D.Cameron has been making a case that the government debt poses a threat to recovery and it should be tackled with a high priority. He makes the following points.

High levels of government debt could cause the UK to lose its triple A rating status. A downgrade in  status would make it more difficult for the UK to borrow. It would increase the cost of borrowing and possibly force interest rates up. This would hamper a recovery.

Gordon Brown is making a case that the most important thing is an economic recovery. Tackling the budget deficit too early, could stamp out a recovery and push the UK back into recession.

Both are making valid points. It is a concern that UK debt is forecast to grow to 100% of GDP. When debt gets so large it could create problems of financial crowding out (higher interest rates) and possibly inflation, and depereciation of sterling.

However, in a fragile recovery, the last thing you want to do it is to be increasing taxes and cutting government spending, as this will reduce aggregate demand and push the economy back into recession.

Conclusion – So What Should We do?

Personally, I feel that:

The Dangers of borrowing in the short / medium term are often exaggerated. The bond market is not panicking at the level of government debt. Interest rates are bonds are still quite low (true, this has been helped by quantitative easing and purchase of gilts by Bank of England). But, this level of government borrowing is not unprecedented. Other countries have similar or worse, levels of debt. The UK has had much higher levels of debt in the past.

This does not mean borrowing is a good thing and it should not be tackled. Clearly this kind of debt level has to be reduced in the long term. Markets will need assurance that the debt is temporary.

But, I feel the immediate priority is an economy recovery. It is only through economic recovery that we will see a recovery in tax receipts and fall in unemployment (which will of course help reduce budget deficit).

I see little threat of inflation. But, if the economy does recover strongly, it makes sense to tighten fiscal policy (higher taxes) first before monetary policy (higher interest rates)

Related

• How much can government borrow?

Despite a few promising signs, the Bank of England’s overall view is still largely pessimistic. They state it could take several years for bank lending to get back to normal. Recent figures on unemployment also present a pretty depressing view, especially for young workers. The Office for National Statistics said that 722,000 people aged 18 to 24 were out of work – one in six

Given state of economy and absence of inflationary pressure, the Bank hinted interest rates could remain close to 0% well into 2010

More analysis on outlook for UK at my other blog – Economic forecasts for UK 2010

Latest Bank of England Inflation report

From figures published February 18th 2010, UK public sector net debt was £848.5 billion. (or 59.9% of National GDP) – Source: Office National Statistics [1]

Excluding Financial sector intervention, public sector debt is £743 billion or (52.7% per cent of GDP)

The PBR (annual government borrowing) forecast for 2009/10 is for net borrowing of £178 billion or 12.6% of GDP.

Graph Showing UK National Debt

National debt UK : ONS

After a period of financial restraint, National debt at a % of GDP fell to 29% of GDP by 2002. Then, national Debt as a % of GDP  increased from 30% in 2002 to 37 % in 2007. This was despite the long period of economic expansion. It was primarily due to the governments decision to increase spending on health and education. There has also been a marked rise in social security spending.

Since 2008, National Debt has increased sharply  because of:

• Economics Recession (lower tax receipts, higher spending on unemployment benefits)
• Financial bailout of Northern Rock, RBS and other banks.

Although 60% of GDP is alot it is worth bearing in mind, that other countries have a much bigger problem. Japan for example have a National debt of 194%, Italy is over 100%.  The US national debt is close to 71% of GDP. [See other countries Debt]. Also the UK has had much higher National Debt. e.g. after the second world war it was over 180% of GDP.

National Debt and Financial Bailout

The Nationalisation of Bradford & Bingley and Government purchase of shares in major banks like HBOS will cause even more borrowing. It is estimated National debt will could rise close to 100% of GDP by 2012

It is way above the government’s sustainable investment rule of 40% maximum. However, the debt is  different in the sense that the government has a reasonable chance of getting, at least, some of its money back. It is different to say borrowing to pay pensions.

