Thatcherites and their progeny believe the books must balance despite the worse economic crisis in 50 years. Even Labour supporters worry publicly about the Chancellor's ‘record borrowing' and the fact that current receipts and expenditure may not match before 2013.

One can easily dismiss the Thatcherite view that public finances are like those of a corner shop, but is there any reason for the informed citizen to worry about the long term cost of a government deficit? The short answer is ‘probably not' under present conditions---but if you're worried, read on.

Some Basics
Clearly, we need to relearn some basic economics. Historically, the corporate and household sectors (ie, the private sector) had surplus savings which enabled government to borrow from them; ie, the private and public sector finances taken together were more or less in balance. Over the past decade or more, though, the private sector in the US, Britain and some continental European countries has run up a large debt which has had to be financed by increased overseas borrowing.

Financial deregulation---from the proliferation of credit cards and dodgy mortgages to the absurdly leveraged position of banks and hedge funds---has enabled both households and firms to become net debtors. In particular, households became more indebted as labour markets were deregulated and real wages for the bulk of the population failed to keep up with productivity growth. Since neo-liberal principles dictated that the public sector should contract, this meant that aggregate demand had to be fuelled by expanding private credit. As one commentator has argued, this can be thought of as ‘private Keynesianism'.

Deleverageing
That such a state of affairs was unsustainable is in retrospect all too obvious. The end of the dotcom bubble eight years ago was offset by cheap credit, but the collapse of the housing bubble could not be contained and dragged down much of the financial system with it. The latter is now ‘deleverageing'; ie, it has stopped lending and is shedding debt in an effort to rebuild its balance sheet. Households are shedding debt whether voluntarily through postponing consumption or involuntarily because their houses have lost value or their jobs are threatened or both.

Can we leave it to the market?
Were government to do nothing, rebuilding private savings would entail a contraction of aggregate demand, resulting in a treacherous downward economic spiral as Keynes foresaw in the 1930s. Left to its own devices, the market would find a new equilibrium at some much lower level of output and employment. Moreover, because the world's economies are increasingly intertwined in trade and finance, a downturn is one country is quickly transmitted everywhere, meaning that all countries would suffer. Inaction is clearly a very costly option for us all. Those who argue that public borrowing merely passes the burden of repayment to the next generation fail to appreciate that ‘passing on' a slump of 1930s proportions would be far worse.

Smoothing the adjustment path for an economy like the UK means that the public sector must borrow massively, in part to help recapitalise the banking sector, but chiefly to boost productive investment---particularly in ‘goods' like education, health and green energy---and maintain household consumption, particularly of those most at risk of poverty. Because an economy like the UK (and the USA) runs a large trade deficit, it relies on the rest of the world for savings---whether in the form of a net inflow of capital into the City as in Britain, or in the form of foreign central banks holding more dollar denominated assets as in the USA.

Risks of Higher Public Debt
When government borrows massively from the public, there are of course risks. One risk is that international lenders will doubt the country's long-term creditworthiness and sell assets denominated in borrower's currency leading to exchange-rate depreciation, itself contractionary. In this respect, the US is far better placed than the UK since the dollar is the world's main trading currency. The pound is more vulnerable, as its recent fall against both the dollar and the euro has shown. But Britain is a medium-sized economy whose government debt in equivalent to just over 40% of GDP; in Iceland, by contrast, the krona collapsed because the perceived debt of its private banks was many times the size of GDP.

Non-currency risk can be more difficult to deal with. Massive government borrowing---remember that its purpose is to offset private recapitalisation---is achieved in one of two ways.

Financing the Debt
First, the Treasury (Ministry of Finance) can sell IOUs, typically long term bonds, to the ‘on-bank public' But to get the public to buy bonds, the market value of bonds may have to fall, meaning that bond yields and interest rates rise. (If the price of a bond with a face value of £100 paying 5% annual interest (£5) falls to £50, the bond's yield has doubled.) Higher bond yields make it more difficult for households and businesses to borrow the money they need to recapitalise or simply to carry on spending.

The second way is for the Treasury to ‘monetise the deficit' by selling its bonds to the Central Bank which credits the Treasury with cash---this is equivalent to printing money. Assuming the Bank is willing to do so, the risk is that monetisation will be perceived as inflationary. Or again, if the public believes that running a deficit will ultimately result in higher taxes (known in the trade as ‘Barro-Ricardo equivalence'), it may reduce its consumption even further thus deepening a depression.

