Sunday, October 12, 2003
A borrowing binge by governments
Posted by David Smith at 09:58 PM
Category: David Smith' s magazine articles

What was the common theme from finance ministers and national leaders just a few years ago? It was that the road to economic success ran via fiscal prudence. Control budget deficits, we were told, and you convince people you are serious about keeping a lid on inflation, allowing interest rates, both short and long-term, to fall.

Lower interest rates on government bonds, even better when accompanied by budget surpluses, have the desirable effect of reducing debt interest payments. Instead of public money going on servicing the national debt, it can be used for higher spending on health and education. As virtuous circles go, it did not get much better.

And there was no sign, certainly during the 1990s, that fiscal prudence had any adverse impact on economic growth. The opposite, in fact, seemed to be true. The more that governments put their budget house in order, the more this appeared to release the animal spirits of the private sector to generate powerful economic momentum.

Things have changed. The same people who preached the virtues of fiscal prudence a few years ago are now arguing the case for temporary imprudence. In Britain, Gordon Brown budgeted for government borrowing of 27 billion this year, just over 2.5% of gross domestic product, falling to 24 billion next year.

Those figures were high, spectacularly so when set against the chancellor’s early prudence, but the outturn is likely to be significantly higher. So far this year, official figures show borrowing running at a 40 billion rate. Even allowing for some improvement in later months from somewhat stronger economic growth, the deficit is unlikely to come in much below 35 billion – comfortably over 3% of GDP – with something similar next year.

In Europe, budget deficits for the euro economies are supposed to be constrained by the stability and growth pact (SGP), under which governments face fines if they do not keep their borrowing below 3% of GDP. But the pact, insisted on by Germany ahead of the euro’s launch to keep other countries in line, is being flouted by the single currency’s two biggest economies.

In September France and Germany launched a 10-point infrastructure plan, designed to boost the euro economies over the longer-term through the traditional remedy of public works. They also said they will stick to their plans to cut taxes, in spite of the fact this will guarantee their budget deficits stay over 3% of GDP in 2004.

America under George Bush, meanwhile, is proving that political labels do not mean much when it comes to the public finances. When the Republicans took over in the White House, the budgetary position they inherited from Bill Clinton’s Democrats was healthy. Three years on, after tax cuts, 9/11, and a big programme of public spending – including the cost of Iraq – it is anything but. The budget deficit is heading for $600 billion, 6% of GDP, and even the US upturn now under way will not bring it down much.

Japan, for the record, is another big borrower, the result of a series of failed fiscal packages during its decade of economic stagnation. Its budget deficit, 7.5% of GDP, is the biggest of the lot in relative terms.

Politicians, of course, have an excuse for this. The rise in budget deficits is, they say, a reflection of what economists call the “automatic stabilisers” at work. When growth slows public spending naturally goes up, for example on the unemployed, while tax revenues weaken. It would not make sense to try to prevent that by raising taxes or cutting spending.

Unfortunately that only goes part of the way to explaining the deterioration in the public finances. The International Monetary Fund calculates so-called “structural” budget deficits, in other words excluding the effects of the economic cycle. It estimates that for this year Britain’s structural deficit is 2.1% of GDP and set to rise further as the government’s public spending increases come through. For France the structural deficit is 2.7% of GDP, Germany 2.3%, America a massive 5.1% and Japan an even bigger 6.7%.

What that tells us is that these deficits will remain even as the global economy recovers. One clear consequence of this is that, unlike in the 1990s when the public sector stood aside, now it will hamper the private sector. This “crowding out” will occur partly through higher bond yields, which is already happening. And, to the extent it is associated with aggressive increases in public spending, an expansion of public sector jobs makes it more difficult, in a tight job market, for the private sector to recruit.

Longer-term, of course, the private sector will have to pick up the bill. Governments can reduce budget deficits either by cutting back their spending, and there will be some of that. But there will also, inevitably, be tax hikes. And business is only too aware of where they are likely to fall.

From Industry magazine, October 2003