Debt or Deficit?

Debt or Deficit?

There is a lot of confusion in the public mind between these two terms and this ignorance is deliberately exploited by politicians on both sides in order to underplay the problem we face.

But it really is very simple.

Debt is the amount of money currently owed by the government to the bond markets. The bond market is simply the forum for private investors, insurance companies, banks etc. to lend money to the government at an interest rate set by supply and demand. It has long been regarded as the safest option for investment by people and institutions with a low risk appetite, the proverbial Widows and Orphens market. So much so that the interest rate so derived is known as the ‘risk free rate of return’.

The mechanics of this system are very straight-forward. Every few weeks a government will offer to the bond market, X million of debt denominated in its own currency over a fixed term of anything from three months to thirty years. The treasury will make the following proposition: I am offering a bond which will pay back £100, (let’s say) one year from now and I want £98 for it today. So the lender pays £98 today and in exactly one year he gets back £100, so he gets £2 interest on a £98 loan which is an implied interest rate of (2/98)x100 or 2.04%. If the government has done its sums right, there will be more money offered by the market than is required from this particular bond issue and the bond sale is described as ‘oversubscribed’ and each bidder gets a percentage of the amount of bonds they bid for at the price offered.

The reverse is also possible. If the government offers a rate that the bond market thinks is insufficient the bid will be undersubscribed and there will be only a partial sale of the bonds on offer. This is hugely embarrassing for the treasury so they work very hard to get their sums right to avoid this.

Previously issued bonds are constantly traded on the bond market so that for any given maturity date, there is a clearing price set by supply and demand in the market. The treasury sets its prices to align with the spot price in the open market so that an undersubscribed issue is extremely rare. Bonds are constantly being rolled over so as one bond issue expires and the principle needs to be returned to investors, a similar amount is being raised through a new bond issue to pay it back.

If the government is not overspending, that is, if its income from tax receipts is in line with what it is spending then the total debt can remain static with the annual interest to the bond market becomes just one more line item of expenditure. If the GDP rises and the debt is static then Debt/GDP ratio actually reduces. However if the amount of debt increases faster than GDP then this Debt/GDP also rises. This is where most governments are currently.

Deficits arise when the amount of money being spent by the government exceeds the amount coming in by way of taxes. The difference has to come from the bond market and the amount of this excess adds each year to the total pool of debt.

The Deficit is the amount by which the Debt increases each year.

And this is where the sleight of hand is played. Politicians deliberately use the term deficit where the audience are led to believe that it is the debt that is being discussed. See the video above for recent examples. So a politician can say, truthfully, that the deficits are being reduced, but by mixing up the two words he can lead the audience to believe that is the debt that is being reduced.

It is not.

The debt is just increasing by slightly less than last year, but it is still increasing. So the statement is technically true but by flustering his words, with plausible deniability, he can leave the audience with a false impression.

This deceit is deliberate.

But you already know that politicians are professional dissemblers, right?

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