Some Thoughts On Debt

23/03/2012 at 2:58 pm

As some commentators have pointed out, this year’s Budget took place in the context of a threat to the UK’s AAA credit rating. Only last week, ratings company Fitch put the country on “negative outlook”, meaning that it sees a slightly greater than 50% chance of a downgrade over a two year horizon.

It was accordingly fortunate that some improvements in his economic forecasts meant that Chancellor Osborne was able to announce a slight fall in the projected peak of the UK’s national debt, revised down to 76.3% of GDP in fiscal 2014-15. He made specific mention of the figure in his statement. Fitch has since gone on the record to say that the reduction is modest and that their stance is unchanged: should the Chancellor deliver on his targets the AAA is likely to be affirmed, but in the meantime it remains vulnerable to shocks.

The number they cite, however, is a peak of 92.7% of GDP in 2014-15. At first glance this might appear confusing, or even incorrect. But in fact both numbers are right.

The government’s preferred measure of borrowing is “net debt” – the value of its liabilities less the value of its liquid assets (e.g. the cash it keeps in the bank to cover spending). This is where the 76.3% comes from. The 92.7% reflects the country’s “gross debt”: liabilities only.

That the difference is so large – 16.4% of GDP, or some £293bn in future cash terms – is interesting in itself. What is also interesting is that the UK reports the 92.7% figure (on p. 109 of the full Budget document for those interested) as the “Treaty debt ratio”: the treaty concerned being the Maastricht Treaty of 1992, under which the calculation of government borrowing statistics is governed across the EU.

In fact it is gross debt to GDP which is generally quoted in respect of Europe’s indebted economies. Italy’s fabled 120% debt-to-GDP ratio, for instance, falls to 100% on a net basis according to data from the IMF. In the case of Japan the difference is even more astonishing: the IMF projects a whopping 238% debt ratio for 2012, but on a net basis the figure is only 139%.

The real point, however, is that we must be careful to compare apples with apples. A casual listener on Wednesday might well have thought that the highlighted figure of 76% was directly comparable with the 120% for Italy, for instance. The truth is a little less flattering.

Nevertheless, progress is being made in Britain. This is underlined by yet more excitement from page 109: the figures for “Total managed expenditure” (government spending) as a % of GDP. On current policy this is projected to fall from 45.8% this year to 39% in five years’ time, at which time the budget is broadly expected to balance.

One final international comparison: 39% of GDP is about what Greece has been raising in revenue over the last few years. This may come as a surprise to those who believe the country somehow went broke through tax evasion. The problem for the Greeks was that while raising 40% of GDP, their government was consistently spending even more. Such evasion as undoubtedly takes place might be regarded as evidence of the Laffer curve: the economic theory stating that once tax rates reach a certain level, revenues stop increasing (and begin to decline if rates keep going up). Here in the UK, the disappointing results from the 50% rate of income tax provide a parallel illustration.

If there is one lesson for governments to draw from the recent crisis it is that spending must have its limits. Europe has been forced to acknowledge this in the most brutal manner. In Britain we have had an easier ride from the markets but the arithmetic points to the same conclusion.

There are still plenty of commentators who see fiscal consolidation – “austerity” – as some kind of demand-dampening mistake. The fact is that there is a limit to what states can raise in tax and borrowing. Sometimes spending cuts are all that is left. Sometimes there is, to coin a phrase, no alternative.

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