Government deficits still matter, just not right now

Deciding when to tighten the purse strings and hike taxes is complex at any time, and even more so when the economic fallout from COVID-19 remains unclear. Getting deficits – the gap between government spending and income – under control will need to happen eventually, but it would be a brave government that pursued such a goal now.

Government deficits still matter, just not right now

COVID-19 wreaks havoc on government finances

The British government, like many others around the world, is on course to rack up a record peacetime deficit for the 2020/21 financial year as it tries to limit the severity of the steepest economic downturn since the Second World War.

Higher government spending and lower tax revenues are forecast to lead to a deficit of £355 billion, or 16.9 per cent of Gross Domestic Product (GDP), a measure of the size of the economy, in the year to April 2021.1

Last May, the UK’s debt-to-GDP ratio was above 100 per cent for the first time since 1963

Last May, total government debt exceeded £2 trillion – more than £100,000 for every family – pushing the country’s debt-to-GDP ratio above 100 per cent for the first time since 1963. The figure is expected to rise to £2.7 trillion by April 2022.

Bank of England mops up

However, there is no immediate pressure on the government to tackle the deficit. It is able to finance its spending through the Bank of England (BoE), which is effectively printing money to buy up gilts (as the bonds or “IOUs” the government issues to borrow money are known).

The government is currently benefiting from very low borrowing costs

In addition, as every mortgage holder knows, it is the size of the repayments you have to meet each month that determines the amount of money you can comfortably borrow. That, in turn, is dependent on the interest rate being charged. The government is currently benefiting from very low borrowing costs. Indeed, excluding gilts bought by the central bank, debt interest costs – at 1.7 per cent of GDP – are at a record low. Furthermore, the Office for Budget Responsibility forecasts that they will fall appreciably further over the next few years.2

Economic theory turned upside down

The idea that deficits don’t really matter runs contrary to the prevailing economic wisdom of the past 40 years. However, this line of thinking is now at odds with the views of many economists and major global financial institutions such as the International Monetary Fund (IMF) and the Organisation for Economic Cooperation and Development (OECD).

The IMF recently said most advanced economies can now live with much higher levels of public debt

Despite arguing that countries should reduce their debt after the global financial crisis in 2007-2008, the IMF recently said the actions of central banks mean most advanced economies can now live with much higher levels of public debt.3

The UK is not the only country rethinking its attitude to government finances. In Europe, discussions are underway that could lead to a loosening of the euro zone’s spending rulebook. In the US, President Joe Biden has launched a $1.9 trillion stimulus package. This is on top of a record $3.1 trillion deficit in the fiscal year to October 2020, equivalent to 15 per cent of US GDP.

There is evidence healthy economic growth can bring high deficits back under control quite quickly. Having stood at 259 per cent in 1947, reflecting the surge in government spending caused by the Second World War, by 1991 the UK’s debt-to-GDP ratio had fallen to 22 per cent.4

On the back burner

It should be remembered that the post-war years were characterised by strong economic expansion, which helped reduce the deficit quickly. We are unlikely to see such rapid growth in the foreseeable future. There are also doubts about whether central banks can keep printing money indefinitely.

There are doubts whether central banks can keep printing money indefinitely

However, that is an issue for another day. For now, with financial markets fixated on the power of central banks to keep the cost of government borrowing low and economies stable, investors seem likely to push any worries about the dire financial straits facing many nations to the back of their minds.

Three points to remember

  • Government spending has surged, and tax revenues have fallen sharply around the world as a result of the COVID-19 pandemic, sending government deficits and total debt higher.
  • Due to a combination of factors, however, the cost of borrowing remains low and governments are under little pressure to reduce the size of their deficits any time soon.
  • While many investors are relatively relaxed about the issue for now, that may change in future.

Related views

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