The truth about debt

Readers Question: You have partially explained the answer to my question in your reply to my other question, “What will we do when we can’t pay back the money owing to the government bond holders when they reach the end if their term”. While I appreciate the convenient use of the debt to GDP ratio I feel that it tends to sidestep the truth about the remaining debt. This is almost like the government using the reduction in the deficit rather than the reality of remaining, possibly increasing debt.

For some reason, the first thing that comes into my mind is the famous quote from Dr Strangelove – “how I learned to stop worrying and love the bomb (debt)”

I guess we can blame Charles Dickens and Wilkins Micawber from David Copperfield.

“Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”

No matter how much you talk about government debt, people won’t feel comfortable until we have a zero budget deficit and zero government debt. –  (even though, I don’t think any modern economy has ever had such a situation – nor would one be particularly desirable.) Many issues are addressed here: The political appeal of austerity.

What does debt cost?

Another way of thinking about government debt is the annual cost of servicing the debt. What percentage of GDP is spent on debt interest payments? What percentage of tax revenues is spent on servicing the debt? You could have an increase in the real value of debt, but a smaller percentage spent on paying interest on the debt. Would you worry about a mortgage – if every year the monthly mortgage payments were becoming a smaller percentage of your disposable income?


The cost of servicing UK debt has risen in the past few years, due to rise in debt. But, by historical standards, it is still quite low and certainly quite manageable. More on Cost of borrowing

Of course, the cost of debt interest payments also depend on interest rates. A rise in interest rates will cause higher borrowing costs. But, with low interest rates predicted, we are unlikely to see a jump in borrowing costs – at least in the medium term.

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The false goal of a balanced budget

The German economy has been one of the world’s strongest economies in the post-war period. There are many aspects of the German economy which deserve praise and emulation – not least strong productivity growth, a booming export sector and prolonged low inflationary growth. In the post-war period Germany has played an important role in promoting economic stability and prosperity within Europe.

But, in recent years, the German economy has seen several cracks appear and German economic thinking is now causing a major drag on Eurozone economic growth and prosperity.

The false goal of a balanced budget

An very important issue in German politics is the desirability of seeing a balanced budget (government spending = government tax revenue). Many German finance ministers have made balancing the budget their primary economic objective. In the UK and US, we see that austerity has a strong political appeal – but in Germany the appeal of ‘responsibility’ and avoiding debt is perhaps even greater. A German friend told me that there is a certain guilt attached to the idea of holding on to debt. (though this guilt is especially felt with government debt – mortgages and business loans are somehow different)


On the objective of reducing budget deficits Germany has been successful. It is also keen to enforce EU rules and the idea of encouraging a balanced budget for its struggling European neighbours.

Angela Merkel recently stated to the EU Parliament, that EU rules must be met:

“All, and I stress again all, member states must respect in full the rules of the strengthened stability and growth pact,” she said. “These rules must be applied credibly to all member states — only then can the pact fulfill as a central anchor for stability and above all for confidence in the eurozone.” (US Today)

Although, Merkel did not name France, the implication was that France must do more to meet the EU Stability and growth pact.

Why is a balanced budget a false goal?

1. Lack of investment

A successful business does not have its objective to borrow nothing. A successful business knows that it needs to invest to make progress and retain its prosperity. Years of cutting government spending has meant that Germany has cut back substantially on public sector investment. There are widespread reports that Germany has a lack of investment in roads, bridges and other forms of transport. There is a fear that important infrastructure, such as roads and bridges are reaching the end of their 70 year cycle, but there is no money to successfully replace them. The economic problem is growing congestion, time wasted and damage to the long term productive capacity of the economy. The Guardian notes

Its (German) investment rate in 2013 was the fourth lowest in the EU; only Austria, Spain and Portugal spent less. Fratzscher, who is head of the German Institute for Economic Research, calculates there is an “investment gap” of €80bn (£63bn).

The Economist reports that German public sector investment is —a paltry 1.6% of GDP— one of lowest in Europe and has fallen since 2009. Continue Reading →


The need for a higher inflation target in the EU

The ECB inflation target is 2% – ‘it aims to maintain inflation rates below, but close to, 2% over the medium term. ‘

However, some economists argue that in the current situation, the ECB should have a higher inflation target of 3-4%.

The main reason for having a higher inflation rate would be to prioritise economic growth and help to reduce unemployment. Higher inflation would also help to contain and reduce government debt to GDP ratios – without excessive austerity.

Having a higher inflation rate will be resisted by many other economists and Central Bankers who believe that allowing higher inflation will lead to costs of uncertainty, lower investment and greater instability in the long-term. (see: costs of inflation) Also, some doubt whether higher inflation will actually help real economic growth.

