Debt and deficit
Debt is the total amount of money you owe.
Deficit is the difference between your incomings and your outgoings (between tax revenue and expenditure, for governments).
Your debt increases by the amount of your deficit each year. So if your deficit is falling, your debt is still going up, just more slowly.
Your debt only goes down if you have a surplus (i.e. a negative deficit, where your incomings are greater than your outgoings). You could run a surplus for many years and still have a significant amount of debt, depending on the size of the debt and the surplus.
You pay interest on the debt, not the deficit. For a given interest rate, the amount of interest you pay will go up as your debt goes up, even if your deficit is falling. The amount of interest you pay (at a given interest rate) will only start falling if you run a surplus that reduces your debt.
If you don't pay your debt (e.g. if you don't pay all the interest owed, or repay the borrowed amount when it comes due), people won't lend to you. If people won't lend to you, you will only be able to spend as much as your incomings.
Failure to pay your debts is known as "default". Mostly, you default when you have accumulated a lot of debt and are still running a deficit (i.e. your outgoings remain higher than your incomings). When you default, you suddenly have to bring your outgoings into line with your incomings. It is like going bankrupt and suddenly finding yourself without access to any credit at all. The cuts it forces you to make are much more painful than if you had managed your debt to bring it down without defaulting. And your access to credit remains restricted much longer if you default than if you manage your debt down voluntarily.
The interest rate that you pay depends on how likely you are to default, in the opinion of the person lending you the money. As your debts increase (even if your deficit is falling), the risk of default increases, and therefore the interest rate increases. You experience a "double-whammy" from paying a higher rate of interest on an increasing amount of debt.
The interest on your debt has to be paid out of your incomings. As it increases, it increases your outgoings, even if you are restraining your spending on other items. Either your deficit increases, or you have to make deeper cuts just to stop your deficit from getting bigger. Increasing debt interest tends to increase the deficit which further increases the level of debt, which further increases the interest rate, and so on. This is known as a debt trap or spiral.
Governments with their own currency have an option that people and other organisations don't have. They can print more money (or the electronic equivalent, known as Quantitative Easing, or QE). This helps in the short-term in two ways:
- It can be used to pay for things, like current spending and debt interest, reducing the deficit and slowing the increase in debt, and
- It reduces the value of the currency, and therefore of the outstanding debt.
QE reduces the value of the currency because there is now more money to buy the same amount of output as before, so each unit of money buys you a smaller portion of the output than it used to. Unfortunately, this has bad consequences for the economy in the medium-term, after the initial short-term benefit. People know that if they leave their money in the bank, it will be worth less in future, so they save less and consume more. Higher consumption is not the solution to a problem of our outgoings exceeding our incomings, quite the reverse.
Higher consumer demand pushes up prices, provoking inflation. People who are lending money know that, when they are repaid, the money will be worth less than when they lent it, so they demand higher interest rates. Higher interest rates increase the cost of the interest on our debts - the opposite of what the government hoped to achieve by printing money. Higher interest rates hurt everyone in the economy, not just the government, by making it more expensive to finance business activites, and to repay mortgages and other debts.
The government can only avoid this effect by printing even more money, so it doesn't need to borrow at the increased interest rates. The only way for everyone else to counter this effect is to try to put up their prices faster than money loses its value. The effect gets stronger as the government prints more money to avoid feeling the effect of monetary devaluation and price inflation. It becomes an inflationary cycle, where people put up prices (including their wage demands) at the rate they think they will need to, in order to negate the effect of the government's money-printing, and then the government has to print even more money to be able to afford its ongoing excessive spending commitments at the newly-inflated prices.
If this were a solution, Argentina would still be one of the richest countries in the world (as it was at the start of the twentieth century), the Nazis would never have come to power because the Weimar Republic would have been a raging success, and Zimbabwe would be an economic model for Africa. Taking the short-term soft option at the expense of the medium-term effect is always a disaster.
We are not so far down this road that we could not turn back if we chose to take some very tough decisions now. But we are far enough that moderate restraint (as proposed by the mainstream parties) will not be enough. Without much criticism from his opponents (remember the Tories' plans to "share the proceeds of growth"?), Gordon Brown has expanded the state and encouraged indebtedness so much that we have a massive structural deficit (i.e. one that won't go away even if we manage to blow another bubble in the economy) and world-beating levels of debt. Shaving a few billion here or there from government spending is no longer an option - we have to take radical action, if only any of the mainstream parties were proposing it.
