Tuesday, June 16, 2009

Principles of Borrowing

Many worry about a large rise in Government borrowing during a recession. There are still analysts who will say it is irresponsible for government borrowing to rise sharply in a recession. However, to look at government borrowing is to examine only part of the equation. It is important to look at overall borrowing and saving.

The important principle of government borrowing in a recession is that it offsets the fall in private sector borrowing. The government borrows to offset the fall in private sector borrowing and spending.

During a recession, consumers become risk averse; rather than take out loans they seek to pay back loans. For example, this year, more mortgage debt has been paid back than taken out. This fall in private sector borrowing (and corresponding rise in private sector saving) can be very sharp causing a potentially dramatic fall in aggregate demand and economic output. If the government maintained the same fiscal position, there would be a sharp fall in output.

This graph shows the inverse relationship between private borrowing and government borrowing in the US.

source: Brad Setser

Also the fact that private saving rises means there is greater appetite for buying government debt and therefore 'crowding out' and higher interest rates are unlikely to occur.

The difficulty is when the economy recovers and private borrowing starts to rise again. As the economy recovers the government need to reduce borrowing. If government borrowing remains very high when private borrowing is also high, - that is when we will get difficulties of financing the deficit / crowing out e.t.c.

Government Borrowing in a recession is a necessity. The larger the fall in private borrowing the larger the rise in government borrowing needs to be. (Rules like the EU growth and stability pact become a nonsense in a recession like this)

The difficulties will come in 2010, 2011 if the economy recovers and the government is unable to reduce its borrowing. To increase government borrowing is politically much easier than to reduce borrowing. But reducing borrowing (when circumstances dictate) is just as important as the borrowing.

1 comment:

Anonymous said...

its things like this that keeps students like us going. thanks for the help.