EU inflation

EU inflation

EU inflation – St Louis Fed


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Inflation target during deflation

Readers Question: How does inflation targeting operate when there is a deflation? and what are the problems associated with this?

It’s a good question to ask at the moment, especially with regard to the ECB and Eurozone.

Firstly, the EU inflation target is – below but close to 2%. If inflation falls below 2%, the Central Bank should pursue a loosening of monetary policy – lower interest rates (if possible), quantitative easing and allowing the exchange rate to fall.

The ECB state

By referring to “an increase in the HICP of below 2%” the definition makes clear that not only inflation above 2% but also deflation (i.e. price level declines) is inconsistent with price stability.

Basically, the ECB target is 2%

The UK has an inflation target of CPI 2% +/-1 (i.e an inflation rate of 1-3%)

If inflation falls below the target then this is a problem and Central Banks should be committed to solving it.

How to increase the inflation rate?

If inflation is falling below 1% – or even forecast to be falling below 1% a Central Bank should intervene. There are several things it can try and do.

1. Reduce interest rates. Lower interest rates make borrowing cheaper and should help to stimulate demand. However, for the UK and the EU, interest rates are already at zero. Therefore, interest rates are not an effective tool for fighting deflation.

The ECB themselves mention a problem of deflation

“Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation.” (ECB Price stability)

2. Quantitative easing. – Money creation. In the UK and US, the Central Banks have electronically created money to purchase bonds and gilts. This has increased the monetary base and in theory increased the money supply in the economy. The effect of Q.E. is hard to quantify but it does seem that the economic recovery in UK and US has been stronger – with a higher inflation rate than Europe – Europe is reluctant to pursue Quantitative easing and as a result is seeing its inflation rate fall close to 0%.

The problem Europe has is that many (especially in Germany) have an almost irrational fear of creating money. Any policy of Q.E. could see itself challenged in European courts. It is also more difficult when you have a common currency area of many countries, whose bonds do you buy?

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Problems of Deflation

  • Deflation is defined as a fall in the general price level. It is a negative rate of inflation.
  • It means the value of money increases rather than decreases.
  • Deflation is not necessarily bad, but often periods of deflation / low inflation can lead to economic stagnation and periods of high unemployment. This is because deflation can discourage spending because things will be cheaper in the future. Deflation can also increase real debt burdens – reducing the spending power of firms and consumers.


In the twentieth century, periods of deflation have been relatively rare. Generally, western economies have experienced inflation. The most significant period of deflation for the UK was in the 1920s and 1930s. These decades (especially, the 1930s) were characterised by economic depression. Prolonged deflation is often considered to be very damaging as it can exacerbate an economic downturn leading to higher unemployment.

Problems of Deflation

  1. Discourages consumer spending. When there are falling prices, this often encourages people to delay purchases because they will be cheaper in the future. In particular, it can discourage consumers from buying luxury goods / non-essential items, e.g. flatscreen TV) because you could save money by waiting for it to be cheaper. Therefore, periods of deflation often lead to lower consumer spending and lower economic growth; (this in turn creates more deflationary pressure in the economy. Certainly this fall in consumer spending was a feature of the Japanese experience of deflation (Japanese financial crisis).
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Impact of falling oil prices

In recent months the price of crude oil has fallen 30%. This fall in the price of oil has a significant impact in reducing transport and other business costs. Falling oil prices is good news for oil importers, such as Western Europe, China, India and Japan; however, it is bad news for oil exporters, such as Venezuela, Kuwait, Iraq and Nigeria.


Impact on oil consumers

Lower oil prices help to reduce the cost of living. Oil related transport costs will directly fall, leading to lower cost of living and a lower inflation rate. Falling oil prices is one reason behind the recent fall in UK inflation to 1.2%

With stagnant real wages, this fall in the cost of living is important for giving Western consumers more discretionary income (more income to spend). A fall in oil prices is effectively like a free tax cut. In theory, the fall in oil prices could lead to higher spending on other goods and services and add to real GDP.

Macro economic impact of falling oil prices

  1. Lower inflation
  2. Higher output


This diagram shows that a fall in oil prices (and a fall in firms costs) will shift Short Run Aggregate Supply (SRAS) to the right, causing lower inflation and higher real GDP. (Some economists say a 10% fall in oil prices leads to a 0.1% increase in GDP (BBC article on falling oil prices)

3. Balance of payments

Oil importers will benefit from a falling oil price because the value of their oil imports will drop. This will reduce the current account deficit of oil importers; this is important for a country like India who imports 75% of oil consumption and currently has a large current account deficit. However, for oil exporters, a falling oil price will do the opposite reducing the value of their exports and causing lower trade surplus. The UK is currently a small net importer of oil, so will have limited impact on UK current account.

