Impact of productivity and interest payments on debt

Readers question: In all the media coverage of the UK deficit / debt / recovery, two aspects are rarely highlighted / quantified / contextualized.

1. The £50bn interest payments on the debt (opportunity cost / %)
2. UK productivity (output per head / sector / history)

I think interest payments on debt are an important metric. The interesting thing is that they have been relatively stable as a % of GDP in the past few decades – and lower than say late 1970s.

It is not just how much you borrow, but also the cost of borrowing – and the % of national income (or tax revenues) that are used to pay the debt interest payments

For example, in a recession, when borrowing goes up – quite often bond yields fall. Bond yields fall because there is greater demand for saving and greater demand for buying government bonds, which are seen as a relatively safe investment.

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UK National Debt

The UK national debt is the total amount of money the British government owes to the private sector and other purchasers of UK gilts.

  • In Dec 2014, public sector net debt excluding public sector banks (PSND ex) was £1,483.3 billion (80.9% of GDP)
  • Source: [1. ONS public sector finances ] (page updated Feb 12th 2015)


Budget deficit – Annual Borrowing

This is the amount the government has to borrow per year.

  • In 2012/13 net borrowing was £115bn (7.4%) (Excluding Royal mail and transfers)
  • In 2013/14 net borrowing is forecast at £105.5bn or 6.5% of GDP (Excluding Royal Mail and transfers)
  • From April to December 2014, public sector net borrowing excluding public sector banks (PSNB ex) was £86.3 billion

UK Net borrowing


Latest statistics at OBR

Note this graph excludes sale of Royal Mail which temporarily reduced actual borrowing in 2012-13


Figures for 2013-14 onwards are forecasts.

View:  Latest statistics at OBR

Further reading on

Deficit down but Debt up?

One potential confusion is that politicians may say the budget deficit is coming down. But, at the same time, national debt is rising.

  • If annual borrowing falls from £80bn to £50bn, the annual deficit is lower. But, at the same time, the national debt (total debt) is still rising.

% of GDP

The most useful measure of national debt is to look at debt as a % of GDP. For example in 1950, UK national debt was £640bn (at 2005 prices) – but this was 250% of GDP.


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Greece could benefit from leaving the Euro?

Just a short post, inspired by this article by Hamish McRae in Independent – Would it Matter if Greece left the Euro?

So often governments have fought ‘tough and nail’ to stay in an exchange rate system. But, when they finally leave – it is the best thing they ever did, and you’re left thinking – if only they left earlier, it would have saved economic pain. For example:

We don’t really know what would happen if you left the Euro – it is uncharted territory. We can only speculate on potential outcomes. But, perhaps this makes us more conservative and highlight the dangers of leaving.

However, given the Euro has been such an unmitigated disaster for Greece.

  • GDP down from $340bn in 2009 to $240bn 2014.
  • Unemployment of 25%

Could it get any worse?

In the short-term, quite probably. But, is the short term pain not worth becoming masters of your own economic and political destiny?

Greece may lose out in the short term. But, in the long term it will enable them to have their own currency, own monetary policy and own fiscal policy. This should give better prospects of long-term prosperity and economic stability.

The cost of staying in

Suppose Greece does endure another decade of austerity and finally returns to normal growth. Is there any guarantee the crisis of 2007-2015 will not return, at some point? It is quite likely. There is an inbuilt deflationary bias in the Eurozone. The Greek economy is just very different to northern Europe. Future Greeks may be very grateful, if the bold step is taken now.

My main point is, Greece should take the decision for the next 50 years, not just the next 5 months.

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Is it a mistake to focus on inflation?

Readers question: should the government focus on achieving a particular macroeconomic objective over the others?

This is a good question. There is a lot that can be said because it encompasses so many different topics.

