Tag Archives | debt

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?

uk-debt-interest-payments

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)

changes-budget-deficit-08-15

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 →

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Budget deficit targets

Politicians are often keen on making targets to eliminate budget deficits by a certain year. There is a strong political motivation to be seen as strong and committed to reducing government debt. Politicians who are vague about the debt are often heavily criticised and it is seen as poor politics. An advantage of budget deficit targets is that it ensure politicians have a stronger commitment to make politically difficult choices – raising taxes or cutting spending.

However, from an economic perspective targets for reducing budget deficits are not always as helpful as they may seem.

Benefits of budget deficit targets

There can be many sound economic reasons for reducing government borrowing. Just because a government can borrow, doesn’t mean it is desirable to.

  • It can prevent politicians choosing politically popular policies, such as tax cuts and spending increases. A deficit target can help prevent politicians putting off making difficult choices.
  • Without deficit reduction targets, some economists fear that there is an incentive to keep increasing the size of government spending, which crowds out more efficient private sector spending.
  • It can reassure markets that the government have a ‘responsible attitude to debt’ and are less likely to rely on printing money to finance the deficit and rely on inflation to inflate away the debt – which can reduce the real value of government bonds.
  • In some cases reducing the budget deficit can help lower bond yields because – with lower debt available on the market there is downward pressure on bond yields.
  • Some argue that budget deficit reduction gives consumers more to spend and firms to invest because the private sector have more confidence when the government is reducing its debt and is acting in a ‘responsible manner’. Others criticise this as being wishful thinking (see: Confidence fairy)

Problems of a budget deficit target

  • To stick to a strict budget deficit target may require tax increases / spending cuts at a time which is not appropriate for the economy. e.g. the UK economy is recovering, but if we increase income tax rates to improve tax receipts it may lead to lower growth and be counter-productive. See: Austerity can be self-defeating
  • Experience of Eurozone economies trying to meet budget deficit targets has been a deep recession.
  • Achieving an overall budget deficit means government have to finance investment spending out of tax revenue. But, arguably there is a better case for allowing government to borrow to finance investment.
  • A zero budget deficit is of doubtful value compared to other macro-economic objectives such as full employment, sustainable economic growth and low inflation.

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Does Government Debt Matter?

Readers Question: Does Government debt matter? Do high fiscal deficits threaten economic stability?

Summary

Many worry that high levels of government debt could cause economic instability. In certain occasions, countries with high debt have seen investors lose confidence, leading to higher bond yields and putting pressure on the government to slash spending, for example several countries in the Eurozone (2010-12). In rare cases, governments with high debt have responded by printing money – causing inflation to spiral out of control, for example, Germany in the 1920s. Another potential problem is when government debt is financed by overseas borrowing. If overseas investors lose confidence and sell their debt it can cause a loss of foreign exchange and a destabilising devaluation.

However, in many cases, high levels of government debt do not cause instability – but can actually prevent a deeper recession. The main argument for government borrowing is that in a recession, government borrowing and government spending can help prevent a collapse in demand and economic growth. In a recession, generally people save more and so wish to buy government debt. This means governments can often borrow cheaply to finance public sector works.

In the 1950s, national debt in the UK reached 200% of GDP, but it did not compromise economic growth or inflation. The UK was able to reduce this debt burden over several decades of economic growth.

Does debt matter?

  • It depends how it is financed – e.g. does it rely on overseas borrowing which can be more risky?
  • What are the prospects for economic growth? – With economic growth, the debt to GDP ratio is likely to fall. If you are stuck in recession, the debt to GDP ratio will likely rise.
  • Are domestic investors willing to buy government bonds? Japan has very large public sector debt, but it has large pool of domestic savings so the government has been able to borrow cheaply.
  • Is the debt cyclical or structural? Debt is a bigger problem if the government is borrowing heavily during a period of growth and there is a structural deficit.

More detail on question

Economic stability would involve.

  • Low inflation
  • Positive, sustainable economic growth (e.g. close to long run trend rate of growth)
  • Stable bond yields (i.e. avoid rapidly rising bond yields which could create difficulty in dealing with debt.)
  • Stable exchange rates

High fiscal deficits mean the government is forced to borrow a large sum – Annual government spending is greater than tax revenues.

For example, in 2011/12 the UK government will have to borrow an estimated £125bn (just under 8% of GDP). Anything over 3% of GDP could be classed as a high fiscal deficit.

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Government borrowing and effect on bond yields and interest payments

Another few graphs to look at the impact of the UK budget deficit on bond yields and interest payments.

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Government net borrowing for 2012-12 excluding Royal Mail pension fund transfer and Asset Finance Programme (AFP – the proceeds from Q.E)

Government borrowing vs debt interest payments

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The very large deficits have had  little impact on changing the cost of net interest payments as a % of GDP. This is because, despite higher borrowing, bond yields have fallen to record lows. The amount of national income devoted to servicing debt interest payments is lower than in the 1990s.

