Problems of Government Borrowing

Post is taken from http://www.economicshelp.org/blog/1504/economics/problems-of-government-borrowing-2/

problems of Government Borrowing by Tejvan Pettinger on April 15, 2011 in economics

What are the Problems of high government borrowing?

There are many theoretical problems of high levels of government borrowing. But, usually these problems don’t materialise under normal circumstances. However, as government borrowing as a % of GDP increases, the problems of government borrowing are exacerbated. With UK facing an annual budget deficit of over 11% of GDP, there are many potential problems.

Higher Debt Interest Payments. As borrowing increases, the government have to pay higher interest rate payments to those who hold bonds (lend government money). In some circumstances, higher borrowing can push up interest rates because markets are nervous about governments ability to repay. This means they have to pay even higher interest rate costs. Currently, the UK pays approximately £43bn in interest payments.

Inflationary Pressure. It is rare for government borrowing to cause inflation. But, the combination of quantitative easing and very high levels of borrowing make inflation more likely.

If markets fail to buy enough gilts to finance the deficit, the deficit can always be financed through ‘monetisation’. i.e. creating money. This creation of money creates inflation, reduces the value of exchange rate and makes foreign investors unwilling to hold UK debt. So far quantitative easing has not caused inflation because of the falling velocity of circulation. But, if the economy was close to full capacity, printing money to ‘monetize the debt’ would lead to inflation. In the case of Zimbabwe this could lead to hyperinflation.

Higher Interest rates.

To finance a budget deficit, the government need to sell bonds. If markets fear there is a chance of default, they will demand higher interest rates to give return for greater risk. Countries in the Eurozone experienced rapidly rising interest rates because of markets fears over their ability to repay. (see: bond yields on EU debt)

Higher interest rates on government bonds tends to push up other interest rates in the economy and reduces spending and investment. (This impact of higher interest rates in reducing private sector spending is known as financial crowding out)

These higher interest rates increase the cost of paying interest payments.

Crowing Out. A classical monetarist argument is that high levels of government borrowing cause ‘crowding out’. What they mean is that the government borrow from the private sector by selling bonds. Therefore, the private sector have less money to spend and invest. Therefore although government spending increases, private sector spending falls and there is no boost to the economy.

However, this is unlikely to apply in a recession because in a recession private sector saving is rising. The government are spending to offset the rise in private sector saving.

Higher taxes in the future. The government will need to reduce borrowing as a % of GDP. It means future budgets will need to increase taxes and / or limit spending. The danger is that if taxes are increased too early too quickly it could snuff out the recovery and cause a further downturn. If they don’t raise taxes markets may be alarmed at size of borrowing. There will be difficult choices for the future chancellors; it is a difficult situation to be in.