Government Borrowing Is Cheap But Risks Breaking the Bank

After ‘Black Friday’, in which manufacturing in Britain and the eurozone slumped and America’s job market stalled, the search for growth is as urgent as ever.

Gilt yields are at record lows, along with US treasuries and German bunds. The 10-year gilt yield is under 1.5%. So why doesn’t the government do what Paul Krugman, the nearest thing to a rock-star economist, advocates?

Krugman, on a visit to Britain from America, put it in his usual colourful way, in a lecture at the London School of Economics and in numerous BBC interviews.

“If you want to worry about debt and deficits, fine, but this is the time, to quote St. Augustine, to say ‘Oh Lord, make me chaste and continent, but not yet,” he said at the LSE, adding: “The bond market is saying borrow, borrow.”

It is a view with many advocates here. Gilt yields are at record lows. Government borrowing is cheap. Why not follow the advice of a group I could call Keynesians but to avoid labels will call the borrowers?

Many people get confused in this debate, because there is a lot of confusion around. Jon Moulton, the venture capitalist, thinks the government should cut spending even harder. I shall leave that for another week.

The first confusion is over the causes of weak growth. Some borrowers imply it is all due to austerity, notably coalition austerity. But it is due to a range of factors, including austerity but also high commodity inflation (squeezing real incomes), the eurozone and the credit crunch.

I asked the Ernst & Young Item Club, which uses the Treasury model, to compare growth under coalition plans with Labour’s plan for slower deficit reduction.

The results are interesting. The economy grew 2.1% in 2010, 0.7% in 2011 and Item projects will grow 0.4% this year. Under Labour’s plans, assuming nothing else changed, growth would have been marginally higher in 2011, 0.8%, and in 2012, also 0.8%, but at the cost of around £24 billion additional government debt.

Item suggest, however, it is realistic to assume gilt yields would have been 0.5% higher under Labour’s plans. They fell this much between Labour’s March 2010 budget and George Osborne’s June 2010 budget.

Plugging this in to the model gives 2011 growth of 0.7% (as under the coalition), and 0.7% in 2012, only slightly faster than currently expected, though with an additional £37.5 billion of debt.

Yes, I hear you saying, but what if there was no austerity at all? Let me turn to the National Institute of Economic and Social Research, which is in the borrowers’ camp.

In May last year, it predicted 2% growth for 2012. Now it predicts zero. There has been no “news” on 2012 fiscal policy in the past year; the IMF suggests a modest loosening relative to previous plans. So other factors explain the shortfall.

The second confusion is over historical precedent. You might think cutting the deficit is some mad, ideological experiment. There is an excellent new Centreforum pamphlet, Delivering Growth While Reducing Deficits: Lessons from the 1930s, by the economic historian Nick Crafts .

Starting from much lower budget deficits than now — roughly 2% to 3% of gross domestic product – the then coalition acted to restore budget balance.

“Over fiscal years 1932/33 and 1933/34 the structural budget deficit was reduced by a total of nearly 2% of GDP as public expenditure was cut and taxes increased, the public debt to GDP ratio stopped going up while short term interest rates stabilized at 0.6%,” Crafts writes. “Yet from 1933 to 1937 there was strong growth such that real GDP increased nearly 20% over the period.”

As in the 1930s, so in the post-1976 period, the 1980s and 1990s. This is no laboratory experiment. It is what has worked every time before, combining fiscal consolidation – cutting the deficit – with loose monetary policy and a devaluation of the pound. If there was a UK economic policy textbook, this is page one, chapter one.

The borrowers, on the other hand, suggest something for which it is hard to find a British precedent. Public borrowing is close to peacetime records. Borrowing in 2011-12, 8.2% of GDP, would have been a record if not for even higher figures (11.2% and 9.3%) for the two previous years.

Labour had a time-limited fiscal stimulus worth about £25 billion in 2008-9, when the deficit was 6.9% of GDP. But I can find no example of a British government, faced with very high borrowing and having embarked on a fiscal consolidation, reversing it.

Things might be different if, as discussed last week, everybody agreed most of the deficit is cyclical not structural. They might be different if the eurozone produces a second collapse, though the deficit consequences do not bear thinking about.

