Debt, Deficit, Surplus and Borrowing

Why do Governments borrow money?  And does an increase in borrowing mean something is wrong?
 

To answer these, we need to first explain the word "deficit".  At its simplest, a deficit is the difference between the money you need to do something, and the money you actually have.  Which neatly explains the word "surplus" as well.  If a Government has a Budget Deficit, then it has less money than it needs to run the Country.  If it has a Surplus, then it has more than enough money to run the Country.

Right, now we know what a Deficit is, we can explain a Debt.  Debt is simply the amount of money the Government currently owes.  If the Government had a current  Budget Deficit of £1bn, then it's possible that it could also have a debt of £1bn.  But this is incredibly unlikely, as the Government's Debt is always carried forward into the next Budget, while the Deficit or Surplus is only a measure of the amount of money in Deficit or Surplus in the current Budget.

Basically the Debt is the running total of all the money the Government has borrowed and paid back to date. Think of it as your bank account.  You have an overdraft of £450.  You get paid £1800 a month, and your outgoings are £1850.  So every month you have a Deficit of £50, but you keep adding that £50 to your Debt.  Say one month you get a bonus of £200. Your outgoings are still £1850, but you now have a Surplus of £150.

Because you are conscientious, you pay £150 off your overdraft, making it £300. So for that month you had a Budget Surplus. But you still have a Debt.  Multiply this by a billion and you have Government spending. Most Governments (and probably most householders) have finances just like this.  The Debt is always there, and never gets paid off.

So that's bad, right?

Well no.  Take your own example.  You probably have a Debt of several thousand pounds at the moment.  You've had it for maybe 10 years, and you'll probably have it for another 15.  It's your mortgage, and the important thing to realise about this debt is that it's worth more to you as a Debt, because you've invested it in a house that you can live in.  In fact you can hopefully sell it for a lot more than you paid for it in the future, so it really is an investment. This is why Governments are always in Debt.  Because borrowing money to make investments is always better than remaining free from Debt and making no investments at all.

Now we can answer the original two questions. Governments borrow money to cover a Deficit and to make investments.  Let's say a Government has a Budget Deficit of £10Bn this year (it has £10Bn less money than it needs to run the Country).  It needs to borrow that £10Bn to top up the Budget.  But it would also like to spend an extra £30Bn modernizing the NHS.  Does it turn round and say "We can't afford to borrow £40Bn.  The NHS can't be modernized this year"?  No, it doesn't.  Because investing that £30Bn will create thousands of new jobs and will bring in more money next year, resulting in a smaller Deficit, or even a Surplus. We do the same ourselves. Owing £200K on a mortgage doesn't stop us borrowing £11k to buy a new car.

So no, an increase in borrowing doesn't mean something is wrong. It can do, if borrowing eventually exceeds your ability to pay it back (I'm looking at you, Greece), but a person (or a Government) who is sensible with their finances should be able to rein things in before that point has been reached.

Going back to our analogy of your monthly wage packet, if you are constantly spending more than you are earning each month, then no matter how little that deficit is, you are increasing a debt. Luckily for most people they actually have some left over at the end of most months.  They may not actually notice this, because the bank account always seems to be zero when the next pay packet arrives, but that's because any left-over is usually soaked up in either luxury goods, or in something "you had been meaning to do when you had a bit of spare cash".  In effect, investing. So when faced with a Surplus or a Deficit, Governments always do the same thing - invest.  In fact in both cases they probably still borrow as well, increasing the Debt they owe.

Isn't this a bad thing? 

Again, not necessarily.  So long as the Debt doesn't increase too fast (in fact faster than inflation) then although it appears to be going up, in real terms it probably won't be. Once more, the analogy of you the homeowner comes to mind. This time we're not interested in your wage packet, but in your Mortgage.  It's currently £200k, and assuming you never move, it will actually always be £200K, or less.  So in 10 years you may still owe a large proportion of it.  But in 10 years you may also be taking home £3,600 a month, not £1,800.  Wages go up every year with inflation. But your mortgage doesn't. Twenty years ago I bought a house for £40k.  When I paid the mortgage off a few years ago, it was still £40k. But to me it looked more like £15K.  Because it was over ten years later, and my wife and I were both earning far more.

In order to understand this in terms of a Government we have to look at their equivalent of a yearly salary - GDP. Gross Domestic Product, or basically the total amount of money that the UK "earns" or creates in a year.  Obviously with inflation this increases year by year, so a handy way to look at the amount of Debt you have is as a percentage of your yearly earnings. Going back to our Homeowner analogy, let's assume you have an outstanding loan of £2000, and you earn £30,000 a year.  Well you don't have a problem. You owe 6.6% of your Salary, and this is perfectly manageable. You can't pay the whole thing off at once, but just over a hundred pounds a month for 2 years is perfectly within your means.

Now imagine you're on Income Support. That's currently £72.40 a week.  £3,764 a year.  Your Debt is still £2000.  But now it's 53% of your yearly income.  The amount hasn't changed, but the debt is no longer manageable. Governments work on the same principle. The actual amount they borrow doesn't matter half so much as whether it is manageable, and whether they can afford the payments, and so (as with our homeowner), Borrowing and Debt is often expressed as a percentage of GDP.

Interestingly, UK borrowing tends to be between 2 and 10% of GDP. This is regardless of whether we have a Labour or Conservative Government, and is more to do with whether we are entering, leaving, or in the middle of a Recession. To weather a Recession you need to stimulate the Economy. To do this you need to Invest, and in order to invest you always need to Borrow. Labour and Conservative Governments may well borrow for different ideological reasons, but they both still borrow.

Debt as a percentage of GDP tends to swing a lot more than Borrowing, with 25% being usual for Boom periods, and as high as £80 during a Recession.  This doesn't necessarily mean the Debt is wildly increasing and decreasing, but can mean that the GDP (or amount the UK earns) is. The Debt will stay relatively the same, because of course we are paying it off at the same time as we are borrowing it.

So what can we conclude from this?

Well, borrowing is not bad.  In fact it is necessary and perfectly normal. All Governments do it.

Excessive borrowing isn't even bad, providing you have a strong Economy and you are borrowing to invest.

Having a Debt is not a bad thing.  In fact you can't borrow without incurring a Debt, and you need to borrow.

Some things to watch out for:

When the Government or the Media tell you the Deficit has increased, they are often actually talking about the amount borrowed.  Remember that this figure will mostly consist of borrowing for investment, not just for covering the Deficit.  If we have a Deficit of £10bn, the Government may well borrow £80bn and invest £80bn of it.

When the Government or the Media tell you they are trying to reduce the Deficit, they almost always mean the Debt.  A Deficit lasts until the next Budget and then you either get another Deficit, or you get a Surplus.  A Deficit is not carried over.

When the Government or the Media tell you they are trying to reduce the Debt, they do mean the Debt.  However we may temporarily decrease the Debt, but we will never get rid of it, because you can't borrow without incurring a Debt, and you need to borrow.

Keep an eye out for those two words, as both the Government and the Media will use them interchangeably, the Media because they don't understand the difference, and the Government because they do understand the difference...but they know that you don't.