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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.

borrowing-percent-gdp-exclude-royal-mail Continue Reading →

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.

borrowing-percent-gdp-exclude-royal-mail

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

debt-interest-payment-budget-deficit

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.

govt-spending-94-12

Government spending as % of GDP

g-spending-percent-gpd-96-14

  • 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)

Continue Reading →

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.

debt

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.

change-growth-budget

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.

deficit

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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Debt as % of Tax Revenue

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.

Continue Reading →

Total UK Debt

  • 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

total UK  Debt – Private + Public

Total UK debt increased sharply in period 1994-2007.

household-government

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)

debt-sector-2007

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.

Continue Reading →

Reason for Eurozone Credit Rating Downgrades

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.
bond-yields

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.

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