Stephen King: Excessive government borrowing leaves taxpayers facing an uncertain future

No, you haven't stumbled by accident upon a column on the great works of Russian literature. The point of my first paragraph is to show that, if there is no meaningful punishment and the utilitarian calculus is faulty or short-sighted, all manner of dubious acts can be committed.

The dubious acts I'm referring to are acts of fiscal profligacy. I'm fully aware that government borrowing as a theme doesn't have quite the same impact as violent murder. Nevertheless, attitudes towards government borrowing are changing. And they're changing in part because the perceived punishment for excessive borrowing no longer seems to be quite so troubling.

The table shows the latest position for government borrowing and government indebtedness in four eurozone countries. Within the eurozone, fiscal performance varies enormously. At one extreme, Italy has an estimated budget deficit of 4.5 per cent of GDP, well above the Maastricht tolerance limit of 3 per cent of GDP. Germany and France are not much better: their deficits aren't as big as Italy's, but they still overshoot the Maastricht target. Spain, however, awash with revenues as a result of its housing boom, has a balanced budget. There are also huge differences in the level of government debt. Under Maastricht, government debt was supposed to be less than 60 per cent of GDP. Germany, France and, particularly, Italy fail on this measure.

Outside the eurozone, similar pressures are emerging. The US budget deficit may have improved cyclically in 2005 but is likely to rise again in 2006, reflecting Katrina-related expenditures. And in the UK, the deficit is bigger than expected, reflecting a combination of structural revenue shortfalls and cyclically weak economic growth. Gordon Brown says we needn't worry about this, arguing that the economic cycle will continue to the end of the decade, enabling him to meet his golden rule. This rule requires him to be neither a borrower nor a lender for the purposes of government activity through the course of an economic cycle. Either he's right, in which case revenues will have to rebound and he'll have to exercise robust control over public spending, or he's wrong, in which case he'll be the first alchemist to have converted a golden rule into one made of base metal.

The key issue, however, is whether any of our finance ministers believe that current levels of government borrowing are excessive. Within the eurozone, finance ministers have to pay lip-service to the requirements of the Maastricht Treaty and the Stability and Growth Pact, which define government borrowing as excessive when it exceeds 3 per cent of GDP. Should countries exceed this limit, they are at risk of fines under the auspices of the Excessive Deficit Procedure. But as the decision to fine countries resides with the Council of Ministers, the chances of fines ever being doled out are low: turkeys don't vote for Christmas.

The eurozone's excessive deficit provisions are only one of the punishments that might face countries with excessive government borrowing. The other source of castigation comes from financial markets. Governments that borrow too much face risks. Their central banks may raise short-term interest rates. Yields on long-term interest rates may also rise. Currencies may come under downward pressure as markets fear a rise in inflation.

So punishments do exist - at least in theory. In practice, however, these punishments are difficult to spot. Let's start with the eurozone. If Italy borrows too much, should bond investors worry? The Banca d'Italia no longer sets short rates, so the connection between Italian fiscal policy and the level of Italian short-term interest rates is rather loose. The lira no longer exists, so the only currency risk is a fall in the euro: for euro-based investors, however, this is no risk at all. Long-term bond yields might rise, driven higher by fears of default, but in reality the risks of default are low. As a sovereign state, Italy retains the power of taxation, so can always promise to meet its obligations to its creditors. And even if the Italian government found itself on the verge of bankruptcy, bond investors might still believe that other European nations would bail Italy out. As for the currency, there is no lira, so there is no Italy-specific currency risk associated with Italian government debt.

In the 1980s and 1990s, before the euro was formed, all these punishments did exist. This is not to say that Italian finance ministers back then behaved with Scrooge-like fiscal zeal. But at least they knew that misbehaviour led to punishment. The ultimate punishment, of course, was exclusion from the euro so, surprise, surprise, the run-up to the decision on euro membership brought out the best in fiscal conservatism from all prospective member countries.

Being a member of the euro is notthe only factor behind renewed fiscal profligacy. In the US and the UK, where deficits have risen in recent years, there has, again, been no market punishment. Bond yields are low, seemingly immune from changes in government borrowing and from increases in headline inflation. Among the explanations are low inflationary expectations, helped along by independent central banks (in other words, no monetisation of government debt), high levels of corporate saving (companies have lost the appetite for the leverage that drove their investment plans in the late 1990s), higher cross-border capital flows (the US can borrow cheaply from the Japanese, who regard US Treasury yields at 4.5 per cent a bargain) and ageing populations (regulatory changes forcing pension funds and the like to increase their holdings of bonds).

All of these arguments reduce the punishment associated with excessive government borrowing. Does that mean that there is no crime or, as Raskolnikov incorrectly believed, that there will be no punishment? Not necessarily. For the Western world, the cost of larger government deficits today will be borne by tomorrow's taxpayers. Unless it can be shown that additional government borrowing will boost the rate of growth of productivity, it is a case of jam today at the expense of less jam tomorrow. Let's hope, then, that today's St Petersburg doesn't become tomorrow's Siberia.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com