Firstly, the three main macro-economic objectives:

  • Higher economic growth
  • Low inflation
  • Low unemployment

There are also less important objectives

  • Reducing government borrowing
  • Satisfactory balance of payments
  • Stable exchange rate
  • Protecting the environment

In this post, I will just consider whether  inflation should be seen as the over-riding primary macro-economic objective

Many economists (and Central Bankers) have often stated that low inflation should be the primary macro-economic objective. They argue

  • Low inflation is essential to long term economic prosperity. If inflation is brought under control, then the stability will encourage firms to invest and consumers to spend.
  • If inflation is too high, then it may require lower growth and higher unemployment in the short term. But, this temporary fall in output is worth the long-term benefit of bringing inflation under control.
  • In the long-term there is no conflict – if you keep inflation low, then we will also see strong growth, low unemployment and more competitive exports (helping balance of payments.
  • For example, in 1980, the new Conservative government promised to tackle the high inflation of the 1970s – They used deflationary fiscal and deflationary monetary policy. Inflation did fall, but it caused a severe recession, unemployment rose to 3 million. (In 1981, 365 economists wrote a letter to the Times saying the government should change approach). But, Mrs Thatcher argued she had to stick to the course to rid the economy of inflation.
  • 10 years later, there was another similar experience when the Conservative government again raised interest rates to tackle inflation, leading to another recession. In 1991, the chancellor Norman Lamont wrote

“Rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying.”

– Norman Lamont, Chancellor of the Exchequer. 16th May, 1991 (Hansard) (Unemployment a price worth paying for low inflation)

ECB and their objectives

More controversially, since the credit crisis of 2008, the ECB have appeared to have an over-riding objective to keep inflation low – even though economic growth in Europe has been poor. To many it seems the ECB have been too concerned about low inflation, and have been ignoring other macro-economic objectives, such as economic growth and unemployment. This explains the reluctance of the ECB to pursue quantitative easing (until very recently). It explains why growth in Europe has stalled, and unemployment has increased to 12% – double the rate of the UK and US.

Low inflation as a false goal


In this particular circumstance it is arguably a mistake to give undue importance to inflation. Europe desperately needs higher growth, and higher inflation to help

  • Reduce unemployment
  • Avoid the threat of deflation
  • Reduce real debt burdens through increasing cyclical tax revenues
  • Higher inflation would also enable southern Europe countries in the Euro to restore competitiveness without prolonged deflation.

Some economists argue that in the current circumstance of a liquidity trap and stagnant economy, we actually need a higher inflation rate to help improve growth.

Macro-economic objectives depend on the circumstances

There are times, when low inflation could be a desirable goal. If growth is too fast and unsustainable, then using monetary policy to reduce inflation and stabilise the rate of inflation can help to prevent an unnecessary boom and bust.

Low inflation is generally desirable. There are many good reasons to target low inflation in the long term.

However, it is also a mistake to target low inflation and ignore other objectives, which are potentially more important. Arguably the social and political costs of mass unemployment are much greater than a moderate inflation rates. Also, moderate inflation (4-10%) is not good, but also reasonably easy to reduce. The costs of deflation are much higher, and possibly much more difficult to solve.



Macro Economic Objectives + Conflicts

A look at the possible conflicts between different macro-economic objectives.

The main macro economic objectives are:

  1. Positive and sustainable economic growth (UK, long run trend rate is around 2.5%)
  2. Low inflation (UK target 2% +/-1)
  3. Low unemployment / Full employment (e.g. around 3%)
  4. Satisfactory current account on balance of payments (i.e. avoid big current account deficit)
  5. Low government borrowing
  6. Exchange rate stability

You could also consider:

  1. Issues of equity
  2. Environmental factors (long run environmental sustainability)

Economic Growth vs Inflation

The main conflict can come between economic growth and inflation (which leads to a similar conflict between unemployment and inflation). When the economy expands it is more likely that inflationary pressures will increase. Inflation is particularly likely to occur when growth is above the long run trend rate, and AD increases faster than AS.

Inflationary growth


For example, in the late 1980s during the Lawson boom, the UK experienced a high rate of economic growth (4-5% a year). This growth rate was above the long run trend rate of growth and this caused inflationary pressure. When the economy is growing very quickly, firms have difficulty employing sufficient skilled labour; this can lead to wage inflation which leads to higher prices. Also if growth is very quick, there may be supply constraints pushing up commodity price increases.  This economic boom of the 1980s proved unsustainable and ultimately led to the recession in 1991 (as the government increased interest rates to try and control inflation.

The excessive economic growth of 1986-1989 led to inflation increasing to 10%. It required interest rates of 12% and the recession of 1991/92 to bring inflation under control.

However, it is possible to have economic growth without causing inflation. If growth is sustainable – if it is close to the long run trend rate, then LRAS will increase at the same rate as AD, and therefore, we will not see inflation.