What is the Real Level of UK National Debt?

However, it is argued that UK’s national debt is actually a lot higher. This is because national debt should include pension contributions and private finance initiatives PFI which the government are obliged to pay.

The Centre for Policy Studies (at end of 2008) argues that the real national debt is actually £1,340 billion, which is 103.5 per cent of GDP. This figure includes all the public sector pension liabilities such as pensions, and Private Finance Initiative contracts e.t.c (Northern Rock liabilities).

• However, these pension liabilities are not things the government are actually spending now. Therefore, there is no need to borrow for them yet. It is more of a guide to future public sector debt. I don’t accept the fact that future pension liabilities should be counted as public sector debt. In 2006, the Statistics Office did change calculations to include some PFI into public sector debt figures [pdf - Treasury.gov.uk]
• However, it is a sign that it will be difficult to improve finances in the future.

Another problem is that with the financial crisis, the government have added an extra £500bn of potential liabilities. Note: the Government has offered to back mortgage securities. They are unlikely to spend this money. But, in theory the government could be liable for extra debts of upto £500bn. If we include this bailout package as a contingent liability National debt would be well over 100% of GDP.

Forecast for National Debt

Source: HM Treasury – may prove to be overly optimistic

The Public Borrowing Requirement forecast for 2009/10 is net borrowing of £178 billion.

Problems of National Debt

1. Interest Payments. The cost of paying interest on the government’s debt is very high. In 2008 Debt interest payments will be £31 billion a year (est 2.5% of GDP). In 2009, they will be £35 billion (similar to defence budget). Public sector debt interest payments could be be the 4th highest department after social security, health and education.
2. Higher Taxes in the future.
3. Crowding out of private sector investment / spending
4. The debt problem will only get worse as an ageing population places greater strain on the UK’s pension liabilities. (demographic time bomb)
5. Negative impact on Exchange Rate (link)

See also:

• Should We worry about National Debt?
• US National Debt
• Books on Debt at Amazon.co.uk
• What went wrong with US economy?
• Problem of Personal Debt in the UK
• How is National Debt financed?
• Public Debt at the Office of national Statistics

History of National Debt

national debt as % of GDP: Source: no 10.gov.uk

National Debt since 1900

• Historical National debt

Defining Public Sector Debt

Simple Way:

• Government Deficit – annual shortfall between spending and tax receipts. The amount the government have to borrow from private sector in a certain year. (see also: PSNCR, PSBR, cumulative public sector current budget)
• Government Debt – The total amount the government owe to private sector (see: also, public sector net debt, national debt, GGGD). This is the accumulation of borrowing over many years.

_{Source: UK Government Debt and deficit ONS}

Debt as a % of GDP

• Debt can be expressed in nominal figures or as a % of GDP.
• in Jan 2009, UK public sector debt was £697bn which = 47.5% of GDP

More Definitions

• Public Sector Net Debt - Total Amount government (central, local and corporations) have borrowed from Private sector – liquid assets. Often referred to as National debt (e.g. in 2009, Public sector net debt was £697bn or 47.5% of GDP
• Public Sector Net Cash Requirement PSNCR – The amount governments need to borrow in a year to meet its shortfall of spending and tax receipts. (e.g. in 2008-09 government has a PSNCR of about £115bn) Often referred to as annual government deficit. Used to be called PSBR (Public sector borrowing requirement).
  - The PSNCR is similar to net borrowing and government borrowing

Debts Not Related to Government Debt

• Current account Balance of Payment deficit – Not related to public sector net deficit. current account deficit related to level of net imports
• External debt – Total amount that UK owes foreign countries. External debt includes government liabilities + private sector liabilities; it is not directly related to public sector debt.

More Detailed Definitions

Public Sector Net Debt – This is statistic most widely used for stating how much the public sector (central, local government and corporations) owe to the private sector.

