If debt is the new Black Death, then Gordon Brown’s government appears to be riddled with plague spots. In the financial year 2007/2008, British government debt totalled just over £500bn. The Treasury now projects that this will rise to nearly £1.4trn by 2013/2014.
£1,400,000,000,000! It is a stupendous figure, yet many outside commentators think it may be an underestimate. Surely Britain either already is, or will soon become, bankrupt?
In fact, we need to step back and see the situation in a wider perspective. Most of the time, debt is a Good Thing for an economy. Companies with new plans and ideas need loans in order to translate them into reality. Governments, too, need to borrow to finance large infrastructural projects. Occasionally debt does get out of hand and causes economic explosions, the Great Depression of the 1930s being the classic example. But these are very rare events; the unique nature of the Great Depression is precisely why it has such a strong grip on economic folklore. (There was a debt-fuelled banking crisis in the early 1990s, but this was confined merely to Scandinavia, where banks took advantage of the removal of exchange controls to invest in European commercial property at the very height of the late-1980s boom; and were then bankrupted by the subsequent collapse.)
Over the 20th century as a whole, the 1930s aside, there were hardly any serious financial collapses in the west. There were plenty of economic recessions, but most of these lasted just a single year, and hardly any for more than two. Capitalism has the dynamism, almost all of the time, to recover of its own accord.
So, current circumstances really are most unusual, as reflected in the actions of the US authorities. Last September, the US government created a stupendous amount of debt – but in doing so, they really did save the world. Without their actions, we would already be in a global recession on the scale of the Great Depression.
Even despite this, output in Germany and Japan is falling faster than at any time since the Second World War, and in Britain and America the falls in GDP are matching those of the early 1980s, the biggest recession since the 1930s. In these circumstances, it isn’t at all strange for governments to increase public-sector debt enormously to bail out the financial system. Indeed, it would be far stranger if this were not happening. We can quibble about the details of the bailout, and are perfectly allowed to jump up and down in rage at the rewards that pompous and arrogant bankers have trousered. But the abiding lesson from the 1930s is that, in a financial crisis, no matter how much money individual people might lose or gain, the authorities have ultimately to defend banks and not people. (We saw a glimpse of the alternative when the Americans let Lehman Brothers go bankrupt.)
Why, then, have the media become fixated by the projected increase in debt? The figures are big, almost unimaginably so. But when the British experience is put into an international context, the hysteria does not appear to be justified. As I write these words, for instance, I read that the Italian government has revised upwards its forecasts for public-sector debt relative to GDP. In 2009, Italian debt will be 114 per cent of GDP, rising to 118 per cent in 2011. On a comparable basis, Britain’s figures are 72 and 87 per cent, respectively. These Italians, we may shrug, they do things differently. But what about the prudent Germans? In the 1997-2006 decade, before the present problems started to materialise, German public-sector debt relative to the nation’s economy averaged 64 per cent. In the United States, the average was 61 per cent, and in Japan (due to its own recession of the early 1990s) a huge 164 per cent. In the UK, it was just 46 per cent. And literally every government is projecting large increases in debt.
Again: should this worry us? Well, we can usefully think of the ratio of debt to GDP as being similar to the size of an individual’s mortgage relative to his or her income. And just like a domestic mortgage, there are two separate components, the interest payments and the eventual repayment of the capital sum.
So, in the UK, for example, the government offers for sale what are known as gilts – from the phrase “gilt-edged”, meaning that if the British government and not Johnny Foreigner backs them, you are certain to get your money back. The gilt states the interest that will be paid, and the date the government will repay the holder (who may very well not be the original purchaser, as gilts can be traded just like shares). The repayment date could be in just a year, or two or three decades hence.
But unlike with a personal mortgage, repaying the capital sum isn’t something governments, at least those in stable western democracies, have to worry about too much. When one tranche of gilts comes up for repayment, it isn’t usually a problem for the government just to issue a new set if it wants to. Obviously, if all the £1.4trn debt came up for renewal at the same time, there might be problems in persuading investors to refinance the whole lot. But provided the Bank of England is reasonably professional and astute, the repayment dates can be spread out over time.
Since the Second World War, all governments have had an important ally in their programme of rolling over and refinancing their debts – inflation. When a pension fund, say, buys part of a new issue of gilts, the amount that the government agrees to repay on the due date is fixed in money terms. But inflation means that when payback time comes round, this fixed amount is worth much less. A simple example:
I borrow £100 today and promise to pay it back in ten years’ time. If inflation averages 3 per cent a year, that £100 is worth only £74 when I make the repayment. If I borrow over 20 years, its value drops to £55.
Now here is a real example. At the height of the mid-1970s economic crisis, UK public-sector debt reached 52 per cent of GDP. In 1975 prices, that debt stood at £65bn. But by 1991, inflation had eroded the real value of that £65bn to just £15bn. So one of the current worries about government debt is that we might be about to enter a period of zero inflation, or even worse, negative inflation (when prices are falling, as they already have done in America). Just as positive inflation erodes the real value of debt, negative inflation increases it. Objectively, any government of a large western economy should have little difficulty in refinancing its debt over a period of time. But markets are far from rational, and there is uneasiness at the idea that governments might have to refinance the current levels of debt with real rather than with inflated money.
A matter of genuine concern is the stream of interest payments that has to be paid over time to holders of the gilts. If debt is 100 per cent of GDP, say, and the average interest rate on the debt is 5 per cent, then 5 per cent of GDP has to be paid out in interest by the government each year. In the current UK context, this would be roughly £75bn – which then can’t be spent on state benefits, the NHS, or education. It has to be paid to whoever is holding the gilts; and it is this stream of interest payments that ultimately limits the size of sustainable government debt.
But this does not mean that at the moment the country is in any sense bankrupt. Britain remains a large, vibrant capitalist economy with the ability to generate this sort of cash. Further, a substantial part of these interest payments will remain entirely within the UK’s borders. Pension funds are major purchasers of gilts, for example, so the interest they receive will simply be paid out to British pensioners. (True, when it comes to wealthy individuals holding gilts rather than institutions, this process does involve a marked redistribution of income towards the asset-rich sections of the community. Keynes thoroughly disapproved of such people who lived off rent and interest payments, and looked forward to a time that would bring the “euthanasia of the rentier”. But in this, at least, Keynes’s foresight deserted him.)
As such, when it comes to debt, an examination of international comparisons and of our ability to refinance and pay the interest seems to suggest that the government is being criticised unfairly. Much of the increase in debt does have a sound economic basis, as the inevitable consequence of a huge financial bailout.
The problem for the government, however, is that this huge expansion of debt has focused attention on the Prime Minister’s previous role as chancellor. When the economy was doing well, instead of repaying debt, Gordon Brown and his acolytes invented a bogus rule to justify continued public-sector deficits. Now the astonishing debt figures crystallise the feeling that Brown has been wasting money on a truly Soviet scale – and at a time when so many of us are hurting.
Paul Ormerod is the author of “Butterfly Economics” and “Why Most Things Fail” (£8.99), both published in paperback by Faber & Faber