Saturday, November 8, 2008

Government Borrowing In Recessions

In recessions, government borrowing will increase. This is because:
  • Higher unemployment means less people will be paying income tax
  • Lower consumption levels mean lower VAT and excise duties.
  • Lower company profits mean lower corporation tax
  • Higher unemployment increases cost of social security payments - unemployment benefit, income support, housing benefit e.t.c
  • Falling house and asset prices reduce stamp duties
In this current recession, the impact on tax revenues is even greater. In the UK the top 1% of income earners pay nearly 25% of total income tax revenues. Therefore, the decline in executive bonuses for bankers and hedge fund managers means tax revenues are falling more than usual.

Furthermore, in a recession, government often try to stimulate the economy using expansionary fiscal policy. This could involve:
  • Cutting taxes so people (hopefully) spend more
  • Increasing public sector spending to stimulate aggregate demand

National Debt in Recessions

In a recession, not only will national debt increase, but as % of GDP, national debt will become higher. This is because the government borrow more, but GDP is decreasing. During economic growth of 3%, the government can borrow 1% of GDP, and National debt as a % of GDP falls

Should We Worry about Government Borrowing in a Recession?

  • Apart from the most hardline neo-classical economist, most economists would say that a rise in government borrowing in a recession, is unwelcome but necessary.
  • To balance the budget would cause a much deeper recession. If the government tried to balance the budget through higher taxes and cuts in public spending it would cause a bigger fall in GDP and lead to even lower tax receipts.
  • However this is what the UK did in 1930, exacerbating the Great Depression (unemployment benefits were cut and taxes raised on the advice of 'treasury economists'
  • Mrs Thatcher also did this in the 1981 recession, making the recession much deeper than necessary.
  • By borrowing more the government is trying to increase aggregate demand and economic growth. The hope is by preventing a deep recession, they will get better tax revenues in the future.
  • The key thing is that this cyclical deficit should prove temporary. This is different to a structural deficit (when the government is borrowing even with high growth)
Problems of borrowing
  • May cause crowding out. Government borrow from private sector so private sector have less to spend. Therefore, demand doesn't increase -
  • If government cut taxes in a recession, then they need to raise them when the economy recovers and starts to grow. The problem is politicians forget to do this. Its easy to cut taxes, but, then they don't want to reverse the tax cuts or spending increases in times of a boom.
  • If National debt becomes unmanageable, it may cause interest rates to rise, or if the Central bank starts printing money inflation could occur.
  • Will require higher tax rates in the future.
But, bear in mind, Japan has been coping with national debt of 190% of GDP. The UK had a national debt of over 125% in the late 1940s and survived. UK National debt is (only) 43% of GDP. US National debt is closer to 70% of GDP.

Suffice to say, Government borrowing is not the biggest concern during a recession.


Anonymous said...

I'm sorry, but i'm new here. I'm not very familiar to econs either, but I'm darn interested. Could you tell me what's VAT again? sorry..

Tejvan Pettinger said...

VAT is Value Added Tax (17.5%). It is put on most consumer goods like TV. in the US they have a similar sales tax

Anonymous said...

Hi there! I`m new to you fascinating blog as well. And I was wondering why does the government need to borrow money during a Recession, instead of simply printing more money?

Tejvan Pettinger said...

Tejvan Pettinger said...

printing money

Ralph Musgrave said...

“Anonymous” above asks what might seem a silly question, namely why don’t governments just print money in a recession. It’s actually a very good question, and the answers are far from clear. I attempt to give an answer at , but I’m not sure I’ve got it right, so criticism welcomed.

As far as I can see the arguments for government borrowing range between the feeble and the hopeless. To illustrate, the arguments for government borrowing at the start of the main post above can easily be demolished: the argument here essentially says that government spending rises in a recession, so it has to borrow. Answer: no it doesn’t! As “anonymous” rightly points out, any government instead of borrowing, could perfectly well print money.

As to the idea that money printing will lead to inflation, the answer is it wont till demand becomes excessive. As long as government can rein in money and demand when this looks like happening, inflation will not ensue. Or in the words of William McChesney Martin, the job of the Chairman of the Fed is to “take away the punch bowl just as the party gets going”.