Could Britain go bust? Or, more precisely, could the government fail to meet its debt obligations? And could that fate befall the next government, whatever its political complexion, if it does not take early action to bring the budget deficit under control? The short answer to the first question is "no, as long as Britain has its own currency". The explanation is that it can borrow from the central bank, which is a state-owned concern and cannot refuse.
According to some reports, David Cameron and George Osborne have been anxious that the budget deficit is so large that at some stage during the next Conservative administration there will be a Day of Judgment. Investors will flee en masse from British government securities. By declining to take up any new issues of the government's debt, they will force it to cancel contracts, sack civil servants and withdraw social security benefits. The worriers think that Cameron's Britain could end in the same mess as Arnold Schwarzenegger's California, where the processes of fiscal disintegration are advanced.
But California's government is the government of a state of the US, not the government of a sovereign state with its own currency. California does not have its own tame central bank or its own officially regulated commercial banking system. For Britain's national government, as opposed to California's state government, the banking system is "the debt buyer of last resort".
The penalty for excessive deficits would not be national bankruptcy as such. Instead, the penalty would come in the form of politically unpopular inflation. When a government borrows from the banks, they credit the sum borrowed to its bank deposit and the government then spends it by buying goods and services from the private sector.
As these extra deposits can be spent an indefinitely large number of times in future, they are also money. If too much money is created relative to the economy's ability to produce, if the rate of money supply growth is well above the trend rate of growth of output, then inflation will emerge. The monetary financing of budget deficits can always avert national bankruptcy. But if monetary financing is on an excessive scale, the consequence will be high inflation.