• It is most public sector financial liabilities – liquid financial assets.
• The majority of public sector debt is financed through selling government securities and treasury bills. Most is held by UK private sector, some by foreigners)
• It is sometimes referred to as the National debt. However, strictly speaking this is not correct because National Debt was used for a much narrower definition (gross liabilities of the National Loans Fund.). Statistics for National debt are no longer produced
• Public Sector Net debt includes some imputed debt e.g. Private Finance Initiatives PFI. These are liabilities not legally held by government, but, in practise they will be liable.
• Some argue the public sector net debt should include more potential liabilities such as future pension requirements e.t.c. But, this is not counted in UK statistics or other countries.
• Public Sector Net Debt increased significantly with governments taking shares in major banks like Northern Rock and RBS. However, due to accounting rules the assets of RBS were not used to offset liabilities of RBS
• The ONS produce statistics for Public Sector Net Debt
• Current Public sector net Debt

PSNCR Public Sector Net Cash Requirement (used to be called PSBR)

The Public Sector Net Cash Requirement indicates the extent to which the public sector borrows from other sectors of the economy and overseas to finance the balance of expenditure and receipts arising from its various activities. The flows which count towards the PSNCR are measured on a cash basis (with a minor exception of interest on National Savings instruments).

source: statistics.gov.uk

Public Sector Net Borrowing

This is similar to public sector net debt but also takes into account capital expenditure. Public sector net cash requirement is particular to UK. Net borrowing is used internationally.

• Net borrowing refers to the countrys accruing net financial indebtedness. Net cash requirment is how much the government need to raise to meet the shortfall.
• Some capital expenditure may require higher cash requirement without changing net indebtedness

General Government Gross Debt (GGGD) used by EU. is similar to Public sector net debt but excludes net debt of corporations. Also does not offset liquid assets.

—————–

Even more detail

• For public sector net debt. The public sector is defined as central government, local government and public corporations.  The exception is the Bank of England, which has traditionally been excluded (either in whole or in part) from public sector finance statistics.

Definition of old National Debt statistics

• The National Debt is the most well-known and oldest measure of public debt.
  The term ‘national debt’ is still commonly used today, often when reference should actually be made to the Public Sector Net Debt measure.  This is because National Debt had a precise meaning, which is very different to PSND
• Data for the National Debt extend back to 1691.  For a large period of this time
• National Debt comprised the total gross liabilities of the Consolidated Fund.
• Since 1968 it comprises the gross liabilities of the National Loans Fund.
• National Debt has quite a narrow coverage, missing the non- central government parts of the public sector and not even being a comprehensive measure of centralgovernment debt.  It also includes liabilities to other parts of government (forexample the National Insurance Fund holds gilts as investments) whereas it is standard for debt measures to consolidate out intra-sector holdings.

Net Public Sector Debt (later renamed Public Sector Net debt )

• The calculation of NPSD started with the principle that this debt measure was
  the approximate stock equivalent of the PSBR.
• It differed from the National Accounts financial balance sheet concept of financial liabilities in that debt was measured at nominal value rather than their value in the market.  This was because it is the value that government will have to pay on maturity.  The market value is only important to the asset holder as a price at which they can sell the asset at that time.  As the redemption date approaches the market value should converge towards the nominal value.

Move away from Cash accounting to National Accounts framework
21. The PSBR was a cash concept unique to the UK, although it had similarities to an International Monetary Fund measure.  With the introduction of the new Public Finances framework in 1998, the PSBR played a less important role as the Government’s preferred measure moved away from the cash accounting basis and onto the accruals basis consistent with National Accounts framework. (net debt) The PSBR continued to be produced but was renamed the Public Sector Net Cash Requirement (PSNCR) to avoid confusion with the Public Sector Net Borrowing measure.  The PSNCR definition and measurement are the joint responsibility of ONS and HM Treasury.

