Cutting now or later: Making sense of the debate on UK government debt

Cut the government’s budget deficit now or cut it later? Economists disagree, again! However, behind the headlines highlighting differences, there is a good deal of agreement. Furthermore, there is a growing consensus among economists in favour of an institutional change that could help resolve disagreements on this issue, or at least allow them to take place at a deeper level than the letters pages of national newspapers.

There is almost universal agreement that UK government debt should not stay at current or projected levels for too long. It should come down. The disagreement is when and how quickly it should come down. Understanding these disagreements requires understanding why UK government debt needs to come down.

The dangers of debt

One intuitive reason is that higher government debt requires higher taxes to pay the interest on that debt, and higher taxes are damaging because they are distortionary. However, we also have to take account of the fact that taxes will have to rise to bring debt down. Indeed, any given reduction in debt requires tax rises that are far greater than are required to pay interest on it, although obviously such large tax increases will be temporary and not permanent. Standard smoothing arguments apply to this intertemporal trade-off, suggesting that we are better off leaving debt where it is rather than bringing it down. This is the random-walk steady-state debt result, and it applies in the same way if we use cuts in spending rather than higher taxes to reduce debt. (See Kirsanova et al. 2009 for further discussion.) We might want to modify this principle for intergenerational equity reasons, but this analysis does illustrate the costs of reducing debt rapidly, and why debt should be regarded as a useful buffer and not a rigid target.

The reason most often given today for reducing UK government debt is the danger that those buying the debt will start requiring a significant interest rate risk premium, because of worries that the UK might default. This is what is happening to Greece and other small Eurozone economies. There are three important points to make about this concern. First, markets at the moment do not think there is any serious possibility that the UK will default. The UK government is not paying a significant premium on its borrowing. Second, the possibility of default depends mainly on politics, not economics. There is plenty of scope for higher taxes or lower spending in the UK – the key issue is whether politics will allow either. In this respect, the UK has a system of government that looks much more decisive than, say, the US, and an electorate that is much less resistant to government austerity than in, say, Greece. But third, you cannot trust markets to get risk assessments right, as we all found out to our cost in the credit crunch.

This means that even those arguing for cuts later rather than cuts now should not discount the possibility that the markets could suddenly grow reluctant to buy UK government debt. The key question is whether we can deal with this problem if and when it happens or whether we should try and minimise the chances it will happen by acting now. This discussion should include consideration of measures that would help bring down debt without immediately hitting demand, such as announcing a future increase in VAT.

A second reason debt should come down is that, in the longer term, high government debt may crowd out investment in capital, reducing UK prosperity. Unfortunately, macroeconomists have no idea how big this effect is. But what we do know is that this effect works through higher interest rates, so at the moment it is not a problem. Anyone who tells you that government borrowing is currently crowding out private investment needs to rethink their macroeconomics.

A final reason debt should come down is a lesson we should draw from the last two years. The zero lower bound for nominal interest rates generates an asymmetry for countercyclical fiscal policy. In a severe downturn, we want to be able to use fiscal policy to support demand, but in a boom we are happy to leave demand management to monetary policy. As a result, we want debt low enough to give us the capacity to use fiscal policy to combat a sharp negative shock, without having to be limited by issues involving default. Arguably, both in the UK and the US, more could have been done to mitigate the recession using fiscal policy if we had not started with significant structural deficits.

The merits of waiting vs the problem of deficit bias

All these problems could be solved by a credible medium-term programme to reduce debt. All our letter writers agree on this. And all should agree that cutting spending now will reduce UK output at a time when the UK recovery has hardly begun. So why not wait until the recovery is well under way before starting to reduce government debt?

For some, I suspect worries over debt represent a political opportunity to reduce the size of the state. But for others, the problem may be a concern that once the recovery starts and budget deficits begin to decline because tax receipts rise, the political momentum to reduce deficits further will be lost. And these fears are not without foundation. Even before this recession, the last few decades have seen government debt in the OECD area roughly double, without any justifiable economic cause. This is the problem of deficit bias. Politicians appear to believe they get more credit for cutting taxes or increase spending than the reverse.

Do we have to risk the recovery to avoid this happening in the UK? Ironically, the UK political party pushing early cuts is also the party that has proposed an institutional solution to this problem of deficit bias. Many economists now believe that fiscal councils, which are government-funded-but-independent watchdogs that would monitor and advise on the state of public finances, are the way forward in preventing this trend rise in public debt (see most recently Besley and Scott 2010, but also Kirsanova et al 2007 for a detailed proposal for the UK.) Fiscal councils have recently been established in a number of countries including Sweden, and the Conservative’s Office of Budget Responsibility could be the UK’s Fiscal Council. 

The details of exactly how a UK Fiscal Council might operate remain open, and examples from other countries differ substantially. However, it would be odd, given the level of expertise that such a council would have to develop, if it did not form a view about the issues discussed above. It is also vital that the council should be seen as politically independent. This raises an interesting question. If the Conservative Party does win the election, will its Office of Budget Responsibility be independent enough to give its own advice in the cut now or cut later debate, advice that could differ from the current party line?

References

Besley, Tim and Andrew Scott (2010), “A new watchdog would guard us from debt,” VoxEU.org, 25 February.

Kirsanova, Tatiana , Campbell Leith and Simon Wren-Lewis (2007), "Optimal Debt Policy, and an Institutional Proposal to help in its Implementation", in J. Ayuso-i-Casals, S. Deroose, E. Flores, and L. Moulin (eds) "The role of fiscal rules and institutions in shaping budgetary outcomes", European Economy Economic Papers 275, April.

Kirsanova, Tatiana , Campbell Leith and Simon Wren-Lewis (2009), "Monetary and Fiscal Policy Interaction: The Current Consensus Assignment in the Light of Recent Developments", Economic Journal, Vol. 119,p 482-496.