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Government debt, deficits and spending

Almost obsessively, financial journalists scribble commentary about government debt and deficit problems, so much so that the topic has become rather confused.  For every journalist claiming that the government is overspending, there is another one saying the opposite and both arguments can’t be true at the same time.

Two things are certain. Debt, once borrowed, must be paid back at some point and interest payments must be regularly paid during the interim. If debt and deficits are left unchecked, interest payments on government debt could mount up to such a level as to cause an unwelcome increase in taxes which would not be a good situation from more or less any angle.  But, is debt generally bad and if not, how do we tell the difference?

In may ways, running government finances is analogous to household finances, and we can therefore usefully apply household financial thinking to a lot of government financial situations.  For example, if a government borrows money to finance the building of a much-needed bridge which produces a financial return measured in millions of hours saved in travelling time, then this would be an example of deficit spending which has a good overall effect.  Conversely, if deficit spending is used to pay for immediate consumption in the economy which therefore provides no investment return over the medium to long term then typically this should be regarded as having a bad overall effect.  What about situations where the economy goes into recession – is deficit spending on consumption items OK under those circumstances?

Mostly, deficit spending on a mixture of capital and consumption items in situations where the shortfall has arisen because of a recession is regarded as being OK.  But, by the same token, a responsible government will aim to run a small budget surplus and pay off some national debt during expansionary times. And a responsible government will take a cautionary view and do everything possible to avoid a situation where there is no emergency reserve of borrowing power under any circumstances. So situations can arise which make it prudent for a government to reduce its expenditure and run an expenditure deficit at the same time.

National debt of up to 100% of national income is considered manageable but, if it rises by much beyond this level, international lenders may start to become nervous and demand a sharp increase in the interest rate payable which would obviously compound the whole problem and risk a major crisis of confidence in the national currency itself. Quite clearly, therefore, not all debt is good and sometimes it’s all bad.

Servicing government debt by making interest payments is made from the same account into which tax receipts are paid so the link between deficits, debt and taxation should be very obvious.  Government deficits and debt can be controlled by reducing government spending or increasing taxes or a bit of both.  The problems here are twofold; firstly, taxes and government spending are political hot potato items about which voters easily become upset and, secondly, both have a negative feedback effect on the economy by suppressing consumption and therefore total national income.  Here, we are at the nub of why deficit spending and total government debt are so furiously debated by opposing sides.

Politics plays an incredibly important part in the tactics and strategies of debt management.  A government at the beginning of its period of office may feel emboldened to take fairly aggressive fiscal spending choices to control debt if it thinks it will be able to ease off before the next election and eventually win support that way.  An example of this would be the UK government’s attack on deficit spending in 2010.  An opposite example would be the US government’s choice to implement tax cuts soon after commencement of the Trump administration when clearly the first thing to happen after doing this would be an exacerbation of an already uncomfortable balance of payments deficit.  The gamble taken by the Trump administration is that the hoped-for rebuilding of the domestic manufacturing base will happen and happen in time to stimulate the economy enough for the overall situation not to spin out of control.

In the end, all debt, whether it is created by government or within individual households, needs to be managed.  And, it should be clear from my above remarks, managing government deficits and debt is considerably trickier than household debt.

From an investors point of view, we are comfortable with governments taking risks with debt and debt management so long as there is a plan is in place to avoid driving the economy into a permanent state of high taxation because that, by itself, dissuades investors from investing in the real economy and, beyond a certain level, usually leads to rampant tax avoidance which would have a negative feedback effect by making worse an already uncomfortable deficit situation.

Posted in Economy, Investments