General Government Gross Debt (GGGD)

The 1992 Maastricht Treaty on European Union obliged EU member states to avoid excessive government debt levels.  The Protocol on Excessive Deficit Procedure (EDP), an annex to the Treaty, defines this as 60 per cent of GDP.

The debt measure used is General Government Gross Debt (GGGD).  This differs from the UK fiscal measure, PSND, in two important respects.  The first is the sectoral boundary, being defined as General Government it excludes the net debt position of public corporations, which are included in the public sector. The second is that is measures gross liabilities and does not net off liquid assets.

Imputed debt in Public Sector Debt

• As noted earlier, PSND includes some imputed debt.  This usually occurs when
  government is considered the true economic owner of an asset or liability, even though it is not the legal owner of it, and an imputation is made to route the transaction via government.
• In 2001 it was decided that PSND should be updated to include imputed debt, in particular those liabilities associated with finance leasing that were part of the GGGD definition.  This moved the definition of PSND further away from being the stock equivalent of the PSNCR.  However, problems with deriving estimates for the level of the imputed debt has delayed the inclusion of finance lease liabilities in PSND until September 2006.  In August 2005 imputed debt associated with securitised bonds issued by London & Continental Railways was included in PSND.

Core Debt

- Excludes cyclical fluctuations

Source: Public sector accounting at statistics.gov.uk

public sector borrowing ONS

• List of Government debt by Country
• Should we worry about national debt
• US national debt
• Problem of national debt statistics

On the surface it appears that the bust has come without any preceeding boom. Though, the economy still displayed aspects of boom and bust. See: Bust without boom?

It has led to a war of words between the German finance minister and the UK. The German minister criticised the UK for crass Keynesianism. Yet, he should perhaps concentrate on Germanys problems – high levels of public debt and their own recession. See: Germany v UK Economy

The continued weakness of the Pound is a reflection that the UK economy has been hit hardest by the global downturn. The UK economy has been hit the hardest mainly because:

1. Housing boom and bust is most noticeable in the UK. The UK is seeing rapidly falling house prices and house prices are traditionally very influential in influencing the UK economy.
2. The UK derives a large portion of its economy from the finance sector and this has been badly affected by global credit crunch
3. Domestic saving is very low, so with onset of rising unemployment and low expectations people are seeking to boost their savings and reduce borrowings.

1. critically examine the effectiveness of monetary policy.

2. what factors do you think limit the effectiveness of monetary policy.

Previously, I have written an essay – what determines the effectiveness of monetary policy

In brief, the aim of monetary policy is to target low inflation (CPI = 2% +/-1). But, also to maintain a steady rate of economic growth. In recent months it has been difficult for the Bank of England to achieve both these objectives. This is because we have had cost push inflation (rising oil, food prices). The cost push inflation causes rising prices and falling economic growth. Therefore, even though inflation has increased to over 4%, the Bank don’t want to increase interest rates because the economy is already slowing down. Therefore, they have left interest rates the same and have been unable to keep inflation on target.

However, in period 1997-2007, monetary policy effectively kept economic growth and inflation stable. This was because cost push inflation was low and the independent Bank of England was successful in preventing growth exceeding the long run trend rate.

Was the Government right to widen the budget deficit 1974-5 in order to stimulate demand, or should it have run less expansionary policies to temper the effect of rising prices?

I’m afraid I don’t have access to many statistics from the 1970s, so it is hard to make much analysis. But basically, the government faced a twin problem of rising prices (mainly cost push) and falling demand. (Stagflation) By pursuing expansionary fiscal policy, they were attempting to maintain full employment ( a noble objective). However, it led to a rise in inflation and inflation expectations. Combined with powerful trades unions in the 1970s, this led to a sharp rise in inflation (25% by 1979). Arguably these rates of inflation were costly for the economy and led to an almost inevitable recession in 1980. see: recession 1980-81

Another factor to consider is how much expansionary fiscal policy actually helped boost economic growth and keep unemployment low. From a theoretical perspective, economists will certainly disagree about this. Monetarists, argue that such a fiscal expansion does very little to boost real GDP in the long run. They will argue that it mainly causes crowding out and rising inflation expectations. Keynesians however, argue that a fiscal expansion does help stimulate an economy, suffering from a downturn.

