Will we face more austerity?

Funding Options

Broadly speaking, the government funds its spending using two things: tax receipts and borrowing.

Tax receipts include VAT, income tax, National Insurance Contributions, Stamp Duty Land Tax, Corporation Tax, Capital Gains Tax, Inheritance Tax, and so on.

With the economy on hold, tax receipts will fall significantly due to lower wages from furloughing or redundancies, a fall in asset values, transactions in house purchases being mostly on hold, and so on.

At the same time, the government has announced funding to companies who have furloughed staff and will see an increase in claims for Universal Credit (and other state benefits), so total spending will go up.

To fund this bigger gap between government spending and tax receipts, borrowing requirements will increase. Like most countries, the UK government borrows money by issuing “government bonds” (also called “gilts” in the UK) on a regular basis.

In the UK, the Treasury’s Debt Management Office (DMO) holds regular bond auctions to raise money for government spending. At these auctions, the DMO offers bonds of different terms/interest rates and potential investors bid for the rights to buy the bonds. The investor(s) with the highest bid pay cash for the bond up-front (which is then used by the Treasury for government spending) and in turn they acquire the rights to the loan. This means they will receive interest payments from the government (normally every 6 months) and the loan will be repaid at the end of the fixed term (anywhere from 2- 30 years, or even more).

As bonds are a type of financial asset, they can be bought and sold by investors (like company shares). This means the original investor (which loaned money directly to the UK government) can choose to sell the bond to another investor, either at a profit or a loss compared with their initial investment. Any subsequent trading of a government bond does not result in any money going to the government – these transactions only take place between different investors.

Bonds can be issued by both companies and governments. Government bonds, especially those issued by developed economies (such as the UK), are typically considered “safer” than company bonds. This is because governments are far less likely to miss payments and, in many cases, can ultimately “print more money” to make debt payments.

This final point raises an important question: if most governments can print their own money to finance spending, why don’t they?

Unlimited spending

The concept of countries spending as much money as needed by “printing more money” is supported by a concept known as Modern Monetary Theory. However, its proponents have not had a major impact on economic policy and it is a hotly debated topic.

Without limits, allowing a government to finance itself by creating money can lead to hyperinflation. Modern Monetary Theorists argue this could then be controlled by the government altering its fiscal policy to keep inflation under control, but others argue this would not be possible.

Currently, the consensus is against Modern Monetary Theorists, and so it is widely accepted that government spending can only be financed through taxes and raising debt.

This leads us to the more practical reason why governments do not simply spend whatever is needed: if investors feel a government is spending too much (and financing this spending by borrowing) they will demand a higher interest rate to compensate for this higher risk. If the rate gets too high, it will make the government’s spending plans too expensive and the plans will have to be scaled back. Investors acting in this way are referred to as “bond vigilantes”.

In summary, unless the UK government suddenly adopts the Modern Monetary Theory, it cannot finance its coronavirus stimulus measures by printing more money. Instead it will finance its spending by borrowing more, which will be acceptable unless investors become “vigilantes” and demand higher interest rates.

Repaying government debt

Repaying this debt over time will become a hot political topic. After the global financial crisis in 2008-09 the conservative-led government, along with several other governments around the world, embarked on a debt reduction strategy by cutting back on government spending (or “austerity” as it is widely known).

The theory behind this is simple: the government must borrow money if its income (tax receipts) is less than its spending. If spending can be reduced without affecting tax receipts the government can eventually use any surplus to reduce its debt. Part of government spending includes making interest payments on outstanding government debt, so if the debt can be reduced it further reduces government spending, and so the debt can be repaid even faster.

Unfortunately, things are never this easy. From a financial perspective, if a government reduces its spending this means reducing services and reducing state benefits. This results in less money in people’s pockets and ultimately lower tax receipts (so a cut in spending can still lead to a deficit in the government’s budget). In addition, from a social perspective, austerity measures can greatly reduce standard of living for significant numbers of people (e.g. cutbacks to local government funding have resulted in changes to bin collections, library closures, etc). These practical considerations, coupled with the fact that wealthy people were broadly unaffected by government cutbacks while the most vulnerable were hit hard, made austerity measures very unpopular with the public.

From an economic theory perspective, austerity is a poor decision. This is because of two economic concepts called the government (or fiscal) multiplier effect and the propensity to consume.

With the government multiplier effect, if the government increases spending by £1 it should ultimately result in economic growth of more than £1. This is because more spending means more jobs, which means more household spending, higher tax receipts, and ultimately greater economic growth.

Linked to the government multiplier effect is the “marginal propensity to consume” or “MPC”. This concept estimates how much more people will spend if they receive an extra £1 in income (or, in terms of austerity, how much people cut back on spending for every £1 of lost income). MPC is not equal across different levels of wealth. Wealthy people have a very low MPC, because they can already afford to buy what they want (so an extra £1 in income will not normally lead to a jump in spending). On the other hand, poorer people have a very high MPC, and so an extra £1 in income will normally lead to close to an extra £1 of spending.

Given these concepts, it is easy to see why a cut in state benefits (i.e. a cut in the incomes of the poorest people in the UK, whose spending will then reduce) might not make sense from an economic growth perspective.

In recent years there have been growing calls for governments to spend more and to become less reliant on cuts in interest rates to boost economic growth. Heeding these calls, the newly elected Tory majority government recently promised a reversal of austerity measures, plus greater investment in infrastructure (amongst other things). This extra spending would ultimately be financed by greater economic growth (due to the government multiplier effect) plus any necessary increase in borrowing.

Of course, the coronavirus has rightly distracted policymakers away from long-term decision making about infrastructure projects, and any new borrowing will be to “make ends meet” rather than to invest in the future of the UK.

So, will we face austerity measures in the future as a result of the economic impact of the coronavirus? In theory we should not, for the following reasons:

• Our country’s practical experience with austerity has demonstrated the negative impact it can have on people’s livelihoods.
• The government multiplier effect shows why austerity can backfire in terms of economic growth.
• Research suggests the current economic conditions we face – including low interest rates and a contracting economy – can lead to greater-than-normal benefits from a government multiplier perspective (so more spending, rather than less, could improve the economy)
• With the official short-term interest rate at an all-time low of 0.1%, the government can no longer rely on the Bank of England to stimulate the economy by cutting rates (which it has done for the last 11 years).
• The only real limitation to government borrowing is a possible rise in borrowing costs due to the intervention of “bond vigilantes”. Given the fact the UK is in control of its money supply (and so cannot fail to repay its debts) and the coronavirus is widely expected to have a short-term rather than long-term impact, there is hope the government will be able to borrow as needed without this threat.

This said, we are very much in the early stages of the economic impact of this virus, and economic theory does not always work in practice. As a result, policy responses by politicians will very much depend on how much stimulus is needed and for how long.