Economics and politics 101

As Western democracies grapple with falling productivity and rising debt, there is a tipping point at which government promises meet market reality – by Undercover Investor

Governments exist to look after the interests of their whole society, overseeing expenditure on public goods (healthcare, defense, infrastructure etc.) that would not easily be undertaken or paid for by the private sector, and in practice they often focus more on the needs of the less fortunate than the fortunate. That is the sign of a mature society.

Society accepts that taxes need to be raised on private sector owners and workers to pay for such things because governments have no money of their own. Tax comes in many forms (corporate, income, capital, spending, transaction taxes etc.), but ultimately, taxes depend upon the private sector earning money and undertaking an activity which can be taxed. For governments to do more for their electorate, they need more money, so they will raise more taxes, so the private sector needs to generate more profits over time that can be taxed. Improvements in conditions, whether public services or welfare, are therefore directly tied to the success of the productive elements of society.

Global Domestic Product is the common measure of economic progress and is a function of demographics and productivity. The number of people making goods and spending money, and the efficiency with which those goods are created, are what ultimately define how fast or slowly an economy expands or contracts. The more people active in an efficient economy, the more one expects GDP to expand and vice versa.

Falling or flat GDP makes a population poorer over time, and is to be avoided, because in a world of falling GDP, the taxes that can be raised by government on the private sector fall over time. This is a problem because government promises rarely, if ever, fall over time.

When there is insufficient government income for their committed expenditure, governments can either seek to tax the people some more, or they can borrow money to spend it in the economy to lift the level of economic activity overall to maintain or promote a positive overall GDP.

The problem with taxing more is that it reduces the tax paying population’s incentive to work, and that taxpayers then have less surplus income after tax to spend (which can lead to falling profits in the corporate sector) leading to a decreasing GDP. The problem with borrowing more is that the interest that needs to be paid on the borrowed funds is not available to spend in the wider economy, and of course, the debt needs to be repaid.

Borrowing is, however, an entirely valid way of lifting economic activity to stabilise the economy through the cycle if the return on borrowed money exceeds the cost of borrowing it. A structural budget deficit, (a budget set each year with the intent of borrowing to make up the tax shortfall) is only rational if GDP can be maintained at a higher level than the interest paid.

Sensibly then, any money borrowed by government should be invested in infrastructure and real assets to earn a positive return across the whole economy. Borrowed money invested well can raise the overall growth level of the economy and provide an improved foundation for growth to support increased private sector productivity which can in due course restore the debt to GDP balance (because the tax taken by government will increase as financial output increases).

The relationship between how much is borrowed, the term on which it must be paid back, the interest rate on those borrowings, and the increase in the growth of the economy because of the borrowing, are all critical.

“Reviewing promises is always painful and breaking them is usually catastrophic for the government in power.”

Well-pitched borrowing, targeted at investment in productive assets, and paying an appropriate rate of interest can lift an economy over time. Too much borrowed, or not enough invested in productive assets, or paying too high an interest rate on the borrowings in comparison with the increase in overall level of GDP that can be achieved, can quickly render a country’s finances worse than having not borrowed in the first place (though there could be some positive societal consequences of having borrowed over time). Borrowing at an interest rate that is higher than the underlying GDP of the economy can only make the country poorer.

“GDP is simply a function of population and productivity on the top line, and debt and costs on the bottom.”

Today, the Western liberal democratic world has a falling population and is struggling with productivity. Governments in such countries have kept their GDP positive in recent years by borrowing, the proceeds of which they have spent to keep the system going. In recent years, the interest costs of this debt were very low, and GDP remained positive, so the mechanism made sense (the interest cost was not really noticed). However, as interest costs have risen more debt is now required to maintain not only the low level of growth, but also to pay the interest on the debt that has been taken out in the past.

In theory, if demographics and productivity keep falling, more debt and taxes are going to be required, until eventually, in the absence of a return to GDP levels that erode the interest bill on the debt taken out, the system cannot be sustained. The tipping point typically lies in the hands of the debt holders (the bond markets) and not the issuing government.

When this happens, government promises to its electorate must be dramatically reviewed. Reviewing promises is always painful and breaking them is usually catastrophic for the government in power. Hence governments typically prefer to keep the system going, because they are typically addicted to staying in power, which means staying in government. History shows us that a radical adjustment in promises is often worse for everyone than would have been the case had the promises to the electorate been reviewed more actively earlier (reference Greece, 2010 to 2018).

It might therefore be interesting to compare two western, liberal, democratic world economies today, one being the largest economy in the world, and the other, an historically significant democracy that once provided a benchmark for how democracies should function. Despite them both being western world democracies using English as a common language, their governments today are far from similar, nor is their approach to managing their elevated debt to GDP ratios.

The United States of America (USA) Government (elected in late 2024) recognising their huge expenditure and debts, initially started a Department of Government Efficiency program to dramatically cut their costs. Within a year, whilst some cuts have been achieved, they came to understand that cutting costs is much harder than initially thought, and it appears today that the Government has pivoted to promoting growth. The ‘Big Beautiful Bill’ promotes tax cuts, corporate incentives and the burning of regulation to attempt to turbo charge GDP growth.

Currently, the USA is running a budget shortfall in the region of 6 % of its annual GDP so there is an extra 6 % of money in circulation being spent each year than the combined goods and services value in the economy each year. This is clearly living beyond one’s means. However, with US GDP today at around 3 % per annum and growing, nominal growth in 2026 might well prove to be more than 5 %. Debt costs currently are around 3 % per annum, so even with a debt to GDP ratio of 120%, there should still be a surplus of total nominal growth over total debt costs. That positive margin should in theory, and with all things being equal (which they never are), reduce the debt to GDP ratio over (a long) time.

The UK Government (elected in mid-2024) inherited a lower debt to GDP ratio of circa 100%, and a not dissimilar budget deficit of around 5%. The UK government has not yet introduced obvious cost cutting measures or growth strategies to address the nation’s finances. The Government is increasing tax on the private sector (both corporate and private individual) and increasing borrowing at the current time.

UK GDP is perhaps only half of the USA level (let’s generously say it will correct up to 1.5% per annum going forward (having been tracking well below 1% recently), and inflation will likely hover around 2–2.5 %. Debt service costs are higher than the USA’s at around 4.0% per annum on average, so there is unlikely to be a surplus of total value created over total borrowing costs. The debt to GDP ratio will therefore likely increase over the next few years, creating an increasing burden for the future. Given the relationship between growth and debt costs, it is less rational for the UK Government to keep borrowing at the rate that it is.

Comparing the two, neither government is in an ideal position, but the prospects for the USA look rather better in the absence of a UK Government plan to either reduce costs or increase growth.

GDP is simply a function of population and productivity on the top line, and debt and costs on the bottom. Both the top and bottom lines of the equation need to be actively managed. One might argue that the US is at least trying. Taxing and borrowing more are unlikely to work for the UK government and its electorate, remembering that the economic prospects for everyone are tied together.

Wherever we are in the world, as investors, we must assess whether central banks and governments can manage their economies effectively from here. If you believe in their ability to do so, it is rational to invest in those underlying economies, but if you do not, you might decide to leave the country, or invest elsewhere, or do as global central bankers themselves appear to be doing; buy gold.

Published by our friends at:

The post Economics and politics 101 appeared first on USNewsRank.