Oil Exporters

For oil exporters a falling oil price is bad news. Many oil exporting countries rely on tax revenue from oil production to fund government spending. For example, Russia gains 70% of all tax revenues from oil and gas. Falling oil prices will lead to a government budget deficit, and will require either higher taxes or government spending cuts. Other oil exporters like Venezuela are relying on oil revenues to fund generous social spending. A fall in oil prices could lead to a significant budget deficit and social problems.

Other oil exporters, such as Saudi Arabia and UAE have built up substantial foreign currency reserves; they can afford temporary falls in oil prices because they have substantial reserves. This is why Saudi Arabia has so far not responded by cutting output.

Why falling oil prices is not enough for Europe

Usually falling oil prices would be welcomed by oil importing countries. However, many are deeply fearful about prospects for the European and global economy.

Firstly, the fall in oil prices is largely a reflection of weak global demand. Continued low growth around the world, is holding back demand. Thus the falling price of oil is a reflection of weak global growth – rather than the harbinger of economic recovery.


Deflation nightmare. The biggest fear in Europe at the moment is the slide towards deflation and the fear of a ‘Japan style’ lost decade. EU inflation has fallen to a five year low (0.4% in August 2014) 31% of Eurozone goods are now falling in price. This is a concern because deflation tends to cause serious macro-economic problems: Continue Reading →


What happens when the government runs out of money?

Readers Question: Since the debt is mainly in the form of government bonds or gilts then it can only be paid back when the term of the bond terminates. What happens if there is not enough money to pay this back?


Government bonds are a method for the government to borrow money. They sell bonds (e.g. for £1,000) and promise to pay back the bond holder in say 30 years. In the meantime, they will pay an interest rate of e.g. 5% a year as compensation.

Default on debt. If the government has no money to pay bond holders, then it will be defaulting on its debt. Bond holders lose their investment.

The government will be reluctant to do this because once it has started to default on its debt – no-one will want to buy or hold government bonds – so you will see the price of government bonds fall, and the market interest rate rise. The government will have to pay much higher interest rates to compensate for the risk of default and it will be difficult to attract buyers of bonds in the future.

Haircut / partial default. If the government is in great financial difficulty it may offer a deal to bond holders that it will pay back a certain percentage, e.g. 50%. In response for writing off 50% of the bond, bondholders may feel it is better to get 50% than nothing. Alternatively, the government may extend the maturity of the bond, e.g. change a 30 year bond into a 45 year bond, to give itself more time to pay it back.
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The price of petrol and tax levels in UK

The UK has one of the highest tax rates on petrol / diesel in Europe – roughly 60% of the final price of petrol goes to the government in excise duty or VAT.

  • UK fuel duty is currently 58p per litre for petrol and diesel
  • VAT accounts for 20-25p per litre
  • The product cost is around 50p per litre
  • firms profit margins is often as low as 5p per litre – even lower for supermarkets, who use petrol as a type of ‘loss leader’ to entice shoppers into the supermarket to spend on groceries.

Between 1993 and 1999, fuel duty rose at 3% above inflation, causing an increase in the price of petrol. However, in 2011, the chancellor introduced a fuel duty stabiliser with a pledge to pledge to keep rates down.


Source: Fuel duty UK

However, there are economic arguments to suggest that breaking the fuel duty escalator is a mistake. With falling inflation, falling oil prices and rising congestion levels – higher petrol tax could help improve struggling government tax revenues and also contribute to a better environment and lower congestion levels.

Arguments for higher tax on petrol

Environmental costs of petrol. Using petrol causes carbon dioxide (CO2 emissions which contribute to global warming. But, also burning petrol / diesel creates other compounds  toxic to life. For example carbon monoxide and methanol. Also, fine particulates of soot cause from car exhausts cause lung problems and are carcinogenic. Air quality standards in cities would be improved by reducing petrol and diesel consumption. Higher tax would act as an incentive to reduce the pollution caused by driving petrol/ diesel cars (See: tax on negative externality for more on the economics of taxing these negative externalities)

Costs of congestion. Cheaper petrol will cause increased congestion levels. Time wasted in traffic jams is a major individual cost and also cost for business. Without increasing the price of petrol, there will be a rise in the social cost of traffic congestion. The CBI estimate that congestion costs the UK economy £8bn a year. Given the limited scope for increasing the road network in many areas, pricing will have to pay a role – otherwise, we will pay for cheap petrol in other ways.

Improved fuel efficiency and falling tax revenue. One of the benefits of increasing petrol duty in the past has been to increase the incentive for manufacturers and consumers to choose more fuel efficient cars. The consequence is that although petrol tax has risen, the total amount of fuel duty we actually pay is falling – because we are using less fuel. This means government tax revenue from petrol tax is falling. In 2012, the government could expect £38bn from fuel duty and VED. (Link) But, by 2029, this tax revenue could be £13bn lower.

