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Cutting Government Debt Is a Myth

U.K. Prime Minister David Cameron warned of the growing risk that Britain's creditors could start to question "our ability and resolve to pay off our debts" on Wednesday as he wrapped up his Conservative Party's annual meeting in Birmingham, Britain's second city.

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"We're one of those Western countries getting on top of debt problems, " Chancellor George Osborne told CNBC on Monday ahead of a key note speech in which he promised Britain would overcome its debt problems under his government's leadership.

"We've got a credible plan to reduce our budget deficit that's delivering very low interest rates for us in the markets at the moment. That is the proof that there's international confidence in our plan, " he added.

On this the U.K. government is correct, international bond investors are happy to hold U.K. government debt even if the 10-year Gilt pays only 1.7 percent interest as U.K. inflation runs at 2.5 percent.

Both Osborne and Cameron are very careful to say they are aiming to reduce the U.K.'s budget deficit, not the U.K.'s debt burden, which continues to rise despite an austerity program that has seen the leaders' government and personal poll ratings fall sharply.

This is because they know that the key political question of our time is how much more debt governments will rack up over the coming years, not how much debt will be cut.

This is because governments in highly-indebted developed nations like the U.K., U.S., the euro zone, and Japan face three options, none of which has any chance of actually reducing total government debt in the short to medium term.

Option one is the course being taken by Cameron and Osborne . Reduce the pace of government borrowing by imposing austerity measures and curbs on government spending that slow the pace at which total government debt is rising . Known as Plan A in the U.K., this strategy has until now convinced international investors to buy U.K. debt and kept U.K. borrowing costs low.

Cameron and Osborne's opponents claim Plan A has driven the U.K. into a deep recession and is failing to address the U.K.'s total debt burden. Without getting into the weeds on the political debate, the response from Cameron and Osborne is that without the government spending cuts, the total debt burden would be far higher as the interest rate international investors would demand to hold U.K. debt would rise.

Option two is to severely slash government spending in the hope of rebalancing an economy towards private enterprise and away from government largesse. This is the option that many of those attending the Conservative Party Conference really want Cameron and Osborne to pursue. "No one is even having that debate, " said one leading delegate and a rising star of the Conservative Party. "We have to be competitive on the global stage and that means slashing welfare, addressing the pension time bomb and getting the long-term unemployed back into work and off the welfare bill."

Known as the nuclear option in some circles, slashing government spending by huge amounts like we have seen in Greece and Ireland over the last few years has led to mixed results. In Greece the story is well known: locked out of the international bond market the Greek economy has shrunk by 20 percent over the last five years leaving the country dependent on bailout money and questions on its place within the euro zone, amid widespread anger and economic misery. Ireland slashed government spending and managed to win the support of international investors who now demand 5 percent to lend to Ireland over 10 years. It's also lead some commentators to ask if the country might soon leave the so-called PIIGS economies.

The International Monetary Fund predicts that for every $1 cut from government spending 50 cents is lost to total output. The multiplier was cited by the IMF as a reason that the U.K. may want to consider a Plan B if growth does not rebound soon and the G7 economy fails to exit its recession . The U.K. may not be for turning, a la Margaret Thatcher's famous phrase, but the IMF and others are beginning to ask if it is time to think about Option three, raising borrowing and government spending in order to boost growth. "The conversation has moved in this direction in recent weeks, " said Marc Ostwald, a strategist at Monument Securities in an interview with CNBC Europe's "Squawk Box" on Thursday.

Option three has to an extent been the course taken by President Barack Obama . With the U.S. government borrowing over a trillion dollars this year and total debt now topping $16 trillion, what to do next is the key question facing American voters as the country edges closer to a fiscal cliff. Keep borrowing and spending in the hope that growth will become sustainable and help put the deficit into surplus or go with option one or option two?

Whatever course America, the U.K. or the rest of the developed world take, no one should be betting that government debt will stop rising anytime soon as government debt reduction is a myth and will remain so for the foreseeable future.

—By CNBC's Patrick Allen

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