Was there any policies the Government could have enacted to try and reduce both the rate of inflation and unemployment simultaniously?

The main approach would have to have been through supply side policies. In particular,

• Reduce power of trades unions to help reduce wage push inflation and real wage unemployment.
• Privatisation to increase efficiency of state owned industries (although this would probably have cause  a temporary rise in unemployment)
• Ending state subsidies
• Education and training to help structurally unemployed workers move to new jobs.

Many of these supply side policies were introduced in the 1980s, with mixed results

• Supply side policies in the 1980s and 1990s
• Economic importance of supply side policies

Related Posts

Solution to stagflation

UK Inflation in the 1970s and 80s – the role of the output gap. Evidence monetary policy errors contributed to inflation in the 1970s

For a long time the UK economy has been bolstered by rising house prices and strong demand from the consumer. However, a series of very disappointing results on the high street suggest that consumer confidence has fallen significantly in the wake of rising living costs and falling house prices.

A full blown recession (negative economic growth) has yet to materialise, but, the signs are for a sharp slowdown.

The data will be of little comfort to the government (facing a record level of government debt – £60billion)

it will also be of little comfort to the MPC, who have to balance the twin problems of inflation and lower growth

• Is UK Heading towards recession?
• Business chiefs and Economists give their opinion at Telegraph

According to the Office of National Statistics for March 2008

• Retail Sales Volume Seasonally Adjusted (2000=100) increased to 140.3 an annual growth rate of 4.7%
• Manufacturing grew at only 0.9%
• Services grew at 3.2%

latest statistics at ONS

I have to admit I was a little surprised to see retail sales increase at 4.7%. Anyway it seems that retail sales and the service sector are still doing much better than manufacturing and production. These are some potential reasons.

Exchange Rate. Against the dollar, at least, the Pound has been strong. This makes our exports more expensive reducing demand. Manufacturing goods are often exported so would explain weakness of manufacturing sector. Imported goods become cheaper so may boost sales on the high street.

• However, the pound has been weak against the Euro, our main trading partner, so I doubt how important this factor is.

Interest rates. The Bank of England has cut interest rates to 5%. In theory this should boost spending because it makes borrowing cheaper. This would explain increased retail sales and services because consumers will have more spending power.

• However, the cuts in base rates have often not been passed on by banks. The credit crisis has led to a tightening of lending restrictions. This is why I was a little surprised to see retail sales growing so strongly.

Food Prices. According to the ONS food sales were the main driving force behind retail sales. Perhaps this reflects the rising price of food, especially bread and wheat. Demand for food is inelastic, therefore, as prices rise people just spend more on food. Therefore total food sales are increasing.

Graph of UK Retail Sales

I was interested in making a comparison between the UK and French economy. and wrote an Essay on The French vs UK Economy.

Generally speaking, most economists argue that the UK economy has performed  better than the French economy in recent years. However, you are right to suggest that the UK economy has relied to a large extent on consumer spending, driven by rising house prices. Arguably this growth has been unbalanced and if house prices fall significantly it will lead to lower growth in the UK and in the future, the situation could be reversed.

Is there a better way to do it?

I think it would be beneficial to reduce the impact of the housing market on the macro economy. Because many householders take out variable mortgages which are a high % of their disposable income, it makes the UK vulnerable to any swings in the Interest rates (and therefore a good reason for UK to avoid the Euro)

The government are trying to encourage longer fixed rate mortgages, but, it is not easy to change a culture of homeownership which is strongly embedded in the UK.

The UK has also suffered from the relative decline of its manufacturing export sector; but, it is not easy for the government to change this.

This question deserves more thought but these are some of the issues which spring to mind.