You might be tempted to say, that because of government borrowing, we have to increase taxes just to pay the interest rate cost. But, this hasn’t happened yet.

Low bond yields are not guaranteed – just look at the Eurozone. But, despite the size of UK government borrowing, we still retain that very useful ability to print money and get the Central Bank to intervene in the bond market, if necessary. Interest payment costs are forecast to stay low into 2016-17.

Government borrowing v bond yields

government-borrowing-bond-yields

more on debt interest payments here

If you teach budget deficits to students, you would typically say – Higher government borrowing is likely to push up interest rates. The logic is that if the government borrows more, they will have to compete for funds from the private sector. Therefore, the more the government borrow, the higher the interest rate they have to offer.

In the case of the Eurozone, increased budget deficits did cause rising bond yields. This was because markets feared illiquidity and demanded higher yield to compensate for the perceived higher risk.

However, if we look at the UK since 2007, a sharp increase in government borrowing has led to a significant fall in bond yields. The fall in the bond yields is mainly because in the recession, savings have increased and the private sector are keener to buy bonds. The Asset Finance programme has also helped keep bond yields low.

See more at falling bond yields

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Government debt under labour 1997-2010

If I got a pound for every time someone said ‘it was debt that got us into this mess in the first place’ I could have made a significant contribution to bailing out the Irish banking system. Usually, when people say ‘it’s debt that got us into this mess. They tend to view all types of debt as the same – equating government debt to financial debt incurred from selling sub-prime mortgages in the US. However, this is deeply misleading. The consequence of bad debt defaults in the financial system, is very different to government debt financed through selling bonds.

Firstly, to what extent did the Labour government really plunge the economy into debt during 1997-2007?

Government debt

debt-under-labour

In 1997, public sector debt as % of GDP:

  • 1997/98 – 40.4% of GDP
  • 2007/08 – 36.4% of GDP
  • 2010/11 – 60.0% of GDP.

At the start of the great recession in 2007, public sector debt had fallen from 40.4% of GDP to 36.4% of GDP. This was despite increased real government spending. After the start of the crisis, public sector debt almost doubled in the space of three years.

If we look at just actual government debt, there is a significant increase.

In 1997, total public sector debt was:

  • 1997/98 – £352 bn
  • 2007/08 – £527 bn
  • 2010/11 – £902 bn

public-sector-debt-total-hmT

Debt to GDP statistics were helped by the period of strong economic growth – a reminder that economic growth is as important at debt levels. It is also worth bearing in mind UK public sector debt in comparison to the post war period. Continue Reading →

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How does the economic cycle affect government borrowing?

The economic cycle plays an important role in determining the level of government borrowing, especially in the short run. Essentially, higher economic growth leads to lower government borrowing, but a recession will increase government borrowing.

Over the past few years  (2008-12) – the idea that an economic downturn increases government borrowing is probably one of my most repeated sentences on this blog.

growth+borrowing

  • At the end of the 1980s boom, the UK ran a small budget surplus (negative net borrowing).
  • The recession of 1991 caused a sharp swing in the budget deficit, with net borrowing rising to nearly 8% of GDP.
  • The long period of economic expansion 1993-2001 saw a fall in net borrowing.
  • The recession of 2008/09 saw record levels of government borrowing with net government borrowing increasing to over 10% of GDP
  • The economic cycle isn’t the only factor affecting the level of government borrowing. For example, net borrowing increased 2002-2007 because the government increased government spending – despite the positive economic growth.

Recent Years since 1999

growth-govt-borrowing-99-12

Why does government borrowing increase in a recession?

Continue Reading →

UK Government spending – real and as % of GDP

In 2011/12 the UK government is forecast to spend a total of £694 billion – £15 billion less than 2010-11.

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Government spending as % of GDP

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  • In 2000-01, several years of government spending restraint combined with rising economic growth, saw government spending shrink to under 35% of GDP. Between 2001 and 2007-08, spending rose to over 40% of GDP due to sustained increases in spending on health, education and welfare spending.
  • Between 2008-09 and 2009-10, the UK saw a large drop in real GDP of 6%, but due to automatic stabilisers government spending increased (e.g. higher unemployment benefits). This caused government spending as % of GDP to rise to 47%.
  • Government spending as % of GDP is forecast to fall closer to 40% of GDP by 2016-17 (if growth targets are met)

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Impact of fiscal consolidation on debt levels

In recent years, I’ve frequently stated that fiscal consolidation can actually increase debt levels. It may seem a paradox because fiscal consolidation aims to reduce the budget deficit by increasing taxes and cutting spending. Yet, under circumstances, policies to reduce debt levels can actually cause a rise in debt to GDP. This seems to be a particular problem for Eurozone countries embarking on deficit reduction during the current recession. The IMF have a produced a paper – The Challenge of debt reduction during fiscal consolidation – which looks at the theory and empirical evidence behind this idea. It’s a difficult paper, but the main conclusions are

