Saturday, November 15, 2008

Government Borrowing and Collapsing Pound

The shadow Chancellor, George Osborne suggested that government tax cuts and borrowing could lead to the collapse of the Pound. (Brown borrowing could destroy the Pound at Independent)
"We are in danger, if the Government is not careful, of having a proper sterling collapse, a run on the pound.

"The danger of a run on the pound . . . is that it pushes up long-term interest rates, which is a huge burden on the economy.

"The more you borrow as a government the more you have to sell that debt and the less attractive your currency seems."

What is the economics behind this?

1. Increased government borrowing is not going to cause a run on the Pound. UK public sector debt is 43% of GDP. Arguably this underestimates national debt because government exclude PFI. But, even so, it compares favourable with
  • US national debt $10 trillion - 72% of GDP
  • Italy national debt - 107% of GDP
  • Japan national debt - 194% of GDP
  • National debt by country
If the government were to borrow an extra £10billion to fund tax cuts, it may cause a rise in national debt from 43% to 44% of GDP, but, it is hardly going to cause a collapse in Sterling. (interestingly many councils burned by the Icelandic bank collapse are going to the UK debt management office to buy government bonds)

2. He suggests higher borrowing could push up long term interest rates (financial crowding out). This is certainly possible. But, higher interest rates would make demand for sterling stronger, not weaker. Higher rates may be damaging for economic growth, but, not sterling. Anyway I doubt interest rates would rise that much from a temporary increase in borrowing. Interest rates in Japan and US are low despite much higher levels of borrowing.

3. You could argue higher borrowing is inflationary, especially if Government started to print money. But, the MPC forecast inflation could fall below 1% in 2009, so this is not a real concern at the moment.

4. You could argue tax cuts are ineffective in boosting spending and economic growth. Many economists would support this. But, being ineffective doesn't mean there will be a run on the pound.

5. The fall in the value of the Pound e.g. 25% fall against dollar reflects
  • a more realistic long term value. At $2 to £1, the £ was really overvalued making American goods ridiculously cheap.
  • Sharp decline in UK interest rates and prospects of more rate cuts to come.
6. The UK economy has declined sharply in past few months leading to the interest rate cuts. But, now our competitors are not doing as badly as us. e.g. Germany announced this week it was entering recession. Because of this, I can't see the Pound continuing to fall in 2009.

I feel the shadow chancellor is using rather sloppy economics. He could criticise the government for borrowing too much in the boom. He can criticise the tax cuts as ineffective. But, to claim that modest tax cuts will cause a run on sterling, sounds as if he is searching for arresting sound bites rather than offering a reasoned understanding of the economy.

See also: The economics of tax cuts

2 comments:

Raisins said...

I was hoping you could explain this - I really don't see how an increase in public borrowing would devalue the pound. All I could come up with is the simple concept of - if the UK govt demands more funds from International speculators, more £ would be supplied - not that that should be construed as a run on the £.

Tejvan Pettinger said...

The vast majority of UK debt is bought by domestic investors.

In the US quite a substantial % about 25% of national debt is bought by foreigners - Chinese. This actually increases demand for dollars. However, if the Chinese ever sold all their trillions of US treasury securities, the dollar would fall dramatically!