3.3.8.1 Deficit Management

Politicians gain popularity by offering benefits to people, so they want to increase government spend – but this has to be paid for from taxation, which is unpopular.

Governments set a budget for how much they want to spend, and they set tax rates which are designed to collect the necessary funds.  But forecasting tax revenues is difficult: the level of economic activity in a country depends on unpredictable factors and upon the economies of other countries (3.3.5.2).  If the economy grows less strongly than expected the tax revenues will be lower, and the costs of benefits will be higher, than budgeted.

In their desire to please people (particularly if an election is imminent) politicians tend to make over-optimistic assumptions.  The British government’s decision to set up an Office for Budget Responsibility in 2010 was intended to restore city confidence in economic forecasts.  As BBC Economics editor Stephanie Flanders explained, in a blog post Why the Office for Budget Responsibility matters, this followed a period when “the revenue and borrowing forecasts in the latter years of the Labour government were objectively atrocious”.

If governments spend more than they receive in tax they have a so-called ‘fiscal deficit’ and they must borrow to make up the difference.  This borrowing can create problems:

●  The debt must be paid back, so tax will have to be higher in subsequent years: possibly placing a burden upon those who had no influence upon the decision to incur the debts and who had not benefited from the increased government spending at the time when the debt was incurred.

●  If a government incurs debt for making infrastructure investments, which will benefit future generations, the borrowing can be justified: morally and economically, creating jobs in the short term and contributing to economic growth in the longer term.

●  If debt is incurred to fund current expenditure such as benefit payments, it amounts to inter-generational theft unless the debt is repaid within the life of the government which made the decision.

●  If government borrowing in a restricted pool of available finance causes a rise in interest rates, its impact is to further reduce consumer demand and to increase the costs of wealth creation – preventing a return to economic growth.

●  Markets will charge higher interest rates to a government if there is doubt whether it will be able to repay its debts.  A BBC article, Timeline: The unfolding eurozone crisis, recorded how some countries in difficulties faced increased borrowing costs during the Eurozone crisis in 2011.  The increased rates further reduce those governments’ ability to repay their debts, in a vicious spiral.

●  If governments control their own currencies, they can repay debts by printing money.  This is inflationary and is a serious problem in itself, as described later (3.3.8.3).

It is evidently imprudent to allow debt to continually increase.  If a government has entered into long-term commitments that exceed its average tax revenue it is running a so-called ‘structural deficit’ which is unsustainable and has to be corrected – either by cutting government spending or by increasing taxation.  Such corrections are painful and reduce economic growth.

Government spending (unlike household spending) can be allowed to increase temporarily though, to make investments for example, if it is taking up spare capacity.  If it avoids job losses it results in higher tax revenues, so it reduces the fiscal deficit.  A policy of austerity does the opposite if it involves cutting government spend when there is spare capacity in the economy: it reduces growth and increases the fiscal deficit.  Nonetheless, politicians have sometimes imposed austerity even when it was inappropriate:

●  Ha-Joon Chang’s article in March 2013, Britain: a nation in decay, suggested that Britain’s “spending cuts are not about deficits but about rolling back the welfare state”.

●  Austerity was imposed on Greece during the Eurozone crisis, against the advice of the IMF among others – as reviewed in a blog post on this website: Greeks Need Relief, not Grexit.

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This page is intended to form part of Edition 4 of the Patterns of Power series of books.  An archived copy of it is held at https://www.patternsofpower.org/edition04/3381a.htm