Tuesday, March 22, 2011

Problems and Solutions on the Deficit

Unless you've been living in a cave for the last few years you'll undoubtedly know that the country currently has a rather large deficit. What I'd like to do with this post is spell out the dangers and the arguments on how to deal with the situation. It's intended as a response to the gentlemanly @Parlez_me_nTory as to why us lefty economist* types don't want to see the deficit cut to rapidly.

The Dangers of the Deficit
The first danger is the obvious one, by taking on a greater stock of debt we are commiting ourselves to larger interest payments. This means tax money going on interest rather than schools and hospitals and such.

The second danger relates to the bond markets, for the government to borrow there need to be investors willing to put up the cash. These investors will only do so if they believe that government debt provides good value for money. Traditionally the strength of government debt has been that it is very safe, if lenders start to believe it isn't, they'll start by demanding a higher interest rate and in extreme circumstances they may outright refuse to lend.

Structural and Cyclical Deficits
A lot of discussion at the moment has centred around the ideas of structural and cyclical deficits.  To explain this we need to look at what traditionally happens in a recession, that is that tax revenues tend to drop at a far greater rate than the loss of output from a recession. GDP might drop by 2% but taxes are likely to drop by far more. Equally, when the economy recovers, taxes tend to rise quite quickly.

To show this, check out the change in spending versus the deficit in the 1990s where the deficit dropped despite increased spending.

The point of this is that it's often the case that an awful lot of the deficit will take care of itself, this is what we call the cyclical deficit. The other part of it is the structural deficit. This bit of the deficit is basically the bit that would sill be there once the economy was back up to speed. There's currently a considerable amount of debate about just how much of or current deficit is structural.

The National Debt and Growth
As a final bit of background, we also need to consider the role of the national debt in all this. In the past 63 years there have, the government has only run a surplus in 14 of them (6 Tory, 8 Labour). Despite this, the trend for the national debt (until recently) has very much been a downward one.

This is of course because this graph judges debt as a percentage of GDP. The reason we use this measure is that GDP can be seen as a reasonably decent approximation of our national income, it makes sense to judge our debts according to our ability to pay. The reason Labour politicians like to make the case for growth is that if we have a vibrant economy, the debts no longer matter as much.

The Case for Deficit Reduction
The case for deficit reuduction is simple enough, it's basically that we are buliding up a level of debt that will at some point become unsustainable and also that if we don't show a willingness to deal with the problem our creditors will no longer lend to us (because they don't think they'll get it back). At this point we face a situation where there simply won't be anY money to pay government employees.

The Case Against
The case against deficit reduction is based around the idea that a public sector worker is also a private sector customer who is spending their money with various private sector shops and businesses. This means that a reduction in public spending will have an impact on the revenues of private sector businesses.

We can generally assume that the private sector will slowly expand creating new jobs which will leed to a virtuous cycle of spending an growth. If cuts our made too rapidly, there is a risk of halting private sector growth which could lead us towards the dreaded double dip recession. It's further argued that even if we don't see a double dip, we will see slow growth meaning that although we may have less debt, that debt will be more of a burden on account of the poor growth.

*Just to be clear, I'd classify myself more as in interested amateur rather than a proper left economist.

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