ChainWhat it assumes · how to break it
Start
The government raises its spending, for example on infrastructure and public services, without raising taxes.
1
As a result, government spending exceeds tax revenue by more, so the budget deficit widens.
budget deficit
budget deficit
Assumes: Taxes are not raised to pay for it.
But: A balanced-budget increase, paid for with higher taxes, leaves the deficit unchanged.
2
This means the government must borrow more by issuing gilts, adding to the national debt.
national debt · gilts
national debt · gilts
Assumes: The deficit is financed by borrowing.
But: If the central bank buys the extra gilts, as it did under QE, borrowing is cheaper for a time, though the debt still has to be serviced.
3
Consequently, debt interest payments rise, especially if extra borrowing pushes up gilt yields.
debt interest · gilt yields
debt interest · gilt yields
Assumes: Markets demand higher yields to lend more.
But: When inflation and interest rates are low, extra borrowing can be very cheap.
4
This means debt interest takes up a growing share of public spending. Every pound spent on interest is a pound not spent on schools, hospitals or infrastructure, and the interest itself adds to the deficit.
opportunity cost · debt interest
opportunity cost · debt interest
Best link to attack
Assumes: Debt interest grows faster than the economy.
Assumes: Debt interest grows faster than the economy.
But: If economic growth is faster than the interest rate on the debt, the debt-to-GDP ratio can fall even while the government runs a deficit.
5
Therefore, to stop the debt rising further, the government may have to raise taxes or cut spending in future, which reduces AD and growth at that point.
fiscal consolidation (austerity)
fiscal consolidation (austerity)
Assumes: The government aims to stabilise the debt.
But: A government with a credible fiscal framework and long-dated debt can delay consolidation without markets demanding much higher yields.
End
The budget deficit widens, debt interest crowds out other public spending, and future tax rises or spending cuts become more likely.
Evaluation chain
- E1However, whether higher debt is a problem depends on the size of the debt relative to GDP, not its size in pounds.
- E2If the economy grows faster than the interest rate paid on the debt, GDP rises faster than the interest bill.
- E3As a result, the debt-to-GDP ratio can stay stable or fall even while the government runs a modest deficit.
- E4So higher debt interest is a serious problem mainly when interest rates are above the growth rate, and much less so when borrowing is cheap and growth is strong.
Another way to attack it: The extra spending also raises incomes through the multiplier, so tax receipts rise and benefit spending falls, recovering part of the cost. If the spending is investment that raises productivity, later growth and tax revenue may cover it, so the debt-to-GDP ratio can fall in the long run.
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Questions this answers
- Assess the impact of an increase in government spending on the budget deficit.
- Discuss whether governments should borrow to invest.
- Explain the difference between a budget deficit and the national debt.
Diagram
No standard diagram. Figures for debt interest as a share of public spending or GDP make strong evidence.
Reverse and related
Government spending cut → deficit narrows, unless the cut slows growth so much that tax receipts fall.