Latest figures from the Public Sector net borrowing results showed that the UK’s budget deficit during the month of July was £557 million. While the markets were expecting to see a surplus of £2.5 billion. So what does budget deficit mean?
In this article, we explain the concept of budget deficit and how it all comes together.
Most governments across the world usually tend to live beyond their means. In other words, the income generated by the government is far less than the government expenditure or public spending. Most governments tend to raise extra money with the taxpayers as the collateral. Public spending ranges from benefits such as pensions, health care, education, defence spending, law and order, international aid and so on.
When the government spends more than it can borrow, it results in a budget deficit which can have a spiralling impact on lot of other factors, which are outlined in this article.
Gilts – How the Government raises money
When a country wants to raise money, it is usually done via bond sales. In the UK, this is referred to as “Gilts” where bonds are auctioned off on behalf of Her Majesty’s Treasury by the UK Debt Management office. Gilts are nothing but government backed bonds and thus are considered to be the most safest form of investment, although due to their “almost” risk free nature, Gilts attract a very low interest.
By selling Gilts, the government basically guarantees the Gilt buyer to pay them a fixed interest every six months until the Gilt matures and at this point, the full value of the Gilt is paid back to the buyer.
In other words, when you buy a Gilt, you are basically buying the government debt. Gilts can be purchased by individual via the participating banks, financial institutions such as insurance companies or pension funds and overseas investors. There are no restrictions as to who can purchase the Gilts, therefore, especially in the recent past, more and more foreign investors have come forward to purchase the Gilts (driven mostly by the UK’s investment strong credit ratings).
Besides issuing Gilts, in some cases, the nation’s Central bank can also step in to print money at times when the economy turns for the worse. A good example of this can be seen with the Bank of England‘s Quantitative Easing or Asset Purchase program, which basically involves printing money electronically and paying for the assets purchased by the BoE. One of the primary responsibility for the asset purchase program is to fund the public spending by the Government.
Measuring National Debt – Public Sector Net Debt
The Public Sector Net Debt or PSND for short measures the total spending on public sector which includes the central and local governments as well as publicly owned companies. Public Sector debt is measured jointly by the Office of National Statistics and HM Treasury.
In order to understand that public sector net debt, one must have an understand of how the public spending accrues. The government usually raises money either for consumption or to increase production.
Health care benefits, pensions typically fall under government consumption, where as investing in infrastructure such as roads, railway and communication networks fall under production. When a government spends money for production it is a good sign as the returns are considerably better as compared to government spending for consumption. As a result of this, more money is required by the government in order to stay afloat. This also results in higher interest rates on the Gilts. In other words, when there is an increase in budget deficit, the cost of borrowing increases exponentially, as can be seen with countries such as Greece, Spain, Italy to name a few.
The downside with increased budget deficits also comes from the fact that credit ratings agencies currently grade Britain at Triple A, which is the highest investment grade. The moment the credit rating is lowered, investor concern would increase resulting in selling of the Gilts, which could then impact the interest rates on the bonds.
While the Central Bank can continue on with the asset purchase program, or in other words print money to buy more bonds, over a period of time, this would result in currency devaluation along with rising inflation which could lead to a full blown economic crisis and almost at the brink of bankruptcy.
Budget Deficit – Where the UK stands at the moment
To gain a bigger picture of the UK’s budget deficit, look at the following table that outlines how the UK Government’s debt has been performing over the ages.
|World War I||150%|
|World War II||200%|
*Figures are rounded off and should not be taken literally.
Controlling the budget deficit, might seem easy in theory, which is to reduce government spending, at least in areas of consumption and to spend the money in the production sector. However, it is a lot more difficult to implement such changes by the government, often referred to austerity cuts, as can be seen with Greece and Spain for example when the respective governments announced austerity cuts, by reducing pensions, increasing the retirement age and increasing taxes is usually met with public opposition.