Question: Can a government borrow rather than cut spending?

Readers Question: Why can’t a debt-crippled and deficit-induced state, go on with its most normal economic activities (by borrowing the needed money to make sure that no or at the most, unproductive spendings are curbed, no tax rates up, and no austerity measures) in a bid to emerge out of debt & deficit potholes sooner than introducing hike in taxes, austerity measures, etc. during a bad or worst or unprecedented economic conditions?

This is one of the most important economic questions at the moment. – To what extent can a government just borrow rather than cut spending and increase taxes?

Austerity in the Eurozone

Countries in the Eurozone have been pressured into choosing spending cuts because there has been falling demand for Eurozone bonds and rising interest rates.

For various reasons, investors are nervous about holding bonds in several Eurozone economies. These reasons include:

  • Poor prospects for economic growth. In particular, many countries facing a debt crisis have overvalued exchange rates and are uncompetitive. However, in the Eurozone, there is little scope for overcoming this un-competitiveness through devaluation.
  • Fears over liquidity, e.g. no lender of last resort in Eurozone. This seems to have the effect of pushing up bond yields to compensate for greater risk of liquidity shortages.
  • Decline in confidence. Markets have become increasingly concerned about prospects for European growth and European debt levels. There is no confidence in medium and long term prospects, and so investors are preferring other countries debt levels.

Therefore, investors have been selling bonds in Italy, Ireland, Greece. This has caused rising bond yields. Therefore, faced with rising bond yields and the prospect of investors deserting the bond market, governments are under much greater pressure to reduce their budget deficits quickly.

Has Austerity Reduced Budget Deficits?

Many countries have pursued austerity and spending cuts, yet their bond yields are still high – showing markets are still concerned about levels of debt and prospects for growth. Austerity policies do reduce income tax and increase spending on unemployment benefits which increase the deficit. Therefore, to some extent, they can be counter-productive.

  • Austerity in Greece failed to be sufficient and now they are partially defaulting.
  • Austerity in Ireland has been ‘relatively’ more successful. There has been a slow reduction in budget deficits and forecasts for them to fall in future years. But, the slowdown in growth and made it more difficult than first hoped.

Falling Bond Yields in UK and US

By contrast, the UK and US have seen falling bond yields since the start of the crisis. This shows that there is still a strong market demand for buying UK and US government debt. This difference is partly due to the fact they have Central Banks willing to create money and buy government bonds if necessary. Also, they have pursued quantitative easing to try and promote economic growth.

Arguably, these lower interest rates show that the UK and US have the ability to increase government borrowing and pursue expansionary fiscal policy – if they wanted. By increasing levels of government spending, the government can offset the fall in private sector spending. At the very least, it was unnecessary for the UK to implement spending cuts at this stage in the economic cycle.

Growth and Reducing Deficits

Arguably, economic growth is a key factor in improving tax revenues and reducing budget deficits. With higher growth (and inflation) governments can increase tax revenues, reduce spending on unemployment benefits and help to reduce the debt to GDP ratio.

Economic growth still leaves a structural deficit. But, when the economy has recovered and is growing strongly, then governments are in a better position to reduce spending – without causing a fall in economic growth.

Reducing Deficit without Reducing Economic growth.

Some measures can reduce a long term structural budget deficit without harming prospects for growth. For example, raising the pension age, making it more difficult to get benefits, reduce governments long term spending commitments, without directly reducing AD.

If you made public sector workers redundant, there would be a fall in consumer spending.

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