Of course, Government can try to ‘fund the deficit' by cutting public expenditure by an equal amount elsewhere (the Tory solution), but such a move is self-defeating since its overall expansionary effect may be zero. So financing a large government deficit may not always be as easy at is seems and may need to be accompanied by some trickier operations.

Deflationary Danger
Under current conditions in Britain, because inflation is about 4% per annum and falling fast, and because it is imperative to prevent the recession from turning into a long-term slump, there is a good case for monetising the deficit, at least in part. We need a low-level inflationary ‘cushion' of around 2% to prevent falling into deflation; ie, a situation where the general price level falls. In Japan, after the property bubble burst in 1989, the monetary authorities inadvertently allowed the country to fall into deflation resulting in a ‘debt trap', and it was this trap which resulted in two decades of near stagnation despite the millions spent on fiscal expansion. Fiscal spending did little for growth but resulted in an accumulated public debt equal to 170% of GDP.

When prices start falling, several things happen. First, consumers tend to postpone their consumption in the expectation that a new car, television or whatever will be cheaper next week or next year. Secondly, since the nominal interest rate cannot fall below zero, the real rate of interest rises---borrowing becomes more expensive. Most important, just as inflation reduces the real value of your nominal debt (your mortgage for example), so deflation increases real indebtedness. Households fall into deeper trouble, and bank balance sheets become ever more difficult to repair.

Fiscal-Financial Balance
In short, where the rate of inflation is low and falling, the monetary authorities seeking to finance a government deficit need to chart a careful course between the risk of pushing up long term interest rates (either directly or through expectations) and the risk of falling into a debt trap and greatly prolonging recession.

Ben Bernanke, chairman of the US Fed, has written extensively about this subject. He favours a policy of ‘quantitative easing', a polite way of saying that the Treasury should buy long-term bonds from the banking system---thus pushing down bond yields---and send the bill to the Central Bank if necessary.

Pushing down interest rates
Nevertheless, it may be too late for quantitative easing. There are circumstances in which injecting cash into the banking system will not work. In the Japanese case, banks were willing to sit on huge cash reserves rather than lend. Because at present the banking system in the US and the UK is so fragile, banks are using injections to rebuild their balance sheets and increase cash reserves rather than to increase lending, particularly lending to small businesses and the housing market.

The banks argue with some justification that they have little choice. Not only is it impossible for them to raise money in the wholesale credit market, but as a result of the recession private savings are drying up while the distressed firms need money more than ever. At some stage, the only answer is for government to buy into the banking system in order to exercise direct control over lending policy.

Nationalisation
That is why Messrs Paulson and Bernanke in the US, following Britain's lead, recently decided that $200bn of TARP (Troubles Assets Relief Program) monies voted earlier in October 2008 should be used to purchase preference shares in the banking system rather than merely to buy back non-performing assets such as mortgage bonds.

In Britain, although technically the government now owns a chunk of the banking sector, it has so far chosen no to run the banks; ie, to treat them as public enterprises. This state of affairs is about to end. Mervyn King, the governor of the BoE, is in effect telling the banks that unless they lend far more (and more cheaply), they will be treated as branches of the Central Bank. This is probably the only way the banking system can now be revived.

One day ....
One day, hopefully, Britain will return to a high-wage economy, a well-regulated banking and financial sector and a brighter future. Far from running down the public sector, we will by then have awoken to the fact that sustained prosperity requires decent infrastructure and well-financed public services, as in the Nordic countries where the size of the public sector is typically just over 50% of GDP. Moreover, Britain under a social democratic government will have a fairer taxation system to pay for the public sector, a system in which fat-cat bonuses have disappeared, the rich pay their fair share and there is far greater social and economic equality.

Meanwhile, the public sector will have to become more indebted if the private sector is to recover. Moreover, both the monetary and fiscal policy frameworks will need to be greatly strengthened if we are to emerge from the current crisis within 2-3 years as the Chancellor now forecasts. My own suspicion is that it will take far more time and borrowing than Mr Darling cares to admit.

George Irvin