None of this means the borrowers are necessarily wrong. The case for a stimulus does not rest on whether austerity caused the weakness. The lack of precedent may be because this time it really is different.

But what they are proposing is risky. A ratings downgrade is not the end of the world but Moody’s, in its January warning on the AAA rating, said a “discretionary fiscal loosening” would be a likely trigger.

Markets see Britain as a safe haven but that is not guaranteed. They can turn on a sixpence. Pimco, the bond firm, once had gilts “resting on a bed of nitroglycerine”.

The Office for Budget Responsibility, having pushed the government into a further fiscal tightening, would find it hard to condone a loosening, even one that focused on capital/infrastructure spending. The government has two fiscal rules, on the current deficit but also on debt.

I urged the Treasury last year to find room for more infrastructure, within existing plans – without borrowing more – and it did in the autumn statement. The IMF wants more of the same, by squeezing some current spending. I agree, though planning delays mean it is hard to get projects up and running quickly. “Shovel-ready” projects are not lined up in Whitehall waiting for the go-ahead.

What makes me most uneasy is government debt. Some borrowers say anything borrowed now would be strictly temporary. But clawing it back later would be hard, with the government already needing to find substantial extra welfare savings.

Public sector net debt is 65% of GDP, excluding direct support for the banking system, or 148% including it, says the Office for National Statistics. Eurostat, the EU statistical agency, puts the figure of 87%. Whichever measure you use, it is rising strongly and those banking liabilities may yet return to haunt us.

When does it become unsustainable? An influential paper by Carmen and Vincent Reinhart and Kenneth Rogoff, Debt Overhangs: Past and Present, argues that tempting though borrowing may be, governments should tread carefully, particularly those with sharply rising debt.

Once debt gets to more than 90% of GDP, the “overhang” consequences can become severe: annual economic growth more than a percentage point lower, sustained for an average of 23 years. As they say, “the cumulative effects can be quite dramatic”. This is something to avoid.

What should the government do instead of more borrowing? A lot more to ease the impact of the credit crunch on business lending and mortgage markets. Freeing up credit provides demand. The great housebuilding boom of the 1930s was built on easily-available credit and an absence of planning. I shall return to this.

My regular column is available to subscribers on This is an excerpt.

This post originally appeared at David Smith’s EconomicsUK and is posted with permission.

3 Responses to "Government Borrowing Is Cheap But Risks Breaking the Bank"

  1. burkbraun   June 3, 2012 at 10:51 pm

    1) Rogoff is invalid for fiat, floating currencies. Inapplicable. Their lessons are drawn almost all from borrowers in other currencies or gold, such as perhaps the euro countries of today.

    2) The precedents seem to be misunderstood. At least here in the US, the lesson of the mid-30's contraction couldn't be clearer- it led to contraction and had to be reversed posthaste. Then WWII created an unstoppable fiscal boom and the crisis was solved. It would be nice to have the effect again without declaring war on anyone.

    3) The weirdly superstitious attitude towards soverign fiat debt is bizarre and without merit. It is a problem when inflation rises to problematic levels, not before. The MMT framework for this couldn't be clearer or simpler… net savings in the private sector and/or net imports call forth government sector deficits as long as needed to balance the books. Otherwise, you are just driving the private sector into unnecessary contraction.

    I'd recommend you study Bill Mitchell's work and blog, though it is tough sledding.

  2. buzz   June 4, 2012 at 3:08 pm

    Thanks David for some refreshing common sense. As a liberal I've become very frustrated with my fellow liberals' simplistic drive to borrow, borrow, borrow as if that were the cure for a burst credit bubble. The fact that inflation and interest rates are low now does not mean they will be forever. When a government runs a deficit it doesn't only need to borrow, it must also commit to later either running a surplus or refinancing the borrowings. It's not the cost of the immediate borrowing that sinks governments, it's the trap to which it leads, the choice between slashing spending and refinancing at excessive interest rates, as you see now in Spain.

    @burkbraun: You need to actually read Rogoff, and do some of your own empirical studying outside the theoretical (I would say escapist) world of MMT. Many countries have defaulted on domestic debt denominated in domestic currency. The latest major example was Russia 1998.

  3. Julie   June 25, 2012 at 4:10 pm

    Silly boy. Listen to Krugman.