  1. A large fiscal multiplier of close to 1 can cause debt consolidation to increase debt to GDP ratios in the short term.
  2. Using debt ratio targets (e.g. EU fiscal rules) are likely to lead to disappointment. Because government miss their debt targets, they may engage in even more levels of fiscal consolidation trying to meet targets. The IMF propose the use of cyclical adjusted debt targets. This allows for the short term increase in debt to GDP caused by the cyclical downturn.
  3. Debt consolidation packages can be modified to minimise the impact on economic growth – e.g. delaying spending cuts until the economy is stronger, and choosing those cuts which have less impact on economic growth. (the IMF don’t mention it, but accommodative monetary policy would also be an issue)
  4. The increase in Debt – GDP ratios is worse for countries with high debt and in a recession.

From the IMF introduction:

With multipliers close to 1, fiscal consolidation is likely to raise the debt ratio in the short- run in many countries. Although the debt ratio eventually declines , its slow response to fiscal adjustment could raise concerns if financial markets react to it s short-term behavior. It may also lead country authorities to engage in repeated rounds of tightening in an effort to get the debt ratio to converge to the official target. Not explicitly taking into account multipliers or underestimating their value may lead policy-makers to set unachievable debt targets and miscalculate the amount of adjustment necessary to bring the debt ratio down.

Why does fiscal consolidation increase debt levels?

  • Firstly  debt is usually measured as debt as a % of GDP. (debt /GDP)
  • If GDP falls, then even if debt levels stay the same, – (Debt / GDP) will rise.
  • In a recession, we are likely to see a fiscal multiplier of 1 or even greater. This means £30bn of fiscal consolidation will see a fall in GDP of £30bn. Therefore, debt falls, but GDP falls by a similar amount.
  • Also, if GDP falls, this will cause an increase in the cyclical deficit. The government receive lower tax revenue and have to spend more on unemployment benefits.
  • In countries without a flexible exchange rate or flexible monetary policy, the fiscal multiplier effect could be even larger than one.

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This model shows, high debt countries, with a multiplier of 1.3 would see an increase in the debt ratio for the first three years. In a recession, the multiplier effect of fiscal consolidation.

Example from 2009-11.

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Source: OECD | S&P pdf on Europe’s recession

How important is the budget deficit?

Readers Question: how important is the budget deficit?

This is an interesting question, and you will get different answers depending on which economist you ask – especially in the current crisis.

Firstly, the budget deficit is the annual amount the government borrow. The government usually borrow from selling bonds to the private sector (though some countries like US and UK have a Central Bank sometimes buying gilts, through policies like quantitative easing)

The most useful way of measuring the size of the budget deficit is as a % of GDP.  The graph below shows that in 2012, there was a large variance in size of budget deficits. The biggest deficits occurred in Ireland,  Japan, UK and US – with budget deficits of over 8% of GDP.

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OECD – Budget deficits 2012

Reasons to be concerned about a budget deficit

  • Countries with large deficits may struggle to attract sufficient investors to buy bonds. If this happens, bond yields will rise causing the deficit to be more expensive to finance.
  • There is a fear that budget deficits could be inflationary. For example, if a country like the UK was struggling to attract sufficient investors to buy UK bonds, the Central Bank could effectively print money and buy bonds. However, unless the economy is in a liquidity trap, printing money will cause inflation, and reduce the value of savings, including government bonds. It is worth pointing out, that in developed economies – inflation from printing money resulting from a budget deficit is quite rare.
  • Cutting the deficit can cause problems. If a country has a deficit that increases too quickly, the government may be forced to adopt to policy aimed at a sharp deficit reduction. This can cause economic problems. For example, many countries in the Eurozone have sought to reduce their budget deficit to comply with EU rules. This deficit reduction has caused lower growth and recession.
  • Increasing national debt. If the budget deficit is above a certain level, we will see national debt as a % of GDP increase. This may lead to a higher % of national income being spent on debt interest payments.
  • Crowding out. One way of thinking about a budget deficit is that if the government is borrowing from the private sector, the private sector have lower funds to spend and invest. The government is therefore ‘crowding out’ the private sector – and some economists will argue government spending is liable to be more inefficient than the private sector.

Evaluation

There is no simple answer to whether a budget deficit is helpful or harmful because it depends on quite a few factors.

1. It depends when the deficit occurs. Basic Keynesian analysis suggests that a rise in the budget deficit during a recession is a good thing. In a recession, private sector spending falls, and saving rises – leading to unused resources. Government borrowing is a way of utilising these unused savings and ‘kickstarting’ the economy. The deficit spending can help promote higher growth, which will enable higher tax revenues and the deficit will fall over time. If you try to balance the budget in a recession, you can make the recession deeper.  Continue Reading →

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