Tuesday, May 18, 2010

Pros and Cons of Government Debt

A common question / remark by Joe Public is something along the lines of - "It was debt that caused us to get into this mess. So why does Government borrow to get out of it?" or - "it was Government borrowing that caused this crisis in the first place."

There were many causes of this financial crisis / recession. Feeble credit ratings, bad subprime mortgage loans, a boom and bust in the housing market. But, government debt wasn't a cause of the 2008/09 recession. See Causes of Crisis. At the start of 2007, government debt as a % of GDP was 35%. It should have been lower; debt to GDP ratio shouldn't have been increasing during the 2002-2007 period of growth. See: UK National Debt. However, government debt of 35% of GDP was historically very low.

The recession certainly caused a dramatic widening of government debts. This cyclical borrowing has highlighted those countries with structural debt problems.

However, it is worth bearing in mind, that an increase in government borrowing was the correct response to the financial crisis of 08/09. (when should governments borrow?) If we hadn't bailed out the banks, financial markets could have frozen returning us to a Great Depression style run on banks (though in a different way).

Fiscal stimulus accounted for a small % of the rise in government borrowing. True, the UK had a VAT cut and temporary spending rises, but, most of the rise in borrowing came from a dramatic fall in tax receipts.

The level of Government borrowing is a problem, and now the economy is emerging from recession, the levels of borrowing need to be cut. But, if we had tried to balance the budget in the depth of recession (or even limited government borrowing) by raising taxes, cutting unemployment benefits (like 1931), the recession would definitely have been deeper, more prolonged with higher unemployment. Furthermore, if the recession had been worse, that would have meant even more decreases in government tax revenue and more spending on benefits.

Is Not Government Debt the Next Problem?

Markets are definitely fearful about government debt, especially in the Eurozone. (see: Euro fiscal Crisis) However, it is more than just a fiscal issue. Why have markets worried so much over European debt when Japan's debt is close to 200% of GDP and Spain's is a paltry 60%? It is partly because the economics of the Eurozone mean that Spain has less room for manoeuvre.

A crucial issue for markets is not just debt, but prospects for growth. It is one thing to have debt, but, it is another thing to have no prospects of growth. This is why Greece looks so unpromising. Not only does it have a forecast debt / GDP ratio of 150%, but, few prospects of economic growth.

Despite dire warnings, I am increasingly hopeful for future of UK economy. Signs of growth give us the potential to cut the deficit and maintain market confidence in UK government borrowing. Whilst we will have a fiscal deflationary impact, monetary policy will remain loose to prevent a sharp fall in AD.

But, the real key for reducing debt is the return to growth. Without economic growth, reducing government debt is like running up a downward moving escalator. - the more you cut spending the further you reduce economic growth and cause lower tax receipts. It is a vicious cycle which can lead to economic hardship and civil unrest.


No comments: