Debt Level Reductions

Readers Question: My question is if some many people are aware of this debt and credit problem, why are governments continuing this policy? Debt is nothing more than future taxes which has a crowding out effect. It is a statement that says, government is a more efficient player in the market than individuals. (from Rapid rise in debt)

When the government borrow, they have to sell bonds (quantitative easing is an exception). These are bought by private sector investors such as pension funds / investment trusts e.t.c

It is argued that government borrowing crowds out the private sector. For example,

  • If the government borrow more it can push up interest rates. To buy the higher levels of government debt, markets demand higher interest rates. Higher interest rates discourage investment and spending.
  • If borrowing rises, people may anticipate future tax increases and so reduce spending now. (Ricardian equivalence)
  • By selling bonds, the private sector no longer use funds for private sector investment and consumption.
  • If this occurs, then government borrowing will fail to increase economic growth but only lead to higher interest rates, and a larger national debt.

These arguments may sound convincing, but, it depends on the state of the economy.Government borrowing in a recession won’t cause crowding out because

  • Consumers become nervous and reduce spending and want to save more. Government borrowing is effectively offsetting the rise in private sector saving.
  • Interest rates are low. Despite the large rises in government borrowing, interest rates on UK and US bonds remain low. (long term bonds are around 3%). The rise in borrowing simply hasn’t increased interest rates. This is not surprising because in a recession there is generally a large appetite for government bonds because there is more private sector saving.

In a recession, the government is a more efficient player than the consumer. The consumer wants to save, but, this makes the  recession worse (see: Paradox of thrift) The government injection helps to create growth and employment. By helping economic recovery, the government also aids deficit reduction as higher growth helps automatic fiscal stabilisers to improve the budgetary position.

The case for government borrowing is that it is necessary in a recession and when there is a fragile recovery. This doesn’t mean borrowing is justified when the economy is growing strongly. When there is strong growth, the government need to reduce its deficit. If the government borrows when growth is strong and the economy is close to full employment, there will be crowding out. It will cause higher interest rates and is unadvisable. It is unfortunate we increased borrowing in the early 2000s, when it would have been better to continue reducing the deficit.

In a liquidity trap, (a period of nearly zero interest rates) borrowing doesn’t cause crowding out. But, there are still limits to how much the government can borrow. This can vary on many different factors such as (prospects for growth, prospects for deflation, level of domestic saving, past history e.t.c) See: How much can Government borrow?

The question is when and how quickly should government reduce debt?

At the moment, recovery is very fragile, unemployment is very high and market bond yields are still low. This suggests the pace of fiscal retrenchment needs to be less stringent than some are calling for.

You could argue the markets are wrong to have low interest rates on government bonds (we have another bond bubble). You could argue, strong recovery is bound to occur. But, this is dubious. There is a strong risk that overzealous deficit reduction could cause another recession – which will of course worsen the deficit because of the cyclical downturn in tax revenues.

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By on June 11th, 2010

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