Readers Question: What caused the massive decrease in the debt to GDP ratio for the UK following World War II?
It is a good question to ask. In the past few years, many European policy makers have felt that rising debt levels needed panic levels of austerity / spending cuts. But, that didn’t happen in the UK in the post war period.
UK national debt peaked in the late 1940s at over 230% of GDP. From the early 1950s to early 1990s, we see a consistent decrease in the debt to GDP ratio. Using the above measure of national debt, UK debt as a % of GDP reached a low of 32% in 1993. (1) At the start of the global credit crunch in 2007, public sector debt was 38% of GDP.
In the past eight years, debt has increased to 80% of GDP, but is beginning to stabilise.
The main reason UK debt to GDP fell in the post-war period was the sustained period of economic growth and near full employment until the late 1970s. This growth saw rising real incomes which in turn led to higher tax revenues and falling debt to GDP ratios.
There was also a positive inflation rate, which helped erode the real value of debt.
Higher government spending in post-war period
Firstly, debt to GDP was definitely not reduced through cutting government expenditure.
Note – Debt to GDP fell, despite higher real government spending on the newly formed welfare state and national health service. In fact government spending as a % of GDP rose from around 35% of GDP in the early 1950s to the high 40%s in the 1970s.
Source: OBR, Dec 2014
Why did UK debt to GDP fall?
- Economic growth averaging 2.5% +. Total real debt increased in this period, but GDP increased at a faster rate. Therefore, the debt to GDP ratio fell.
- Positive inflation.
- Patience. After early 1950s, debt to GDP fell over the next four decades. It took a long time to reduce debt to GDP.
- Relatively low budget deficits (though the UK very rarely had a budget surplus)
Post war economic boom
This graph shows UK real GDP. In 1955 it was less than £100,000 m (quarterly). By the early 1970s, real GDP had doubled in a relatively short period of time.
This graph also explains the sharp rise in debt as a % of GDP 2007-2013 – real GDP stagnated and stopped growing.
UK post-war inflation
Inflation helps reduce real value of debt. This occurred in 1970s. Though interest rates did rise in 70s to give some compensation to bond holders.
UK post-war budget deficit
What caused economic growth in the post war period?
- Global economic boom
The UK economy benefited from the period of rapid global economic growth, especially in Western Europe. In fact, in this period, UK growth lagged behind many of our Western European neighbours. But, overall the UK enjoyed a period of rapid growth in trade and economic growth. The global economic boom was helped by
- Recovery of Japan and Germany
- Low global inflation
- Increased free trade, with reduction of tariff barriers
- Relative political and economic stability
- Technological improvements, such as computers, better petrol engines. Some of these technological improvements were quite low-tech like containerisation,
UK growth was so rapid, we experienced labour shortages. This lead to the mass immigration of the 1950s and 60s to help deal with the labour market shortages. This helped increase the working population and increase real GDP. GDP per capita rose at a slower pace than actual real GDP.
3. Improved education
In the post-war period there was a growth in university education and secondary education became more comprehensive.
4. Effective demand management
One of the cornerstones of William Beveridge’s Welfare proposals was the assumption that a comprehensive welfare state required considerable efforts to achieve near full employment. The UK experienced boom and bust cycles, but the downturns were relatively minor and there were no real recessions of any significance until 1973.
In the post-war period, the government controlled monetary policy and fiscal policy, and had a willingness to cut interest rates during economic slowdowns. The benign global economic conditions helped give a low trade off between inflation and unemployment.
UK growth could have been higher
Many commentators state that although the UK did enjoy a post-war economic boom, it was actually a missed opportunity and our relative competitiveness declined. The UK had many failings such as
- Uncompetitive industry
- Poor industrial relations
- Lack of vocational training
- A degree of complacency – not felt in countries, such as Japan and Germany.
High tax rates
Another feature of the 1940s, 50s and 60s were very high tax rates. The Second World War created a political climate which tolerated extremely high income tax rates. The highest rate of income tax peaked in the Second World War at 99.25%. It was slightly reduced after the war and was around 90% through the 1950s and 60s.
In 1971 the top-rate of income tax on earned income was cut to 75%. Though a surcharge of 15% on investment income kept the top rate on that income at 90%. The top rate of income tax was cut to 40% in the late 1980s.
With income tax rates of 70% plus. Rising incomes will lead to significant increase in tax revenues for the government.
There was more effort to tax capital. In 1965, James Callaghan, the then chancellor introduced capital gains tax of 30pc to stop people avoiding income tax by switching their income into capital.
Tax revenue was regularly over 40% of GDP.
Inflation higher than interest rates?
Inflation played a role in helping to erode the real value of debt. In the post war period inflation was averaging 3-5% – with periods of near double digit inflation.
The 1940s and early 1950s saw periods where inflation was above Bank of England interest rates; there were also periods in the 1970s when some of the debt was reduced through the effects of inflation – to some extent a period of ‘inflating away the debt. However, in 1950s, and 1960s, real interest rates were positive. It wasn’t just a matter of inflating away the debt. (see blog on inflating away the debt?)
Despite the high levels of UK debt, the cost of servicing UK debt remained relatively low (less than 4% of GDP). This is a reflection of relatively low interest rates. It is also interesting to note the current cost of servicing national debt is lower than in the 50s, 60s, and 70s.
The fall in UK national debt as a % of GDP reflects one of an important issues regarding to debt reduction – take care of economic growth and unemployment and this will play a considerable role in reducing debt to GDP ratios.
The UK experience of the 1950s and 60s is in complete contrast to the current European experiment of sacrificing growth to meet deficit reduction targets – the result being often rising debt to GDP ratios in Europe.
However, it is worth bearing in mind, the post war period is often referred to as the ‘golden period of economic expansion’. The UK was helped by several factors which enabled it to borrow such a large amount. These factors included:
- High personal savings ratio
- Patriotic effect of buying ‘war bonds’
- Generous loan from the US which we took a long time to pay back.
- Rapid global growth which made debt reduction much easier.
In the current climate many of these factors are not there.
Burnt by the credit crunch, investors are possibly more sceptical about government debt (though that hasn’t stopped UK bond yields falling to near record levels)
The outlook for global growth looks less promising – especially with our main trading partners.
It is all very well saying all we need to do is to increase real incomes and boost economic growth, but in practise it might not be as easy as that.
Could the UK happily borrow 230% of GDP like in the late 1940s? – I don’t think so. But, when politicians tell you the only way to reduce debt is through painful austerity, you could remind them of the 1950s and 1960s when the opposite happened. The striking thing is the steady reduction in debt to GDP, whilst at the same time seeing real government spending levels rise.
Debt as % of GDP more important than budget deficit
One final point is that debt as % of GDP is a more important statistic than a budget deficit. Total debt reflects the long-term situation better than annual deficits which are influenced by cyclical factors.
(1) note there are different measures of government debt. But, whichever method you use, there is a broad decline in debt to GDP