What might be the problems with running a deficit?
A government runs a deficit when - roughly speaking - what it spends is more than it receives in taxation. Supporters of austerity typically cite
three main threats from a deficit: the cost of interest on the debt; the threat of higher taxation which
will be required to cover excessive spending; and thirdly the impact on
investors who will become concerned if they see a country’s debt continuously
rising. The more concerned investors are, the less willing they will be to buy
government bonds and the more the UK will have to offer in interest to obtain
foreign capital. According to the Conservatives, this was a spiral Britain had
become locked into because of borrowing under the Labour government that was in power up to 2010,
and so public spending had to be drastically reduced in order to prevent our
debt growing to a point where it would become unsustainable.
Is the debt to GDP ratio more important than the deficit? [Terms like 'GDP' are explained in the definitions section at the end of this background]
Many economists argue that what matters is not the
size of a country’s debt or deficit, but its debt to GDP ratio. For instance,
the United States has a national debt far higher than Greece’s, but this does
not matter because the American economy is so much bigger, and its debt thus
represents a much smaller percentage of the country’s income. According to this
view, borrowing is not inherently bad even if a country’s debt is large in
absolute terms, and there is no need for the government to always run a budget
surplus. This is partly because the cost of money varies. When the crash hit in
2008, banks stopped lending and interest rates plummeted. Even now they remain
exceedingly low, which means governments can borrow for much less than they
could before the crash, and invest in the economy. This is important because
whether the cost of a country’s debt increases or decreases depends on its
relationship to the country’s GDP and the level of interest the country pays on
its debts. Even if government borrowing increases the amount a nation owes, its
real cost could still fall, so long as the country’s GDP grows by a greater
proportion than its debt, or a fall in interest rates reduces the size of
payments needed to service its borrowings.
However, an alternative school of thought (that which
supports austerity) would claim that such an expansionary economic model
renders a country vulnerable; interest rates can go up as well as down.
Economists have also suggested that there is a tipping point, whereby once the
debt to GDP ratio reaches a certain level (around 90%), government spending
cannot generate sufficient economic growth to compensate for further increases
in borrowing. Proponents of this view would claim that the economic impact of
running a budget deficit is different for an economy with a low debt to GDP to
ratio than a high debt to GDP level.
The position in Britain
Britain’s national debt currently stands at over £1.5trn,
with its debt to GDP ratio estimated to be between 82% and 90%. In relative
terms, this is significantly lower than other developed nations (Japan’s debt to
GDP ratio is three times as large). It is also relatively modest by historic
standards. In 2010, when the coalition embarked on their programme of fiscal
consolidation, the amount the UK owed as a percentage of GDP had been higher
for 200 of the previous 250 years. Indeed, Britain built the NHS, welfare
state, industrialised and ruled much of the world when it had higher levels of
relative debt.
The claim that future generations would be overwhelmed by public
debt has been around since the country first undertook such borrowings in the
18th century, yet has consistently failed to come to pass. Britain
is also fortunate in who it owes; foreign investors make up just a third of the
country’s creditors, while the bank of England (effectively the government) accounts
for another third. This is because under the policy of quantitative easing, the
Bank of England injected around £375bn into the economy through the purchase of
assets from hedge funds and banks, including government bonds (thus government
debts were transferred from private ownership to a public institution). This public ownership of UK debt further
reduces the pressure it is likely to come under from a loss of investor
confidence.
While Britain’s debt may be relatively low, the country’s
deficit is about £85bn per annum. This is down from the £171bn a year it stood
at when Labour left office, a peacetime record.
Although Britain has owed substantially larger sums in the
past, the circumstances in which it did so were far more advantageous. Because
of its global domination, 18th and 19th century British
government bonds were not subject to the same competition from foreign regimes
as they are today. Nor was Britain’s domestic capital market so accessible to
investors. Thus in previous centuries, investors had little choice but to opt
for British government bonds, which is no longer the case. This means that
Britain has much less capacity to control the interest it pays on its loans.
Moreover,
the UK has consistently struggled to control its finances since 1945. At the
same time as it was constructing the NHS, Britain was simultaneously forced to borrow money from America and Canada to remain solvent. The country’s post-war
decline was a reflection of its financial limitations and the weakness of the
pound, as consecutive governments struggled to balance social spending with
increasing defence costs. It was this pressure that led to Britain’s
humiliation at Suez in 1956 and influenced decolonisation. Ultimately it forced
the country to abandon its base in Singapore, in the wake of a humiliating
devaluation of the pound in 1967, brought on by the haemorrhaging of currency
reserves. In short, Britain’s post-war history has been of a country steadily
abandoning overseas commitments in an attempt to live within its means.