A study by the Institute for Fiscal Studies (IFS) has stated the government face a significant fall in tax revenue from fuel duty and vehicle excise duty (VED). They state that revenue will fall from the current levels of 1.7pc and 0.4pc of GDP respectively, to 1.1pc and 0.1pc by 2029 – in its report Fuel for Thought, commissioned by the RAC Foundation.

Given the poor performance of UK tax revenues in recent years, increasing petrol tax would help meet this deficit. Also, higher petrol tax would further increase the incentive for greater fuel efficiency.

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Attempting to reduce debt after First World War

In the recent blog – Post-war economic boom and reduction in debt, we saw how the UK successfully reduced national debt as a % of GDP from 230% of GDP to 30% of GDP, over a period of 40 years.

However, the story after the First World War was very different. The UK finished the First World War with similar levels of debt. However, attempts to reduce the debt burden were largely unsuccessful.

UK debt 1920s

After the war, debt continued to rise to 180% of GDP in 1923. However, debt as a percentage of GDP barely fell to 160% in the late 1920s, before a slight rise at the start of the great depression.

However, this continued high level of national debt occurred despite years of austerity and attempting to balance the budget.

1913-38-UK budget-deficit

The primary budget deficit excludes interest payments on the debt. Even including interest payments (Public sector net lending) the UK ran a balanced budget  until the late 1930s.

Yet, this balanced budget did nothing to reduce the overall debt burden.

In the early 1920s, we see a sharp change in the budget. The government pursued a tightening of fiscal policy – spending cuts and tax rises to try and balance the budget.

A failed economy

real gdp 1920s

The UK economic performance of the 1920s was very poor. The post-war recession was very deep, and it took several years of slow growth to recapture the lost output.

The poor economic performance of the UK was due to several factors

1. Fiscal austerity and the highly contractionary budgets of the early 1990s

2. Relatively high real interest rates

real interest rates

With a period of deflation in early 1920s, the real interest rate become very high – good for savers but highly damaging for those with debt.

3. Return to gold standard and an overvalued exchange rate which led to expensive exports and a decline in competitiveness.

Conclusion and parallel with Europe

The 1920s were a lost decade for the UK economy. Despite the ‘Treasury view‘ dominating about the need to balance the budget, we never saw a reduction in the debt to GDP ratio from the very high level. The problem was that fiscal austerity was combined with:

  • Tight monetary policy – high interest rates
  • Deflation – falling prices causing lower aggregate demand
  • Overvalued exchange rate, leading to a fall in exports.

If you want to reduce the ratio of debt to GDP, the UK economy in the 1920s is a perfect model of how NOT to do it.

The problem is that the UK economy in the 1920s has many parallels to the current European economy.

  • Europe is pursing fiscal austerity but is seeing a fall in real GDP
  • Inflation is dangerously low and close to deflation
  • Many Eurozone countries are still facing an overvalued exchange rate
  • Monetary policy is relatively tight, with the ECB still reluctant to offer a significant loosening of monetary policy. (see: deflationary bias of the Eurozone)



National debt – mortgage comparison

Readers Question. You make the point that the debt to GDP fell in the post war period since the GDP rose faster than the debt but that still left the debt to be repaid and as such there was still the interest to be paid. I was expecting you to explain how the current debt could be eliminated. It is so large that I can’t see how it can be done. Talks of reducing the deficit pale into insignificance in the light of reducing the total debt.

The point is the debt burden was steadily reduced over a period of 40 years. It was becoming a smaller share of national income. That’s how we will pay off the current debt – steadily over the next 30 or 40 years. There is no necessity to completely pay off the debt.

National debt – mortgage comparison

People who struggle with the idea of government debt probably think nothing of taking out a mortgage of up to 400% of their annual income. With a mortgage you pay back your debt over a period of 40 years – and you could continue to roll the mortgage over for a longer period if you wanted.

Suppose you take out a mortgage for £100,000 and have a monthly repayment of £500.

If your income is £2,000 a month – 25% of your monthly pay goes on ‘servicing’ your mortgage debt.

If your income increases to £4,000 a month, then cost of servicing your debt falls to just 12.5% of your monthly income. Therefore rising income is making it relatively easier to pay for your mortgage.

You don’t have to worry about paying off your mortgage all at once. The crucial thing is can you afford the mortgage payments? If your income fell to £1,000, then your debt becomes a real problem because 50% of your income has to go on paying your debt.

There is nothing ‘immoral’ about taking out a mortgage. Similarly there is nothing ‘immoral’ about government borrowing. Government borrowing can be beneficial, e.g. borrowing at 1% to finance public sector investment which gives a rate of return of 10% a year. – In that case society is benefiting from government borrowing.

Cost of servicing debt

A key issue is what % of GDP / % of tax revenues goes on servicing debt


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