit member countries could run is a budget deficit of 3% of GDP. (By the way, I am glad this target for government borrowing has not been enforced. That would have been very damaging. See: Growth and Stability Pact)
Unfortunately, this target looks a bit of a joke. To give a few examples:
- Ireland’s budget deficit runs at 14% of GDP
- Greece at 12% of GDP
- UK at 11-12% of GDP
Though, I don’t believe in sticking to arbitrary targets, clearly these levels of debt need to be reduced, at least in the medium term, and definitely over the longer term.
But, What are the Problems in Reducing Debt Levels?
1. Deflationary Fiscal Policy
To reduce levels of government debt is deflationary fiscal policy. It requires higher taxes and lower spending. Higher taxes will reduce consumer spending and will reduce growth of Aggregate Demand and could hamper economic growth. It could even push an economy back into recession. The irony is that by trying to reduce the deficit you could cause another recession and this would worsen the deficit because a recession would cause lower tax revenues and higher unemployment benefits.
2. Political Resistance
An effective strategy to reduce government spending is to restrict public sector wage increases – even cut wages. But, many EU countries have strong trades unions in the public sector. In France wage cuts could lead to a wave of strikes. Recently, Greece experienced anti government riots – a cut in public sector wages could be a spark to renew them. In the private sector, it is easier to fire people. If a firm goes out of business – people expect to be made unemployed. But, jobs in the public sector are seen as recession proof.
Of course, there will also be political resistance to tax increases.
3. Disincentive Effect of Higher Taxes.
In the UK, the modest tax rises suggested so far, are mainly direct taxes on income. For example, a rise in NI contributions and the new 50% top rate income tax. However, these higher taxes could have the effect of encouraging top earners to move elsewhere. From an economic point of view a more efficient tax would be higher indirect taxes on goods like VAT, and excise duty on alcohol, cigarettes and petrol. However, these taxes would be criticised for increasing inequality. (people on low income tend to pay a higher % of their income on these goods.
4. Everybody Likes Public Services
Nobody likes to see cuts in health, education, transport e.t.c
Recent post: Debt Panic and Debt Planning – more on when and how much to cut debt