Wednesday, April 29, 2009

How To Deal with Very Large Debt

With borrowing forecast to top at least £175bn next year and national debt as a % of GDP forecast to rise to 80% what options does that leave future chancellors?

Options for Dealing with Public Sector Debt

1. The Borrowing is Necessary. National Debt at 80% of GDP is not the highest in the world nor is it unprecedented for the UK; during war, the UK has borrowed over 200% of GDP. If we seek to reduce debt too quickly, it could push any fragile recovery back into recession, cause more unemployment and this would only aggravate public borrowing. Running a fiscal deficit is an effective way to boost AD and help the economy recover. It is this economic recovery which is the key to restoring public finances.
  • However, borrowing from the markets will not be easy in this climate. The UK faces grave international competition from other countries with large debts. Investors may have less confidence in holding UK debt if they fear the inflationary impact of quantiative easing. If markets lose confidence in the government's ability to pay, it could affect sterling and make it very difficult to borrow - creating a crisis in the UK.

2. Rely on Monetary Policy. To boost economic recovery, it would be better to rely on monetary policy - low real interest rates, quantitative easing. This can boost spending, prevent deflation without the problem of having to borrow. This could mean interest rates stay low during any recovery as fiscal policy tightens. In the worst case scenario quantitative easing could be used to inflate away the UK debt, but, this would lead to a collapse in Sterling and effect confidence in the UK for many years to come.
  • Quantitative easing remains unchartered territory. It could be inflationary and it is difficult to predict its impact
3. Savage Cuts in Public Spending. The government may be forced to roll back past spending commitments to health and education. Projects like a replacement for trident e.t.c could be delayed indefinitely.

4. Raise Retirement age. To deal with increased demands on government spending, the government could immediately raise the retirement age. This would significantly cut spending on pensions and improve tax receipts. But, it would be politically unpopular to say the least. However, this policy may have been necessary even without the current crisis. (Demographic Time Bomb)

5. More Sin Taxes. One of the few tax sources not to fall in a recession is cigarette, petrol and alcohol. The government could increase these because demand is relatively inelastic.

Maybe the government need to do a combination of all of these, though I doubt they will appear in many political manifestos in the forthcoming election...

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