The truth about debt and deficits

25th April 2012

Federal government debt is a different story to personal, consumer debt. Unlike private actors who don't have the capacity to create money, explains this blog, the government can issue money at the tap of a keystroke, which means that debt service per se is never an issue. "The federal government (for example) can always create the dollars to ‘fund' its spending."

The struggle is finding a balance to get an appropriate fiscal and monetary policy in place to promote growth and drag the country out of recession, and the use of QE has been replicated by the EU response.  

However it's clear that now in its 5th year, this financial crisis is still alive and well. In fact, reports have put fear into investors with news that the debt crisis rescue plan could unravel.

News continues to bombard us, suggesting that fiscal policy hasn't worked. "Even those who see themselves as moderates on the issue are embracing a commitment to "eventually" slash deficit spending once recovery gets underway."

Deficits as a barometer of economic activity

The UK government met its 2011/12 deficit reduction target by a whisker despite higher than expected borrowing in March, reports Reuters, though the rise in total debt above 1 trillion pounds highlights the scale of the task ahead.

But an uncertain growth outlook, as the Eurozone debt crisis threatens Britain's biggest trading partner, could yet derail the government's attempts to reduce a deficit that exceeded 11 percent of GDP when it came to power.

Government deficits are barometers of economic activity: when economic activity declines, tax revenues plunge and social welfare expenditures rise as more people are thrown out of work. As a consequence, in bad economic times, there are higher deficits – conversely, when prosperity returns, deficits decrease.

Yet recent figures show that austerity to slash the deficit does not work as it was imagined by its advocates. The effect of cutting government expenditure (and raising tax rates for that matter) not only reduces the contribution from the government towards the GDP calculation, reduced spending will ripple through the economy, leaving consumers with less money to spend, and in turn businesses having poorer profitability, giving more negative impact on the GDP calculation.

But who is responsible?

Whether you believe the deficit is down to consumer or banker greed, or pure government ineptitude is open for debate. But when it comes to being responsible for it, it's a government as well as a personal issue. It is clear that most households in the UK were materially leveraged due to the cheap liquidity in recent decades. However, the government must take the lead in addressing the deficit.

The biggest issue is uncertainty and the timing of implementation of any policy to tackle this.

A lot of people have argued that the government should have put more money aside in the good times to weather the bad. This is laudable, but under Clinton, for example, the US had a massive surplus and look at where they are now. It's not as simple.

The danger is that with the political and regulatory response of the financial crisis, the real economy will be impacted. This is about how these reforms will impact real corporate firms who use the banks or, for example, commodity trading companies, or corporate treasurers.

With these unintended consequences all the work that is being done to lift the country out of recession could be severely compromised as individuals and families start using the extra money they have put aside to meet higher living costs.

But it's important to point out as a final note that spending and debt are necessary in any economy.

The key question is which sector should carry the burden: families and businesses, or the government? What do you think?


More from Mindful Money:

UK in double dip recession

Paradigm Lost: Rethinking our global economic system

Could fracking save the UK energy sector?

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The Financialist

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