Difficulty of Reducing Debt

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

3 thoughts on “Difficulty of Reducing Debt

  1. Some of the problems you refer to above are largely nonexistent (at least for the UK).

    The above claim that the UK has increased government debt to the tune of 11-12% of GDP is wholly untrue – at least as far as 2009 goes. Reason is that the entire increase in government debt in 2009 has been quantitatively eased. I.e. what we HAVE done is to print an additional amount of money equal to about 11-12% of GDP

    In that the population’s increased desire to save persists, this additional money will NOT have to be reined in (via increased tax/reduced public spending or whatever).

    However, chances are (I would guess) that some of it WILL have to be reined in to avoid excess demand and inflation. But as long as the “reining in” is done competently, this will not mean that, to quote you, that “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 amount of deflationary policy (i.e. “reining in”) ought to be just enough to prevent excess inflation, no more and no less. In other words these deflationary measures will “reduce growth of Aggregate Demand”, but only from a level that is a complete delusion. This is a bit like deleting “100mph” from the speedometer of a car which cannot possibly do more than 90mph.

    An entirely separate problem is that government spending from 2010 onwards was planned in the pre-crunch years on the basis of no crunch. I.e. GDP will be lower in 2010 onwards than was previously thought.

    Assuming the public sector is to be scaled back to the same extent as the private sector, then this means public spending will be lower than was planned.

    This is not a public spending “cut” in any faintly realistic sense of the word “cut”. That is, it is a plain physical impossibility (never mind the economics) for us to enjoy the levels of public and private spending in 2010 onwards that were envisaged in the pre-crunch years.

    Of course we will see the usual parade of trade union leaders complaining about increased taxes and public spending cuts. These individuals are living in Alice in Wonderland or Cloud Cukoo land (take your pick).

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