Low inflationary growth

In the UK from 1993-2007, we had our longest period of economic expansion on record. The economic growth did not cause inflation. This is sometimes know as the great moderation.


The UK great moderation from 1992 to 2008 – low inflation, positive economic growth.

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Impact of deflationary fiscal policy in UK

A report by NIESR suggests that austerity pursued by the government in 2010, needlessly led to a delayed economic recovery and could have cost the UK 5% of GDP or £1,500 per person.


The austerity was unnecessary because

  • The lower growth led to delayed rises in tax increases and
  • Interest rates were at 0%, and demand for government bonds high.
  • By delaying budgetary changes until the recovery was stronger, the government could have avoided a double dip downturn and still be able to reduce debt to GDP in the long term.

The impact of the deflationary fiscal policy could have been worse if:

  • The government had stuck to its initial austerity targets for cutting spending even more over the first Parliament
  • If the Bank of England had not used monetary policy to offset the decline in aggregate demand.


“The delay in the UK recovery over the first part of the coalition government’s term is at least in part a result of the government’s fiscal decisions. I have argued that these decisions were a mistake… It will be many years before we can settle on a figure for the total cost of that mistake, but measured against the scale of how much governments can influence the welfare of its citizens in peace time, it is likely to be a large cost.”

Professor Simon Wren-Lewis NIESR

Impact of discretionary fiscal policy

Implied discretionary fiscal change

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Deflationary Bias in the Eurozone

Readers Question: Is there an inbuilt deflationary bias in the Eurozone?

Note: I originally wrote this post in 2010. Unfortunately, every year there is a reason to update the post and suggest the deflationary bias in the Eurozone keeps getting stronger.


Deflationary bias means that there is a tendency for economic policy to promote lower growth and lower inflation. It means there are pressures which keep demand subdued leading to lower inflation, higher unemployment and lower growth. Now, we are seeing outright deflation (fall in prices)

I agree that there is a deflationary bias in the Eurozone. This is proved by the long period of low economic growth (2007-15) and an inflation rate that is remaining well below target. Headline inflation in the Eurozone has fallen to -0.2% (Outright deflation, though core inflation, is still 0.7%). Growth is anaemic and unemployment well into double figures (11%) – Unemployment is higher in Europe than many other countries.

European Unemployment Eurozone vs Non-Eurozone economies


Source: Eurostat

Although core inflation is still positive. Many countries on the periphery are experiencing a real threat of prolonged deflation.

What explains the deflationary bias of the Eurozone?

Low Inflation Target

The ECB have very strong attachment to keep inflation less than the target of 2%. For example, in 2011, temporary cost-push inflation, led to an increase in the EU headline inflation rate. The ECB responded by increasing interest rates. The Bank of England responded by keeping interest rates at 0.5% (even though inflation was much higher in the UK than EU). The Bank of England argued it was important to give importance to wider economic issues of growth and unemployment. The ECB were much less willing to accept, even a temporary deviation from the inflation target over fears temporary inflation would increase inflation expectations. It showed the ECB are much more willing to risk lower growth than risk higher inflation. (see also: ECB v Bank of England)

Whilst the ECB have an inflation target, they have no explicit target for unemployment or economic growth. EU Unemployment has risen to 12%, but there has been little action to increase aggregate demand.

The ECB have worried than any unconventional monetary policy may reduce their credibility and long-term ability to tackle inflation.

Reluctance to pursue unconventional monetary policy

Despite a prolonged period of low inflation, the ECB have been very reluctant to actually implement unconventional monetary policy  (e.g. Quantitative easing). It took outright deflation to finally push the ECB into proper Q.E, in Jan 2015.

The ECB is reluctant to engage in any quantitative easing because

  • They are reluctant to create any possibility of future inflation, printing money is an anathema to German Central Bankers, who wield considerable influence over ECB monetary policy.
  • The ECB has a reluctance to start buying bonds of different countries, deciding which to buy; and there have been constitutional excuses for not printing money.

The result is that countries with many deflationary pressures (strong exchange rate, fiscal austerity) don’t have any monetary stimulus to offset the fall in demand. (e.g. UK can pursue quantitative easing when we experienced deep recession). Countries in Eurozone can not.

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Policies to solve deflation / low inflation

Deflation means a fall in prices (a negative inflation rate). Policy makers should generally be concerned if there is an inflation rate of less than the target of 2%.

