Tuesday, 23 June 2009

Why do governments run a deficit?

I have never understood why governments think it appropriate to owe money year-in and year-out. When exceptional events occur and they borrow to alleviate or avoid adverse effects, such as in times of war, their position is entirely understandable. But I fail to see why they should not place balancing the books at the very top of their list of priorities at all other times. After all, £1billion borrowed at 3% costs £30million which is a lot of paperclips. It is beginning to look as though government borrowing this year might reach £200billion, assuming a 3% rate of interest that is a mouthwatering £6billion in interest in one year alone.

Having said that, if the interest is paid to UK-based lenders it is (apart from relatively insignificant costs) a zero-sum game because the money is taken in tax from the domestic economy and paid back into the domestic economy. Only that part of the interest that goes overseas is a true loss and in that respect government debt is never really as expensive as it might seem. Nonetheless, there is always an overseas element in government borrowing so it does amount to a net drag on the UK economy and even if it is less than the headline figure of total interest payable, it is still money that came from UK taxpayers and ends up outside this country.

Even the element of interest that is paid to UK lenders has its problems because it is taken from everyone and handed to very few. It amounts to a redistribution of wealth which would never be countenanced if it were stated government policy. If only politicians were brave enough to point out to the public that government debt means sending vast sums overseas and giving additional income to UK investors in this country, I suspect government debt would also not be countenanced. At a time when, correctly in my view, the government will not hand-out money to prop-up ailing manufacturing businesses willy-nilly, it is handing-out money to prop-up ailing pension funds and banks - additional money to that which the banks have already received and which has caused outrage in some quarters.

The reasons why they do not balance the books are fairly obvious. They fear political damage from reducing spending and believe there is political profit in spending on pet projects. Somehow the damage done by the cost of borrowing is never brought into the equation. It seems to me that a government of any political hue would be onto a huge vote-winner if it said it was going to eliminate, for example, all official naggers in order to reduce debt and free the interest payments on that debt so that it can be spent on the services people really want or to reduce debt even further. Implementing any additional spending resulting from this in an efficient manner raises other issues but in purely political terms it seems to me that the concept is unassailable.

Balancing the books is one thing, building reserves is a different kettle of ballgame. We are probably decades from the UK government being in a position to build reserves even if it slashes spending vastly. Not only do we have the current borrowings to repay (including those in the pipeline for the next year or two while the effects of the recession work their way through the system) but we also have to face two other major sources of debt. Numerous public spending projects have been funded on the never-never and kept off the books (the so-called PFI arrangements) yet they will have to be paid for in the next few years, and public sector pension liabilities will become an increasing drain as the baby-boom generation retires. I have read all sorts of estimates for the cost of these two elements and have reached the firm conclusion that no one really knows how much is involved save that it will be many billions of pounds a year for many years to come.

These are debts every bit as much as a government bond is debt, they involve a liability to fork-out money now and in the future in return for no future benefit. Just as the benefit from a bond is received once as a lump sum and then payments are made to the bond holder over time without him having to do anything more than he has already done, so the benefit of the new hospital, road or school and the benefit of the public-sector employee's work has already been received and must now be paid for without anything further coming in return.

The current position of UK government finances is utterly dire. The amount that must be paid out in future years to cover the cost of on-going borrowing and the cost of servicing PFI debts and pensions is a one-way street. Not only is it vast, it is also money going out for which nothing will be received in return. If anything requires government to seek to balance the books in the future it is the painful lesson we are now learning about the cost of debt. Let's put this in context. Over the last decade we have seen a huge expansion of government spending on non-essential functions - not only the nannying naggers I complain about regularly, but also the countless advisory bodies funded by government to tell government what it wants to hear and the absurd posturing of every branch of central and local government employing "climate change" advisors and assessors to evaluate what can be done to reduce government's "carbon footprint" and many other peripheral activities that no private sector business would waste a penny on. None of this nonsense can even remotely be described as necessary expenditure, it has been incurred because the government thought it could afford it and thought there was political capital in doing so. Had none of that cost been incurred and the sums involved been put instead in a big biscuit tin under the Prime Minister's bed we would be some way towards having the pot required to pay for on-going pensions liabilities.

This illustrates what balancing the books actually means. It does not mean looking only at one financial year and seeing whether receipts balance outgoings, it also means making provision for future liabilities. Governments of both parties have failed miserably to do this and the price of that failure is going to be felt over the next decade and more. For them to have run deficits while an even greater deficit was building up in the background was, I am sure, the result of decisions being made on purely political grounds. Eventually facts always hit home.


Stan said...

Good post, FB. The budget deficit - and increasing reliance on foreign capital (particularly China) to support government borrowing is a major concern.

Personally, I would argue that the ever increasing trade deficit is of equal concern if not more so and we should not forget either the huge personal debt liability.

sobers said...

The cost of borrowing £1bn may only be £30m in INTEREST, but you still have to pay back the CAPITAL at some point. Of course the bond holders usually get paid back in £s worth considerably less than they were when the loan was taken out. Even 2% inflation halves your capital in 35 years.

The UKs continued social stability depends on us being able to borrow to spend, and repay existing debt capital. If we can't for some reason, hello Mad Max!

Mark Wadsworth said...

"Why?" Because they can.

Of course in the long run it adds to the deadweight cost on the economy, but since when have governments cared about that?

I am probably the only person who consciously voted Labour in 2001 for the simple reason that they had reduced spending as % of GDP and also made modest inroads into the total government debt. That dream was soon shattered, of course.

sobers said...

@MW: that was because Gordo was forced to follow Ken Clarke's spending plans for the first three years. Once he got full control the money was hosed left right and centre.

TheFatBigot said...

I agree with everything the three of you have said. To my simple mind it illustrates what a huge gulf there is between what the government does and what it can afford to do.

It's a topic all four of us have commented on many times but it really is at the heart of current problems. Government simple cannot afford to oversee and direct health and education in the way it does, it cannot afford the nannying naggers, it cannot afford the carbon footprint measurers that blight every aspect of public services, and it cannot afford much more besides.

Frankly, I doubt that it can really afford more than 70-ish % of what it currently does; and that is quite apart from the issue whether it should be involved in certain fields at all.