Fiscal Policy and Government Borrowing A2 Economics Presentation 2005

Key issues The meaning of the budget balance Differences between a budget deficit and a budget surplus How does the government fund a deficit? What are the main causes of a budget deficit? Economic effects of a budget deficit –Crowding out –Macroeconomic effects Problems in forecasting budget balances Brown’s golden rules for borrowing

Government budget balances

The cyclically-adjusted budget balance

The budget deficit / surplus The public-sector net cash requirement (PSNCR) is how much the government needs to borrow each financial year The national debt is the total amount of borrowing undertaken by the government that has not yet been repaid. The budget surplus of the last few years has allowed the government to reduce the national debt If there is an economic slowdown, the public sector finances will worsen.

Measures of the Budget Balance The amount the government has to borrow each financial year can be measured in a number of ways: The Nominal PSNCR –The total government borrowing requirement for a financial year in money terms only The PSNCR as a % of GDP –This gives economists a good measure of the scale of the debt problem that may exist

Recent trends in government borrowing The budget deficit peaked at 8% of GDP (or £46 billion) in The budget deficit gradually came under control during the middle of the 1990s as the economy recovered steadily from recession. Under Labour the budget moved from deficit into surplus towards the end of the 1990s. The causes were very strong growth, high levels of employment and a boom in company profits. The budget surplus peaked at over 2% of GDP in Most recently the budget balance has moved once more into deficit. Government borrowing is forecast to grow steadily in because of a weaker economy and the effects of substantial increases in planned government spending on priority areas such as health, education, transport and defence

Concerns over higher government borrowing (1) Extra borrowing can push up long-term rates of interest and therefore create some “crowding-out effects” on the private sector of the economy (2) Higher government borrowing today adds to the future national debt, a burden on future tax payers. (3) There are inter-generational equity issues involved with budget deficits – one principle is that each generation should meet the costs of the benefits they derive from current government spending. (4) Increased government borrowing may eventually require higher taxation to fund it again.

Possible crowding-out effects Quantity of loanable funds Interest rate (r) Demand for loanable funds Supply of loanable funds R1

Possible crowding-out effects Quantity of loanable funds Interest rate (r) Demand for loanable funds Supply of loanable funds R1 D2 R2

The crowding out effect A higher level of government borrowing means that the total demand for loanable funds increases E.g. the government must tap into the supply of available savings held in different financial institutions Depending on the elasticity of supply of loanable funds – this might cause a rise in interest rates (e.g. the government needs to offer a higher rate of interest to attract buyers of government debt) Higher nominal interest rates might then squeeze other components of aggregate demand (1) Contraction in planned business investment. (2) An increase in the marginal / average propensity to save (3) Possible effects on the sterling exchange rate and the competitiveness of exports

Some evaluation points about a rising budget deficit (1) A budget deficit might be caused by cyclical factors which will unwind at later stages of the economic cycle (2) Government borrowing helps to stabilise aggregate demand during a downturn. (3) Borrowing to finance capital investment is perfectly legitimate – because it adds to the economy’s stock of capital (4) Government debt is currently low, expressed as a percentage of GDP – there is plenty of scope for higher borrowing without any upward pressure on interest rates – the UK government rarely has a problem finding people to buy their debt

Government debt

Brown’s Fiscal Rules The Golden Rule: –Over the economic cycle, the Government will borrow only to invest and not to fund current government spending –The Golden Rule commits the government not to borrow, except to finance investment. Current tax revenue has to pay for all of current spending, once cyclical fluctuations are averaged out. –But what counts as investment? Spending on training nurses? The Sustainable Investment Rule: –Government net debt as a percentage of GDP will be held over the economic cycle at a stable and prudent level (thought to be close to 40% of GDP)

Problems in forecasting government borrowing The budget balance is the difference between two huge numbers – small forecasting errors can have a huge effect The government must forecast its budget on the basis of projected economic growth – economic shocks can upset any previous forecasts Exogenous shocks to government spending (e.g. extra spending on wars) Other changes to economic circumstances – e.g. lower inflation has reduced the expected flow of revenue from ad valorem taxation