If there is one thing that recent times have taught us, it is that governments will borrow more and more each year. Barely a month goes by without an international institution such as the International Monetary Fund (IMF) or Organization for Economic Cooperation and Development (OECD) warning the United States and United Kingdom about the parlous state of their finances.
Indeed, in almost every year in post-war history, the US administration has recorded a budget deficit—in other words, it has received less in tax revenues than it has spent, and has had to borrow to make up the difference. It is not alone. The UK has also recorded a series of budget deficits (also known as fiscal deficits) in recent years, pushing its government finances further into the red.
It was not always this way. For most of the US’s history—and for much of the UK’s—governments kept the budgets balanced, plunging them into the red only in times of war and economic slump. There are also a number of countries that operate budget surpluses, including Norway (because of its prodigious oil reserves) and Australia (because of its metal resources).
“As we have seen time after time in developing countries, unbridled government borrowing and spending produce hyperinflation and economic devastation. So deficits must matter.”
Alan Greenspan, former Federal Reserve Chairman
Where does it all go? Although it is the subject of debate, most economists believe that the era of persistent government deficits began when the state started to provide extensive social security systems for their citizens. This involved spending massive amounts of money on, for instance, health, unemployment insurance and education, all of which tended previously to be handled by the private sector or by charities and trusts. It was a shift from a warfare state to a welfare state.
Where does the spending go? A quick look at the US Federal Budget for 2008 (see pie chart, below) shows that the vast majority of this is spent on so-called mandatory items—in other words, spending that the government is obliged to perform. This includes social security (mainly payments to the elderly), income security (payments to poor families), Medicare and other health payments, including Medicaid (respectively, government health spending for the elderly and the poor) and interest payments on the debt the government has taken out in previous years. By far the biggest chunk of the government’s discretionary spending is on defense (salaries of servicemen and women, and equipment—from aircraft carriers to guns). The “other” category includes spending on federal institutions such as the courts system, support for farmers and NASA.
The pie chart shows US government spending for 2008. The breakdown is very similar in most Western economies.
However, since the amount the US government spent in 2008 exceeded the amount it raised in taxes, it is having to make up the balance with some $410 billion worth of borrowing—a hefty amount.
On top of this, because of the Federal structure of US government, each state also has its own budget (and tax-raising abilities), most of which is spent on education and local infrastructure such as highways. Sometimes congressmen from particular states insert special additions to Federal bills to help pay for expensive local projects (even though the bill to which these flyers are attached might be completely unrelated). This is called “pork barrel” politics and is another reason why the deficit has risen so sharply—particularly during the presidency of George W. Bush, who, unlike his predecessors, proved extremely reluctant to use his right to veto the bills. His successor Barack Obama pledged to reverse this in the future.
Automatic stabilizers
Any modern state with a welfare system sees its budget deficit swing sharply into negative territory during a recession. The fall in profits and wages at such times means that companies and individuals pay less tax to the government. Simultaneously, the amount the government has to spend increases, since it has more laid-off workers to support through its unemployment support system. Government spending automatically helps “stabilize” the economy, keeping people off the streets and safeguarding their welfare. In short, this is Keynesianism in action (see Keynesianism).
For example, in the early 1990s, when the UK faced a serious downturn and housing-market slump, the deficit rose from 1 percent of GDP to 7.3 percent between 1990 and 1993. This happened because of the so-called automatic stabilizers inherent in the way modern budgets are structured.
Ever-increasing shortfalls It is important to distinguish between the annual budget deficit and the total stock of outstanding government debt. As the annual deficits mount up they increase the overall amount owed by the government—often called the net debt. As of late 2008, the total US debt owned by the public was $5.3 trillion ($5,300,000 million), though this does not include the liabilities of Fannie Mae and Freddie Mac, the mortgage guarantee institutions bailed out by the government in September 2008, or indeed the banks it subsequently had to bring into temporary public ownership.
Both this and the budget deficits tend to rise each year. This is not necessarily a concern—provided the debt is not expanding much faster than the economy. This is why deficits and debt levels are often expressed as a percentage of a country’s gross domestic product. The US public debt, for instance, was 37 percent of GDP in late 2008. As a country’s national debt increases, the amount it has to pay in interest payments also increases, with these repayments also being pushed up by higher interest rates.
Consequences of higher borrowing If deficits are allowed to run out of control, they can cause a variety of economic problems for a country. The first is that higher borrowing tends to weaken that country’s currency.
In the UK in 2008, the pound weakened by almost one-fifth after investors judged that the government was set to borrow excessively in the coming years. The flight from a debtor country’s currency is quite rational, since when a country gets into excessive indebtedness its response is invariably to inflate away that debt by printing more currency. Any hint that this might happen—which would erode the value of anything denominated in that currency—and foreign investors usually run a mile.
The other consequence is that investors will demand a higher rate of return on their investments to compensate them for this risk. This pushes up the interest rate that the government has to pay on its debt, making it more costly to borrow in the future.
Most fundamental, however, are the long-term consequences of borrowing too highly. Effectively, government borrowing is merely deferred taxation from future years, since the extra borrowed money has to be paid back at some point in the future. This is not a problem if the money is being used to enhance future generations’ welfare, such as investing in building new schools, but it is a real cause for concern if the money is merely being used to satisfy the public sector’s current appetite for cash.
Breaking the Golden Rule This is why a number of countries have set themselves fiscal rules to ensure that future generations do not have to bear the cost of current borrowing. A good example is the Golden Rule set up in the UK by former Chancellor of the Exchequer Gordon Brown. He pledged to borrow money only for use on investment in public projects, and never to fund current spending, such as state workers’ salaries.
However, the rule ran into trouble in late 2008 as it became clear that the government would have to borrow extensively in the face of recession. It was a phenomenon mirrored across the world, and it underlined the enduring truth about public finances: governments keep borrowing until markets or voters prevent them from doing so.
the condensed idea
Governments are addicted to debt
| timeline | |
|---|---|
| 1936 | Keynes argues in The General Theory of Employment, Interest and Money that governments should borrow more in times of recession |
| 1945 | US total public debt touches 120 percent of gross domestic product following the Second World War |
| 2009 | President Barack Obama concedes that the US budget deficit will rise to $1 trillion as efforts continue to fight the financial crisis |