How important is the budget deficit?

Readers Question: how important is the budget deficit?

The budget deficit is the annual amount the government borrow. The government usually financed the budget deficit by selling bonds to the private sector

To libertarian and free-market economists, budget deficits are liable to cause significant economic problems – crowding out of the private sector, higher interest rates, future tax rises and even potential of inflation. However, Keynesian economists are more sanguine arguing that in an economic downturn, a budget deficit plays an important role in stabilising economic growth and limiting the rise in unemployment.

Budget deficits have potential economic costs, but it depends on the economic climate, the exchange rate system, interest rates and the reason for government borrowing.

deficit

OECD – Budget deficits 2012

The most useful way of measuring the size of the budget deficit is as a % of GDP.  The graph below shows that in 2012, there was a large variance in the size of budget deficits. The biggest deficits occurred in Ireland, Japan, UK, and US – with budget deficits of over 8% of GDP.

Potential benefits and costs of a budget deficit

budget-deficit-pros-cons

Reasons to be concerned about a budget deficit

  • Need to cut spending in the future. Higher deficits are not sustainable for ever. Reducing a budget deficit can be problematic. If a country has a deficit that increases too quickly, the government may be forced to adapt policies aimed at a sharp deficit reduction. These ‘austerity measures’ can cause a fall in aggregate demand. For example, during 2012-16, many countries in the Eurozone sought to reduce their budget deficit to comply with EU rules. This deficit reduction caused lower growth, recession and unemployment.
  • Increasing national debt. A budget deficit increases the level of public sector debt. Large deficits will cause national debt as a % of GDP to increase.
  • Opportunity cost of debt interest payments. A higher deficit will also lead to a higher % of national income being spent on debt interest payments.
  • Crowding out. One way of thinking about a budget deficit is that if the government is borrowing from the private sector, the private sector has lower funds to spend and invest. The government is therefore ‘crowding out’ the private sector – and some economists will argue government spending is liable to be more inefficient than the private sector.
  • Potential rise in bond yields. Countries with large deficits may struggle to attract sufficient investors to buy bonds. If this happens, bond yields will rise causing the deficit to be more expensive to finance.
  • Potential inflation. There is a fear that budget deficits could be inflationary. For example, if a country like the UK was struggling to attract sufficient investors to buy UK bonds, the Central Bank could effectively print money and buy bonds. However, unless the economy is in a liquidity trap, printing money will cause inflation, and reduce the value of savings, including government bonds. It is worth pointing out, that in developed economies – inflation from printing money resulting from a budget deficit is quite rare.
  • Confidence effects. High levels of government borrowing may adversely affect confidence as consumers and firms fear future tax rises or higher interest rates.

Evaluation

There is no simple answer to whether a budget deficit is helpful or harmful because it depends on quite a few factors.

1. It depends on when the deficit occurs. Basic Keynesian analysis suggests that a rise in the budget deficit during a recession is a good thing. In a recession, private sector spending falls and saving rises – leading to unused resources. Government borrowing is a way of utilising these unused savings and ‘kickstarting’ the economy. The deficit spending can help promote higher growth, which will enable higher tax revenues and the deficit will fall over time. If you try to balance the budget in a recession, you can make the recession deeper. Austerity can be self-defeating.

Read moreHow important is the budget deficit?

Does the government determine the interest rate for bonds?

Readers question: Does the government determine the interest rate for their bonds? The government finances its debt by selling bonds on the open market. (in the UK they are termed gilts) In the UK, government debt is managed by the UK Debt Management Office DMO. They sell gilts on behalf of the government. Initially, they …

Read moreDoes the government determine the interest rate for bonds?

Are there different types of government borrowing?

Readers Question: National debt is now extremely high. However aren’t there different kinds of debt e.g that which funds current spending, that which funds investment in infrastructure and emergency (bank bail out etc) Surely it’s the first we should really be worried about and less concerned with borrowing that makes the economy more efficient such as infrastructure

1. ‘National debt is now extremely high.’

UK national debt

But, is national debt extremely high? In one sense, a public sector debt of £1,193.4 billion  is very high. But, if we compare national debt as a % of GDP (which is most meaningful comparison) over the past 100 years, it is significantly lower than between the 1920s and the 1970s. The increase in national debt we have seen in the past few years, is partly a reflection of the recession and rise in cyclical borrowing. In a recession GDP falls, but tax revenue also falls and government spending increases. If the private sector cut back on spending in a recession, it is helpful to the economy for government borrowing to rise temporarily.

debt-interest-payments-percent-gdo

If you look at the cost of servicing national debt (interest payments as % of GDP) it is also relatively low. The cost of debt interest payments as a % of GDP was significantly higher in the 1980s.

2. aren’t there different kinds of debt

Not really. When selling bonds, the government doesn’t distinguish between the use of the government borrowing. However, we can split debt up into

  • Structural deficit – the level of borrowing that would occur if the economy was operating at full capacity (i.e. ignoring borrowing as a result of the recession)
  • Cyclical deficit – the level of borrowing that has occurred as a result of the economic downturn.

    Read moreAre there different types of government borrowing?

The bizarre logic of deficit reduction increasing UK growth

The Prime Minister has got into a bit of pickle by trying to maintain the view that deficit reduction policies have not reduced economic growth, and in fact have had the opposite effect.

“They (are) absolutely clear that the deficit reduction plan is not responsible (for low growth); in fact, quite the opposite.” (link)

There is an economic logic to arguing that given the size of  the UK budget deficit, the government need to consider policies to reduce it. Economists will disagree over the timing of deficit reduction. Some economists argue that the deficit shouldn’t be reduced whilst we are still in a recession. Others may argue, we have no luxury of waiting.

I favour the former view that recovery should come before austerity. But, I can at least understand the argument that we should cut the deficit now. However, what I can’t understand is the belief that if you cut public spending in the middle of a recession, that it will have not have some negative impact on economic growth – and in fact spending cuts will have the opposite effect in boosting economic growth. It is really a bizarre logic to hope that cutting spending at the present time will increase economic growth. With falling output, falling construction output  there is no evidence of any ‘crowding in’ in the UK economy. There is however plenty of alternative evidence, e.g. IMF reports, that austerity has caused a negative multiplier effect and reduced growth.

I wonder if there are any economists who really believe that cutting government spending during a period of private sector deleveraging will actually increase economic growth? If David Cameron wrote an A-level essay on ‘discuss the impact of a fall in government spending’ – he would really struggle to get an E grade, and would probably fail.

Has the UK responded to news of public sector wage freezes and lower government spending by rejoicing at the planned reduction in the budget deficit and gone on a spending spree to celebrate?

UK consumer confidence

The impact on confidence has been the opposite. Relatively minor spending cuts have created pessimistic expectations. There has been no confidence fairy miracle. As you would expect spending cuts in an already depressed economy have further reduced real GDP.

Read moreThe bizarre logic of deficit reduction increasing UK growth

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