Friday, January 27, 2012

Reducing Government Borrowing

Readers Question: Bond yields are very low at the moment in the UK. Does it make economic sense to try to cut public borrowing at low interest rates only to push private borrowing, at high interest rates, up to higher and higher levels?  In my mind, the austerity measures are causing financial inequality to increase, as people are being pushed further and further into costly debt. It seems morally wrong if nothing else!

It is an interesting point. A justification for government borrowing is to boost aggregate demand in a recession to stimulate economic growth. In a recession, when many people are losing their jobs, government spending is a way to limit the impact of a recession. If you withdraw unemployment benefits (e.g. 1931) or cut spending then people respond by spending less, leading to lower economic growth and increased inequality.

It is argued in a liquidity trap demand for saving is high, even at low interest rates. In this case, the government can borrow more without pushing up interest rates. This has been the case in the UK and US since 2008. Despite rapid increase in levels of government debt, bond yields have fallen - as you would expect in a liquidity trap.

Countries which have pursued austerity policies aggressively have seen a fall in the rate of economic growth, leading to higher unemployment and lower tax revenues. Ironically, austerity measures have often failed to reassure markets and reduce debt to GDP ratios. (e.g. Portugal, Greece, Spain)

Reasons to Reduce Government Spending

You could argue, that given size of UK budget deficit, it is necessary to take steps to reduce it. If we didn't take some steps, then people may not want to buy UK bonds. This would push up interest rates on government debt. The Government may claim, that bond yields on UK debt are only low because they have a plan to reduce debt.

On the other hand, you could argue, that the government were too quick to reduce debt. They should have waited until the end of the recession, and liquidity trap. When the economy showed signs of real recovery - that is the time to pursue lower spending.

By cutting spending too hard too quickly, they have pushed some people into more private debt and caused a double dip recession which will make it even harder to reduce debt to GDP ratio.

How Much Can a Government Borrow?

A key question is how much can the government borrow? For example, recent budget deficits were a record for peace time. The government may argue the sheer size of the budget deficit meant that some spending cuts were necessary.

The government may also point to the Eurozone, where bond yields have been rising on fears of government default. See: EU bond yields In this climate, they argue we need to tackle the deficit.

However, you could argue higher debt yields in the Eurozone are due to structural problems in the Euro
  • lack of competitiveness because of single currency and inability to devalue
  • Lack of economic growth
  • Lack of lender of last resort.
Therefore, outside the Euro, the UK doesn't need to fear rising bond yields because of higher government borrowing.

Another issue is total UK debt (private + Public sector). Total UK debt 500% is one of the highest in the world so the UK needs to make some progress at debt deleveraging - even if it is necessarily painful - but, that is a consequence of our past spending.

To answer your question. I believe the government reduced spending at the wrong time (economy still in recession). They should have targeted economic recovery has highest priority, and pursued debt reduction over a longer time frame.


1 comment:

Barney Stevenson said...

The comparison with the Eurozone, with no lender of last resort is apt - we have low bond yields in the UK largely because the Bank of England is buying up government debt, not because of the Government's deficit reduction plan (which isn't working anyway, with public debt still increasing).

I totally agree with your analysis that the government have tackled public borrowing too quickly - I think the Tories saw it as an ideal excuse to justify their ideological belief in cutting public services. Unfortunately large numbers of people have bought into their reasoning, including, most worryingly, the Shadow Chancellor, who has stated that a Labour government would maintain the level of the Tories' cuts. Nobody is offering a credible alternative at the moment.