Wednesday, 22 June 2011

No 210: Govt spending v Govt Borrowing

EITHER of these topics could be in the exam tomorrow. However, be careful, they are not exactly the same.

Think about yourself for a moment: are the reasons you spend money the same as the reasons why you might need to borrow money? For example, are you likely to borrow money just to buy food? Are you likely to need to spend money every day? Are you likely to need to borrow money every day?
 
In other words, governments need to borrow money to spend only on certain things, and only at certain times.

We know that govt borrowing is necessary when G > T. Therefore a govt will need to borrow if there is a sudden increase in G and/or a sudden fall in T. What could cause such situations to happen? 

In a question about the effects of government borrowing, you can refer to some arguments about the effectivess of government spending. I would say, "some economists argue that since govt spending for demand mangement is ineffective, therefore they should not borrow money to finance this" and give some reasons for it. 

But what you are really looking for are the effects of the borrowing itself. These could be: 

  • higher interest payments mean govt has to reduce other areas of spending or raise taxes (as we have seen with Cameron's spending cuts);
  • possible need for bail-out (ECB and/or IMF) which would lead to even tighter fiscal policy;
  • reduced confidence in the govt's ability to manage the economy sucessfully, particularly affecting future government borrowing;
  • inflationary risk if govt increases money supply to pay borrowing or deliberately causes inflationary pressures to reduce the real cost of borrowing;
  • financial crowding out;
  • an unacceptable burden of debt passed on to future generations.
Try to read about what is happening in Greece at the moment to give you a sense of the real-world consequences of excessive govt borrowing.

Also be careful not to mix up the base rate of interest and the rate government pays on bonds.

The first is the rate offered by govt to buyers of govt debt. The second is the rate govt lends to banks. 

The rate on bonds affects the amount of interest govt will have to pay back in the future. It does not affect the other interest rates in the economy, particularly those for households and firms. It might though affect the attractiveness for banks of lending to govts or to businesses/consumers. It could affect the exchange rate too, as described next.
 
If the govt wants to borrow a lot more, possible lenders become worried since they are more concerned about the govt's ability to pay back its debts. In order to attract them, the govt offers a higher rate of interest (called the yield) on its bonds. 


This might attract foreign investors if the bonds are thought by them to be a good mixture of reward compared to risk. In such a case demand for the currency would increase, causing an appreciation. 

However, at the moment no-one wants to buy Greek govt bonds, even though, for example, the yields on 2 year bonds are 28.24%!!!
  

2 comments:

  1. The Budget deficit, public sector and government borrowing came up in Jan/June 2010 so why do you think that they will be repeated in the exam tomorrow? Thank you.

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  2. I suggest all students study the full range of topics as listed in the syllabus.

    However, there are certain topics which have been persistent in economic news over the past few years: the budget deficit is one of them, as has rising inflation.

    I don't know if there will be a question directly about these issues tomorrow. If they do we have guessed well.

    However, a good answer linking economic theory to the current economic situation should mention the most important economic "hot topics" of our time (for example, deficit and inflation).

    Therefore, these topics are well worth reviewing even if a question does not directly address them.

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