Current Affairs

UK Budget deficit: Why all the fuss?

It’s been at the epicentre of all things polarising in many of George Osborne’s policies. But the latest controversy to cast a shadow over the Chancellor’s plans to eliminate the fiscal deficit was the recent vote by the House of Lords to delay plans for cuts on tax credits. Such a rebuff from the House broke centuries of convention, but, more importantly for Osborne, leaves him £4.4 billion further away from fulfilling his promise to bring Britain back into the black by 2020.

But why his determination to eradicate the deficit if it means inflicting such an unpopular policy, which would no doubt hit low-income families the hardest?

Net borrowing currently stands at around £70 billion – which in turn equates to roughly 5% of GDP. Britain was last in a state of surplus in 2001, yet the 2015 figure of £70 billion is well down on its 2010 counterpart, which breached the £150 billion mark.

So should Osborne even be fretting? And what are the side effects of a government not “living within its means”?

Opportunity costs

The obvious downside to a deficit is the added expense of paying off the interest on national debt. This invariably falls on the taxpayer, and clearly there is an opportunity cost by committing funds to interest on debt as opposed to using them for Government spending.

But there are additional ramifications to a deficit too. In order to cover the numbers in the red, Government must borrow from the private sector. It does so by asking the Bank of England to sell bonds and gilts to the private sector. However, this can cause a reduction in the private sector, known as crowding out, which in turn can have a contractionary effect on an economy. After all, if you are lending £10,000 to the government, that’s £10,000 gone amiss which could have been used to buy stocks or invest in business.

Then there’s the austerity conundrum, which is at the heart of the debate between the Left and the Right. A deficit unquestionably ties the hands of policymakers, as spending is constrained by the straitjacket of debt, but there are a few ways of dealing with this. The chosen path in the Tory manifesto is to cut spending; particularly on welfare which, unlike investment in infrastructure, offers no prospect for economic return or growth stimulation.

Tax credits are a prime example of this, although their proposed slashing was intended to be offset by the introduction of the National Living Wage. Osborne’s thinking on this was fairly clear – transfer the burden of topping up the income of low-income working families from Government to the employer. Clever. The problem, of course, is that such a ‘transfer’ would never work as smoothly in practice as it would in theory, and there will be many families who would suffer in the process.

Cut, or spend our way out of trouble?

Cutting spending also has a contractionary effect on the economy, which has knock-on effects like higher unemployment and lower tax revenue for Government – the latter defeating the very purpose of deficit reduction.

And so to the other school of thought – the argument made by anti-austerity campaigners. Many politicians believe the best way to counter a fiscal deficit is to give the economy a shot in the arm by boosting spending so as to create employment and growth. As a result, both employment and incomes should rise, meaning tax revenues are boosted by more people being in work. In addition, more people in work means fewer people on welfare, which itself impacts positively on the budget.

Yet the above is only applicable if a country is a long way off ‘full employment’, and even then, Greece provides an eye-opening reality check on the dangers of such a gamble. And while UK economists may scoff at any comparisons between our economy and theirs, it should be borne into mind that in 2014, Britain had the ninth-largest debt pile as a proportion of GDP in the entire EU. Debt also soared to nearly 90 per cent of national income in the same year, well in excess of the EU’s statutory debt limit of 60 per cent.

So who’s right about the deficit?

It is the big dark cloud which hangs over our otherwise recovering economy. Indeed, inflation is as stable as it ever has been, growth has been steady in recent years and unemployment is on the decline. Economists are divided as to the significance of a deficit as a factor in economic stability, with many actually seeing it as a necessity to negate a recession. Others, though, subscribe to the oldest theory of all - living within one’s means.

At Lending Works, we believe the latter to be a touch narrow minded, and that whether it is at an individual or macro-economic level, debt can be a resource for positive change, and a means for prosperity - provided that it is managed properly, affordable, and, ultimately, can be paid off in due course. But is that a fair analysis of the status quo?

It would seem not. Spin it whichever way you like, but the current numbers do not reflect well on our collective fiscal responsibility, and if a downturn were to be on the horizon, £70 billion of debt would represent a position of weakness from which to face up to it. So while socio-economic obligations cannot be discarded, something needs to be done.

The question is, what? That’s for our well-paid economists and politicians to decide. But gauging from the controversy in the House of Lords last week, the solutions may well be as far away as they ever have been.

Main image "George Osborne and Christine Lagarde" by Chatham House. Image subject to copyright. A link to the image and appropriate licence can be found here. You must not use or reproduce this image other than in accordance with the licence.

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Michael Todt

Mike joined Lending Works in early 2015 with a background in marketing and journalism. Having long held a passion for economics, he is now the chief contributor to the Lending Works blog, and regularly writes about all things peer-to-peer lending, fintech and personal finance.