The debate about Britain’s economic policy rumbles on, with a speech by the Shadow Chancellor Ed Balls last week. In previous posts I have dismissed the claim made by some that the government’s cuts are unnecessary, and most commentators, including Mr Balls, seem to accept this, even if they don’t say so explicitly. But there is a furious debate about how quickly the cuts should be implemented: 5 years as the government plans, or 8 years as Labour suggests, apparently including Mr Balls, though in the past he has been suggested longer. An impressive array of economists seem to support the Labour argument.
The basis of the critics’ argument rests on conventional macroeconomics, and runs that cutting too fast creates needless unemployment and risks a spiral of lower demand which will make things worse. This argument is open to challenge on its own terms (see The Economist’s Buttonwood column here, or Bagehot here), but the government’s defenders don’t generally try; instead they trump it with an argument about unsustainable levels of government debt. I want to look at the macroeconomic argument in a future post. Today I will consider whether unsustainable debt really is such a risk.
If government debt gets too high, it can derail the whole economy. A default, when governments renege on the terms of their debt, can be absolutely catastrophic. The problem is that if governments can’t raise the money then all the functions of government are threatened. For countries like Greece who are part of the Euro, this means that they literally can’t pay the bills – salary payments are stopped and so on. This is such a frightening prospect that there are strong incentives for other members of the zone to organise a rescue. Countries like the UK do have another option: they can debauch their currency by paying bills with newly created money. That’s how hyperinflation starts; the most recent example is Zimbabwe, and its implications are hardly less disastrous than default.
So what are the risks for Britain? The good news is that before the crisis struck overall debt was modest by international standards at a shade over 50% of GDP. Even better, the maturity profile of this debt, i.e. how soon it has to be rolled over, was long term – longer than any other major economy. The bad news is the massive size of the current deficit – 11% in 2009, and the fact that 8% is “structural” or won’t bounce back with the economic cycle. That means that total debt is increasing rapidly; by the end of 2010 it was already 75% of GDP. This gives two main problems.
The first problem is that debt risks spiralling out of control. Few think that the current economy is capable of more than modest growth, austerity or not, which means that extra wealth is not being generated fast enough to get us out of trouble. And debt comes with an interest bill. There are some classic economic models of this, and on these the warning lights are flashing red furiously. At some point lenders (characterised as the “bond markets”, but potentially including you and me) refuse to lend, or at least start to put the rate of interest up, making things worse.
The second problem is more subtle. If total national debt levels off at a high level, this will drag down the whole economy for a long while to come, as we spend too much resource servicing the debt. One study suggested that serious problems start to happen when debt reaches 90% of GDP – less than two years away at the current trajectory. Taking longer to eliminate the deficit means that overall debt will level off at a higher amount, unless the aggressive option really does lead to meltdown.
There are three further overlapping problems for the UK. Debt markets are very open; there is a degree of dependence on overseas support; and the pound is a floating currency. Government debt problems are much easier to handle if there is ready access to lenders who are effectively forced to lend to you; this has helped such high debt countries as Japan and Italy. Superficially the UK seems to look this way: pension funds are massive, and traditionally hold lots of government debt (gilts) for actuarial reasons. But such funds are aggressively and independently managed, helping to make our financial services industry internationally competitive. That means they switch away from buying gilts as soon as they think it is not such a good deal. Dependence on overseas investors appears to be relatively modest, as buyers of gilts are overwhelmingly domestic (or so I believe). But the country still runs a significant current account deficit (unlike Japan, and even Italy), meaning that the economy as a whole does need foreign lenders. The floating pound is often presented as a get out of jail free card – but the benefits of being able to devalue are two edged. Foreign investors will be wary of sterling if they think it will devalue; domestic investors will likewise increase their overseas exposures in the same event, reducing their ability to buy gilts (unless these are issued in foreign currency, but let’s not go there).
But, the government’s critics maintain, there’s no sign of trouble, and never has been. The government has had no trouble selling gilts, at very low interest rates. The trouble with this argument is that markets can turn in an instant, and you won’t know until too late. An investment decision depends on a judgement looking far into the future, and this can move very quickly. Government ministers seem to have got a genuine fright in May 2010 with the Greek crisis. By and large the closer a commentator actually is to the debt markets, the less sanguine they are about the whole thing. There are just too many risk factors.
So what to think? The Labour plan is probably viable, if backed by a real determination to follow it through (and Alistair Darling, the outgoing Labour chancellor would have been an excellent figurehead, unlike Mr Balls). But it undoubtedly takes more risks with catastrophe. Whether it is worth doing so does come back to your view on the macroeconomic risks. If you think that the austerity programme really will lead to meltdown, then this has real power. But neither is the government argument implausible. It’s about the risks you are prepared to run.