The crash: its causes and how governments responded
Since the 1980s, Western governments (particularly Britain
and the United States) have pursued policies of privatisation and deregulation,
ultimately creating the conditions that sparked the credit crunch when Lehman
Brothers collapsed in September 2008. Because the banking system was so loosely
regulated, financial institutions were able to bypass restrictions limiting the
amount they could lend in relation to their total reserves, becoming
dangerously exposed. As the economy grew and profits rose, banks relaxed
restrictions on mortgage access in order to tap into a new market; sub-prime
housing (this comprised people who would not normally have qualified for
loans). So long as house prices kept increasing, it didn’t matter if the people
the bank lent the money to couldn’t pay it back because the bank could simply
foreclose on the property and make a profit. By developing a complex series of
insurance products which were then sold on to other corporations, banks
succeeded, at least in theory, in outsourcing all the risk from these
transactions, and thus had little incentive to deny credit to those who sought
it. However as more and more people began defaulting on their mortgages the
housing bubble burst, leaving banks unable to pay each other as the value of
their assets plummeted.
As banks faced insolvency, Western governments embarked on a
series of bailouts to prevent them from failing. The UK taxpayer funded a
£500bn rescue package in October 2008, while the US Treasury pumped $700bn into
the American banking system. Both packages aimed to provide banks with fresh
capital to restart lending to each other, as well as purchasing some of their
bad assets.
The approach of the Labour, Coalition and Conservative governments
These measures prevented economic meltdown, but failed to
stave off recession. As the economy contradicted, the Labour government
embarked on a programme of fiscal stimulus in November 2008. This comprised
reductions in VAT, measures to support those on low income and other
initiatives totalling £20bn, and was financed largely through a big increase in
government borrowing. By the time of the 2010 election the need for spending
cuts had been accepted by all major parties, and had been assumed as part of
Labour’s plan.
On coming to power the Coalition ended Labour’s expansionary
policy and embarked on an extensive range of public sector cuts, aimed at
gradually bringing government expenditure into line with revenue. Following an
initial VAT hike, a cut in public investment projects and a reduction in the top
rate of tax, 2013 saw the first major round of welfare cuts. That April saw the
implementation of the bedroom tax (where people had their benefit reduced if they
were judged to have a spare bedroom), major reductions to legal aid with many
family law cases rendered ineligible for funding, a reduction in the value of
benefits by linking them to the consumer price index and the scrapping of the
disability living allowance. Austerity measures undertaken during the course of
that parliament are estimated to have saved around £38bn.
Following their election in 2015, the Conservatives
announced that a further £30bn worth of savings were needed, which was to
include an additional £12bn of welfare cuts. Measures announced so far include
the ending of housing benefit for people aged below 21 and the limitation of
child benefit to two children. The process of deficit reduction was supposed to
have balanced the budget by 2015, but persistently low growth forced the
coalition to revise this target to 2018, while George Osborne has now
extended it to 2020.
Definitions
GDP – Sum of the goods and services produced in a country over
a specified time period (typically a year).
GDP Per Capita – The sum of the goods and services produced
within a country over a specified time period, divided by the country’s total
population.
National Debt – The total amount a country owes its
creditors at any given time.
Deficit – The amount by which a country’s debt increases
over a given time period.
OECD – Organisation for Economic Co-operation and
Development, comprising 34 countries and including many of the world’s richest
nations.
G7 – The seven most economically advanced countries in the
world, as determined by the International Monetary Fund
Keynesian/Fiscal Expansionism – Policies which increase
public expenditure in order to stimulate growth. Such policies are often
referred to as ‘Keynesian’ in reference to the economist John Maynard Keynes,
who argued that governments should increase spending to stimulate demand in an
economy at times when businesses and households are restricting their own spending.
Non-Domiciles – Tax status that only requires individuals to pay UK taxes on income which is transferred to or earned in the United Kingdom,
rather than on earnings or investments that remain overseas.
Tax Gap – The difference between the total amount of tax
owed to the UK government and the amount collected.
OBR – Office for Budgetary Responsibility
