Tuesday, June 24, 2008

Balanced Budgets - Should Governments Borrow?

When Mrs Thatcher came to power, one of the things she promised is that her government would take the attitude of a careful housewife, only spending what they receive. If it is reckless for a housewife, to spend more than she receives in income, then why should the government spend more than their tax revenue?

Many argue that political pressures encourage governments to borrow and therefore, we should have legislation to force governments to balance their budget. (A similar constitutional amendment in the US, only narrowly failed). But How Bad is Government Borrowing?

Problems of Government Borrowing.

Crowding out of Private Sector.

The government needs to borrow by selling bonds to the private sector. The argument is that if the government borrows from the private sector, the private sector has less money to spend and invest. Furthermore, many, especially those of free market principles, argue that government spending has a tradition of being more inefficient than the private sector. This is because governments are subject to special interest groups and lack of a profit incentive. Therefore, if you cut government borrowing, you will increase the role of private sector investment and help the economy to be more efficient.

  • However, it is argued that government borrowing may not cause crowding out, because people who buy bonds are just using money which otherwise would have been idle. Also, it is argued government spending is not more inefficient than the private sector. For example, government spending is necessary to overcome market failure such as lack of education, health care and investment in trains.
Interest Payments.

The problem with borrowing money is that you have to pay interest on your debt. For a government like the UK, the government has an annual interest payment of £26 billion on the National Debt. Borrowing incurs a cost on future generations and future tax payers.
  • Government borrowing is a way of foregoing higher current tax rates. We get lower tax now, but, we have to pay for this in the future with higher tax rates to pay for the interest rates. Some economists argue, this is not a problem because you could invest the lower tax rates in the present to increase your economic wellbeing so that you will be able to pay back the government's borrowing in the future. Therefore, they argue, eliminating government borrowing will reduce interest payments but at the expense of higher tax rates and foregone investment opportunities. The problem I have with this argument is most tax payers do not invest current lower tax rates so that they are in a better position to pay higher tax and the future interest. We not only have to pay the government borrowing, but also the market interest rate. Rather than paying £25 billlion in interest payments, the government could be investing in public services.
Expansionary Fiscal Policy

Government borrowing can stimulate the economy in times of a slowdown and recession. Lower taxes should increase consumer's disposable income and encourage consumer spending and therefore economic growth. To balance the budget in a recession would require higher taxes and lower spending; this would make the recession worse. Monetarists argue that fiscal policy is ineffective in increasing Real GDP. But, most economists would argue rigidly sticking to a balanced budget in the time of a recession, would be a disaster (e.g. as UK government did in 1931 at height of Great Depression) This is why balanced budget proposals usually make provisions for 'balancing the budget over the course of the economic cycle.'



Governments should not be borrowing. They should only spend as much as they collect from taxes. At good economic times they should not waiste the surplus created but save it to be used to boost economic activity in a downturn. Unfortunately,thousands of years after Joseph saved Egypt from famine the european governments have failed to learn this very basic lesson in economics. Joseph was wise and honest. So he told Faraoh that in good years when the harvest was plentiful he should put aside some of the wheat produced to be used during the times when the harvst will be poor.Joseph himself supervised the collection process. All european governments need to re read the story of Joseph and apply it.

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