Fiscal Policy, Government Debt, and Public Spending Explained

This is post 10 in a series on Trading Economics: A Guide to Economic Statistics for Practitioners & Students by Trevor Williams and Victoria Turton (Wiley Finance, 2014, ISBN: 978-1-118-76641-5).

Thomas Jefferson once said that spending money to be paid by posterity is basically “swindling futurity.” Meaning: borrowing now and making your grandkids pay for it is kind of a scam.

It’s a great quote. And it’s still relevant today.

What Is Fiscal Policy?

Fiscal policy is the government using taxes and spending to influence the economy. That’s it. Raise taxes, cut spending, or do the opposite. Those are your main levers.

Here’s how it works. When the economy is struggling, the government can spend more or cut taxes to put money in people’s pockets. When the economy is overheating, it can pull back.

Fiscal policy works alongside monetary policy (which is what central banks do with interest rates and money supply). Both aim for the same goals: stable prices and full employment. But they use different tools to get there.

A Quick History of Fiscal Policy

The story of fiscal policy is basically a story of going in and out of fashion.

Under the gold standard (before the 1930s), the focus was on balanced budgets. Governments were supposed to spend only what they took in. No deficits. No debt accumulation.

Then the Great Depression hit.

John Maynard Keynes looked at the world falling apart and said: this is wrong. When the economy collapses, resources sit idle. Factories shut down. Workers are unemployed. The private sector isn’t spending. So someone has to.

His argument was simple. In a recession, the government should create additional demand. Spend money. Build things. Put people to work. Yes, that means running a deficit. But it’s better than letting the whole economy collapse.

From the post-war period to the mid-1970s, governments took Keynes seriously. They used fiscal policy actively. Spent money on infrastructure, welfare, public services. The economy grew. Things were good.

Then the mid-1970s happened. Inflation went wild. And people started blaming all that government spending. Monetarism took over as the dominant philosophy. The idea was: stop messing with spending and taxes, just control the money supply.

Fiscal policy fell out of favor for decades.

Then 2008 happened. The financial crisis hit, and suddenly governments everywhere were pulling out the fiscal playbook again. Tax cuts. Stimulus packages. Bail-outs. Keynes was back.

UK Debt Through History

Here’s something interesting about government debt. If you look at a chart of UK debt over the centuries, a clear pattern emerges.

Debt spikes during wars. The Napoleonic Wars. World War I. World War II. Every time there’s a major conflict, debt shoots up because governments are spending massive amounts on military.

After the wars end, debt gradually comes back down as the economy grows and governments pay things off.

But here’s what makes the recent period unusual. UK debt has been climbing sharply since 2008, hitting around 75% of GDP. And there’s no war. It’s a peacetime debt accumulation, which is historically uncommon.

That makes people nervous.

What Does Government Actually Do?

It’s easy to complain about government spending. But what does the money actually go toward?

• Healthcare. The NHS doesn’t run for free.
• Infrastructure. Roads, railways, bridges, broadband.
• Welfare and social protection. Pensions, disability benefits, unemployment support.
• Education. Schools, universities, training programs.
• Defense. Military spending.

These are things that most people agree need to exist. The debate is about how much to spend and how to pay for it.

Fiscal Transfer: Robin Hood Economics

One important function of government spending is fiscal transfer. Here’s the concept.

The government takes money from prosperous areas (through taxes) and redistributes it to struggling ones (through spending and services). London generates a lot of tax revenue. Parts of Northern England, Wales, and Scotland need more public services relative to the tax they generate.

This redistribution keeps the whole country functioning. Without it, wealthy areas would get richer and poor areas would get poorer. Whether you think this is fair depends on your politics. But the mechanism is real and significant.

The Key Terms You Need to Know

Fiscal statistics come with their own vocabulary. Here are the ones that matter most.

Public Sector Net Borrowing (PSNB): This is basically the government’s annual deficit. How much more it spent than it took in through taxes. If the government spent £700 billion and collected £650 billion in taxes, the PSNB is £50 billion.

Public Sector Net Debt: This is the total accumulated debt. All the borrowing over the years that hasn’t been paid back yet. Think of PSNB as the annual credit card bill and net debt as the total balance.

Current budget: This tracks day-to-day spending versus income. It excludes big investment projects. The idea is to separate regular operating costs from long-term capital investment.

Cyclically-adjusted measures: These try to strip out the effects of the economic cycle. More on this in a second.

Structural vs Cyclical Deficits

This is an important distinction that most people miss.

A cyclical deficit is the part of the budget gap that exists because the economy is in a downturn. When the economy is weak, tax revenue falls (fewer people working, less spending to tax) and welfare spending rises (more unemployment benefits). This part of the deficit goes away automatically when the economy recovers.

A structural deficit is the part that persists even when the economy is doing well. It means the government is spending more than it collects even in good times. This is the problematic one because it doesn’t fix itself.

When politicians talk about “fixing the deficit,” they mostly mean the structural part. The cyclical part will take care of itself if the economy grows.

Government Spending as a Share of GDP

How big is the government in the UK economy? It varies a lot depending on conditions.

During the 2008 recession, government spending hit about 50% of GDP. That’s half the economy flowing through government hands. When you include automatic stabilizers (unemployment benefits going up, tax revenue going down), the government’s role in the economy expanded massively.

At its lowest, government spending was around 35% of GDP in 1989 and again in 2000. Those were periods of strong economic growth when the private sector was doing the heavy lifting.

So the government’s share of the economy swings between roughly a third and a half, depending on how things are going.

The Debt-to-GDP Ratio

UK government debt rose sharply after 2008, hitting around 75% of GDP. That sounds scary. But context matters.

After World War II, UK debt was over 200% of GDP. And the economy recovered. Debt came down over the following decades through a combination of economic growth, inflation, and fiscal discipline.

So 75% isn’t unprecedented by historical standards. But it’s still well above the 30-40% range the UK had gotten used to in the years before the crisis.

There’s also research suggesting that when debt-to-GDP ratios cross above 90%, economic growth tends to slow down. The logic is that high debt levels crowd out private investment and create uncertainty about future taxes. Whether 90% is a hard threshold or a rough guideline is debated. But the general idea that too much debt is a drag on growth is widely accepted.

Why This All Matters

Fiscal policy is one of the two big tools governments have for managing the economy. It went out of fashion, came back with a vengeance in 2008, and the consequences of those decisions are still playing out.

Understanding the difference between structural and cyclical deficits, knowing what the debt-to-GDP ratio means, and following the trends in public spending gives you a much better picture of where an economy is heading.

And whether you agree with Jefferson about swindling futurity or with Keynes about spending your way out of a recession, the numbers are what they are. They don’t care about ideology.

Book: Trading Economics: A Guide to Economic Statistics for Practitioners & Students by Trevor Williams and Victoria Turton (Wiley Finance, 2014, ISBN: 978-1-118-76641-5)

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