Tag Archives | debt

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.

• 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

Why does government borrowing increase in a recession?

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

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

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

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

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.

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.

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

Readers question: Why is public debt stated as a proportion of GDP and not as a proportion of the government tax take?

Generally, government debt is shown as a % of real GDP because this is best reflection of a countries ability to repay.

For example, in France, the government spends 52% of GDP (National Output). In Switzerland, the government spends just 32%. In France the government takes a higher share of tax than in Switzerland. If France and Switzerland had equal levels of debt, then Switzerland would look more indebted, because the debt would be a higher % of tax revenue. French debt would look a smaller burden because the tax revenue is relatively larger.

However, this wouldn’t completely reflect the ability to repay the debt. For example, if Switzerland had a high level of debt to tax, it is in a better position to increase tax rates to raise more revenue if necessary. France by contrast already has high tax rates, and when France tries to increases tax rates it may create disincentives (like famous movie stars moving to Russia).

Also, you could argue that a lower tax country like Switzerland will encourage more private enterprise and a stronger economy. If a country was strangled by high taxes. It would see it’s debt to tax ratio fall, but the economy may weaken.

However, although it is best to measure government debt as a % of GDP, it is still useful to examine debt as a proportion of government tax take. For example, some developing economies struggle to raise tax revenue. A large proportion of GDP may be beyond the government. If the government can only collect 10% of GDP in tax revenue, this limits their ability to repay even modest levels of debt. It is definitely worth taking into account.

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• When examining debt levels in the UK, there is government debt – measured by public sector borrowing (often referred to as National debt). See: UK National Debt.
• We also have private sector debt which is composed of personal loans, personal mortgages, business debts, and debts of the financial sector.
• Total Debt includes both private sector debt plus government debt.
• Private sector debt can be split up into
  • Household debt – personal loans
  • Non-Finance corporates – Company debts
  • Financial – debts of banks and financial corporations

Total UK debt

total UK  Debt – Private + Public

Total UK debt increased sharply in period 1994-2007.

Since 2008, there has been a fall in household debt as a % of GDP – as households cut back debt levels. (note GDP also fell in this period)

Financial sector debt has stayed constant at 200% of GDP.

Main Features

• Total UK debt is 500% of GDP in mid 2012
• The largest component of debt is from the financial sector.
• The deleveraging is greater than may appear from the statistics. Although debt levels have remained flat, this is against the backdrop of falling real incomes.

Compare experience of US – where total debt fell in period 2009-12.

Overall Indebtedness in Developed Economies

Source: Debt and Deleveraging pdf at McKinsey

The UK has seen the biggest rise in total UK debt in past 20 years. Only Japan is slightly higher.

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Readers Question: Hello! I was just wondering in the midst of the European crisis when all economically strong countries have been downgraded?

Many countries in the Eurozone have seen a downgrading in their credit rating for Government debt.

1. The economic crisis saw a sharp rise in levels of government debt to GDP. In a recession, countries like Spain and Ireland saw a big fall in tax revenues. E.g. with collapse in property markets, the tax revenue from stamp duty (tax on house sales) fell. This meant tax revenue fell. Also with rise in unemployment, the government have to spend more on unemployment benefits.
2. Secondly, the Eurozone crisis has led to poorer prospects for economic growth. Europe’s economy has been stagnating because economies have pursued austerity measures (spending cuts and tax increases). With lower GDP, it is hard for countries to gain any more tax revenue. They are facing a deflationary debt spiral.

The rise in bond yields show investors don’t want to buy EUrozone debt. This is one factor in the downgrade.

1. Thirdly, being in the Euro has made countries more vulnerable to liquidity shortages. Because there was no Central Bank willing to act as lender of last resort and print money, markets were nervous of buying Eurozone debt. (this has been reduced somewhat in 2012, with ECB being more active in maintaining liquidity.

There’s a bit more detail on Eurozone crisis.

Related

• What determines credit ratings?