Thursday, 24 February 2011

The terrible tyranny of public debt dynamics

Debt charts can often scare the crap out of you. If the line heads upwards, dark images of financial ruin and bankruptcy come to mind.

David Miles, external MPC member, produced this alarming picture in a recent speech. It highlights the UK debt-to-GDP ratio since the middle of the 19th century. If one includes the debts of recently nationalized bank, the current debt to GDP ratio stands at 150 percent. It must have had the audience nervously searching their handbags for the Valium.

Actually, that number is a little too alarmist. There are assets that one should place against those bank liabilities. The real level of public sector indebtedness is closer to 70 percent. Still, there is something shocking about that number. In the space of three years, the public sector debt has doubled as a percent of GDP.

Apart from the recent reckless rise in government borrowing, this chart points to a deeper truth about public debt. It warns us about debt dynamics and how a comparatively short period of fiscal irresponsibility can create decades of trouble.

To see why, consider the situation in 1914. The UK government had a comparatively low level of indebtedness. Along comes the First World War, and borrowing shoots up. Public sector debt continues to rise during the great depression. Who would have expected that? The interwar governments were actually Keynesians, borrowing to pump up the economy, with dismal results in terms of higher economic growth. Yes, the economic history of the interwar period is highly politicized and often grossly misrepresented.

As the second world war approaches, governments re-establish a degree of fiscal prudence, Debt levels start to fall, and economic growth picks up. However, borrowing again increases sharply during the second world war. By 1945, the debt to GDP ratio is at 250 percent.

After the war, it starts to decline, more or less continuously for 60 years. By the middle of the last decade, the debt-to-GDP ratio returns to pre-1914 levels. The punchline? It took almost one hundred years to work off the debt accumulation incurred during the first world war.

This chart illustrates the appalling tyranny of debt dynamics. Once a country accumulates a lot of debt, it has to use a large proportion of its future taxes to service that debt. With a huge chunk of taxes eaten up by interest payments, governments have strong bias towards higher fiscal deficits, and a continued accumulation of debt.

Higher inflation doesn't help in the long run. Nominal interest rates increase in line with higher inflation. The only way to pay down the debt is to run fiscal surpluses. That means cutting back expenditure and hiking taxes.

This is why the UK economy is in such a dangerous position right now. The debt ratio is rising rapidly. As we accumulate more debt, more of our future tax payments will have to be set aside for higher debt servicing costs. This means less money will be available for future social expenditures.

This is why arguing against an upfront fiscal consolidation is so dishonest. Those people who argue for an aggressive expenditure cuts today understand debt dynamics. We realize that the best way to preserve public expenditures over the long run is to maintain balanced public sector budgets. Every pound of debt avoided today, means more money available in the future for education, health and pensions.


AgainsTTheWall said...

But how much of the CPI rise is due to monetary inflation and how much to tax increases and supply shortages?

Interest rate rises will do UK plc no good at the present time and the MPC is right to be cautious

dearieme said...

This shows that we have had two horrible episodes in the last century and a half: the two-round battle with Germany, and the two-twats surrender to Blair and Brown.

Jim said...

What I would really like to see is projections of how much interest payments will make up of the budget, taking into account how much new borrowing, and debt roll over, is planned for the next few years. And to see how those figures vary if long term interest rates rise above current ones.

Thats the smoking gun - when debt payments get above a certain % of your budget you're toast. From memory I think its 30%, but I'm not sure.

DBC Reed said...

Why does the government have to borrow anyway? Why does n't it just create money the way the banks do?Why do governments pay banks to create credit for them to borrow off them at interest?

james c said...

'There are assets that one should place against those bank liabilities.'

No-the reason that you don't include the bank liabilities is that the nationalised banks are limited companies.

The reason why the national debt has risen so sharply is that the private sector has suddenly stopped borrowing.