Debt and Deficits – Sustainable but Unfair

At the end of January 2010, UK government debt stood at £848bn and around 60% of GDP. The European Commission says ‘additional fiscal tightening measures’ are required. The Tories warn that investors are getting anxious and that the ratings agencies (who also certified the security of mortgage-backed derivatives) are about to downgrade the UK government’s debt, with the likely consequence of increased interest rates to pacify bond-holders.

Two-thirds of Treasury bonds are held by UK citizens and institutions – mainly banks and pension funds – that rely on them as secure and predictable basic assets. This is UK government money owed to UK citizens by the UK government. It is a purely internal redistribution of claims that cannot be compared, as it sometimes is, to household debt. The one-third of Treasury bonds held by foreign investors, such as other central banks and financial institutions, is a rather different story. Clearly these bond-holders have less direct interest in the long-run health of the UK economy, and so may and sometimes do, exert pressure on governments to increase the rates of return on the new bonds they issue. Were these rates of return to exceed a reasonable expectation of the political and economic tax revenue capacity of the UK government, then there would be difficulty in continuing to fund the current level of debt in the same way. In fact this situation seems a long way off. Currently interest rates are low, UK debt is not particularly high relative to other countries, and the UK has strong social and economic assets to back its liabilities. This makes UK government debt a particularly safe form of wealth in a time of economic turbulence and one that tightening capital regulations are likely to create even more demand for. The real question about the UK’s debt is not so much whether it is sustainable, but whether it is fair.

The UK government spends money created by the Bank of England for the purpose of adding value to the national economy. In times of economic stability, the purpose of government spending is for public infrastructure that would be difficult or more expensive for the private sector to provide adequately. When the economy enters a downturn, the replacement by government spending of reduced private spending can minimise the long-term economic costs associated with unemployment and business failures. Although there is no real limit to the amount of money the government can create, to avoid ‘too much money chasing too few goods’ with consequent inflation and the loss of value of money and other financial assets, some of the money created has to be removed from the economy after it has served its purpose. Why doesn’t the government just increase taxes to do this? The economic reason is that if something is taxed, we are generally less likely to do it. So higher taxes on income may reduce employment, and higher taxes on spending may lower consumption and reduce business income. These effects would both lower incomes and have the effect of reducing actual tax revenue. At least as important, there is a political reason. Raising taxes is a sure way for the governing party to lose votes!

Once governments have taxed to the economic or political limit, money can still be removed from the economy by encouraging those with more money than they currently want to spend to return it to the Bank of England in exchange for Treasury bonds. To persuade people to hold a rather less safe and less liquid asset than current bank deposits, interest must be paid. The ultimate responsibility to meet the repayments and interest remains with the labour and goods of UK citizens, just as if the ‘funding’ was from tax. The difference is that bond funding is less likely to have an effect in reducing incomes and tax revenue in the short-run than would increasing the usual forms of taxation.

If bond issue is to be superior for non-bondholders to an immediate increase in taxation as a way of offsetting government expenditure, their benefit from delaying the impact of taxation must offset the compensation to bond-holders. The real output of the economy must grow fast enough that the real burden of repaying the bond plus interest later is less than the burden of taxation now. This is quite a high hurdle to pass, since bond-issue concentrates the liabilities of the government in the hands of relatively few wealthy citizens and institutions whose prime motivation and concern for their bond-holding is financial return. (This is true even although quite a significant number of us will have some indirect financial interest in government bonds through our investment and pension funds.) If governments either contemporaneously increase taxes or spend money without an offsetting mechanism then the costs are spread throughout the national population, who have a common interest in maintaining the functioning of government and its services. Any rebalancing required because the anticipated benefits of government expenditure fail to materialise therefore takes place within the democratic process of the country, rather being dictated by the financial concerns of relatively few, a substantial proportion of whom are not UK residents. There is therefore a sense in which the issue of bonds rather than the alternative mechanisms of offsetting government expenditure is a form of anti-insurance, that concentrates economic risk rather than spreading it.

A more grown-up approach would seem to be to try to offset additional government expenditure more by taxation and less by bond issue, but by taxation on things that we actively wish to discourage. Taxation on cigarettes, alcohol, fossil fuel use and carbon emissions are all in this vein, but we may need to go further. One possibility is to aim taxation at the same target as bond issues – inactive bank deposits. Currently, holders of more money than they need are able to easily make even more money by exchanging it for government bonds, while the ordinary taxpayer who has no more than he or she needs may well be paying in the future for excessive reliance on bond funding. This seems to be the wrong way round, and so I would propose a tax on bank balances that have not been spent in some particular period of time – say 1 or 2 years. Clearly, simple account transfers would have to be excluded from the criteria of ‘spending’. While this might seem unfair to ‘savers’, it should be borne in mind that they are the chief beneficiaries of inflation-avoiding offsetting. Moreover, they will have the option of avoiding the tax by spending their deposits on consumption or productive investment. If they do so this should both lower government costs by itself generating employment and additional infrastructure, and would increase the revenue from existing payroll and expenditure taxes. This change could benefit everybody and increase the UK’s economic independence from global financial markets.

© Diarmid J G Weir 2010

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