For example, in the Eurozone  Jan 2015, the headline inflation rate is -0.2%. Even if we strip away volatile prices like oil, core inflation is 0.8%. This is a very low rate of inflation.

There are many serious potential problems of low inflation / deflation

  • Higher debt burdens,
  • Decline in spending,
  • Higher unemployment.

See costs of deflation for more detail.

 What options are available to overcome deflation?

Monetary policy

The traditional tool of monetary policy is interest rates. If inflation is too low, the Central Bank can try to cut interest rates. In theory, this should boost spending and aggregate demand. For example, lower rates reduce cost of mortgage payments, giving people more to spend.


A simple theory to increase inflation – cut interest rates, boost AD and increase the PL


However, there are times when cutting interest rates are not sufficient. In a liquidity trap – zero interest rates may not encourage sufficient spending. For example, after the credit crunch – lower interest rates failed to boost demand sufficiently. Lower interest rates failed to solve low inflation for many reasons:

  • People preferred to save,
  • People took opportunity to pay off debts
  • Banks didn’t want to lend, so firms couldn’t get loans despite low rates
  • Banks didn’t pass the full base rate cut onto consumers.

Unconventional monetary policy

With a failure of interest rates, the traditional tool of monetary policy, Central Banks have need to consider unconventional monetary policy. Some of these policies are relatively untried.

Helicopter drop – print money

In theory, creating inflation should be the easiest thing – just print money and according to the quantity theory of money – we should get inflation. A particular policy for printing money is termed the ‘helicopter drop’ – where the Central Bank gives newly created money to consumers directly. Central Banks have been reluctant to pursue this strategy, presumably because it goes against the mentality of serious Central Bankers and their inflation fighting credentials. But, it would be a solution to deflation. The most challenging aspect would be knowing about much money to print, to get the right amount of inflation.

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Greece austerity

Greece is a very good example of the damage of austerity can do to both economies and the social fabric of a country. Firstly Greek austerity is almost unprecedented in its scope and intensity.

Greece government spending and revenue

greece austerity

Source: Statista

Greek government spending was cut from €120 bn in 2008 to €90 bn in 2014.

To put that into context – the UK years of ‘austerity’ have seen government spending rise from to £522bn in 2007/08 to £722 bn in 2013/14 (UK government spending)

To cut government spending by 25% in nominal terms is quite rare. In addition, the Greek economy was also saddled with other difficulties which have contributed to lower economic growth.

  • Due to higher inflation rates, Greece experienced a decline in competitiveness . Because it was in the Euro it couldn’t devalue and this led to a large current account deficit – lower exports and reduced domestic demand.
  • No control over monetary policy. The ECB increased interest rates in 2011, and have, until very recently, rejected any form of quantitative easing to help boost domestic demand in southern Europe.

Cost of Austerity

The cost of this austerity has been enormous in terms of economics, social and political upheaval.


Source: wikipedia

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Reasons for net migration into the UK

The latest stats for UK net migration show an annual net migration of 260,000 (June 2014). This is roughly split between EU and non-EU migrants

  • 142,000 from EU
    • 44,000 of the EU are from the EU8 (most recent EU countries – Poland, Hungary, the Czech Republic, Slovenia, Slovakia, Estonia, Lithuania, and Latvia)
  • 168,000 from non-EU (of which Commonwealth countries account for 62,000)

Reasons-for-migration-uk – ONS Migration study Nov. 2014

  • According to data by the ONS, the biggest reason for net migration into the UK is to pursue education studies. This accounts for 153,000 out of the net migration of 260,000 (Nov. 2014)
  • The second biggest reason is work related 61,000 – of which this is split into 41,000 definite job and 24,000 looking for work.
  • The third biggest reason is to join family already living in UK – 54,000
  • Other reasons 13,000 includes vague responses, such as ‘coming back to live’

Asylum seekers

  • Asylum applications (excluding dependants) rose from 4,256 in 1987 to a peak of 84,130 in 2002, and then declined to 23,507 in 2013. (Migration observatory)
  • In 2012, asylum seekers accounted for 10% of net migration
  • In 2013, the rate of asylum seekers in the UK as 0.47 asylum applicants per 1000 people The European level is 0.91 per 1000.

Reasons for migration depend on country of origin


  • For recent arrivals (2007-11) study is one of main reasons for migration.
  • Employment and unemployment rates for UK citizens and EU migrants are very similar.

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