Who Is Afraid of the National Debt?

Much of the Keynes-bashing of recent decades was a reaction to the adulation surrounding a rather deformed and naïve image of Keynes in the decades following the Second World War. Without going into the subtleties of what Keynes really meant and how he was misinterpreted, one might usefully separate Keynesian economics from Keynesian mechanics. The latter at least is incontrovertible, resting as it does on the proposition that like all accounts, the national accounts always balance. They may balance at high or low levels of total income. An intended change in one item of the account is either accommodated by intended changes of the opposite sign in other items, or the intentions must be frustrated by a lower (or, subject to physical constraints, a higher) level of total income at which intentions are revised and mutually accommodated.

One might, for argument’s sake, envisage that people in an Anglo-American style economy who have been getting ever deeper into debt in the last ten years, decide to mend their ways and reshape their budgets, so that intended net household saving moves from around 0 to 5-7 per cent of disposable income. A simultaneous increase in net government dissaving (roughly, the budget deficit) by an extra 4 per cent or so would offset this. Assuming that nothing else changed, a fall in private debt would simply be balanced by a matching increase in public debt. Of course, corporate net saving or dissaving and net exports may all change at the same time, and in 2008-2009, the sum of all these changes was such that gross national product was reduced by 2.5 per cent. None of this is meant to indicate the direction of causation nor the policy that, adopted in timely fashion, might have altered the course of these variables. All that is meant is that a rise in the net national debt may be mechanically offset by a fall in private debt. Another way to describe this is that the issue of government bonds is taken up by private savers. Does this mean that nothing much is wrong, for as the saying goes, “we owe the national debt to ourselves”?

Everyday plodding rather than emotion is needed in approaching this problem. To begin with, the debt is in part owed to ourselves, but in part we owe it to foreign, mainly Chinese, Japanese and Gulf Arab institutions and individuals whose saving covers the part of government dissaving not offset by our own domestic saving. In the accounts, this appears as negative net exports or capital imports. Our own net wealth decreases and some of our gross worth comes to be owned by foreign savers. In an age of globalisation, this is not a catastrophe. It does mean, though, that our future balance of payments will be forever burdened with the service of this debt and if net exports continue to be negative, the burden will continue to increase year after year. It must be discharged or it will be added to the existing debt and thus augment the annual burden to be discharged. Ultimately, this must put the competitiveness of our economy to an increasingly severe test.

This is not a matter for despair, for the competitiveness of an economy can undergo a vast sea change in a mere decade or two. The United States were hugely competitive in the 1950s and ’60s and Europe was groaning under a “dollar shortage”, but no later than 1971 President Nixon felt compelled to abandon the gold exchange standard and introduce an “interest equalisation tax” to protect the U.S. foreign capital account. Be that as it may, the seeds of a problem are being sown in Europe and we must not be too surprised if they grow into big and ugly weeds.

However, whether or not “we owe it to ourselves”, the root of the matter is that we owe it. If the national debt is a constant percentage of national income, the burden of servicing it is also constant and whether the service charge accrues to foreign or domestic savers, the economy will in due course adjust to it and remain in balance. But if the debt as a percentage of GDP keeps rising, it eventually becomes too big to support and a stop must be put to it one way or another.

Britain in 2000 had a national debt of 30 per cent of GDP. “New Labour”, elected after 12 years of Conservative rule in 1997, was by then in full swing to increase government expenditure. It reconciled this spending spree with the dictates of fiscal prudence by calling the extra money devoted to the National Health Service, education and the police “investment” which it is not irresponsible to finance by borrowing. By 2007, the national debt has rocketed up from 30 to 60 per cent of GDP. This percentage was still below the French 65 and the German just over 60 let alone Italy’s over 110 per cent. Its level was perfectly tolerable, but its rate of increase was not. Then came the so-called “crisis”, a medium-sized financial accident that started with American residential mortgages and was blown up into panic proportions mainly by the self-fulfilling prophecies of official and media Cassandras. A world banking system that by the very nature of banking depended on confidence, was loudly and shrilly declared to be teetering on the brink of collapse. As a result, it did slide to the brink and was there rescued from falling off by emergency capital injections and guarantees of the American and all major European governments.

Emergency measures leave a mark after the emergency has passed. Britain’s current-year deficit of 12.4 per cent of GDP will not automatically fall to 0. The Treasury’s latest scenario foresees a gradual reduction to 5.5 per cent in 2013-14, raising the ratio of debt to GDP to 76 per cent, only a little above the Western European average. It is not made explicit how the deficit reduction is to be achieved—spending cuts are no doubt tacitly assumed—except that the growth rate of the economy is supposed to rise spectacularly to 3.25 per cent from 2011 onwards. If the average interest rate on the debt were to settle at 5 per cent, the interest cost on the projected 76 per cent of GDP would be 3.8 per cent of GDP a percentage point more than at present. To accommodate this and still achieve a reduction of the deficit to 5.5 per cent, non-interest spending would have to be squeezed by 7.9 per cent of GDP. Anyone who believes that this will be done has never understood democracy.

In his major pre-election speech, Britain’s probable future Chancellor promised Churchillian blood, sweat and tears for the next five-year Parliament. He announced specific spending cuts that sound highly unpleasant for all except the lowest income groups. Even so, the total of these measures would save only 0.6 per cent of GDP, hardly worth the political cost.

Simple arithmetic is sending a bitter message. As long as the budget deficit (and never mind the “primary deficit”) as a percentage of GDP exceeds the growth rate of GDP, its ratio to GDP must go on rising. In a recent very serious study by a former high Treasure official, the ratio of debt to GDP is slated to reach 120 per cent of GDP by 2017. Making room for the interest charge on this debt, even if it were really “owed to ourselves”, would necessitate sending cuts that no elected government would survive. Because the debt ratio would nevertheless go on rising, the spending cuts would have to grow in a vicious circle, a prospect simple not worth entertaining.

There is always a solution to every dilemma, though often it is a bad one. If in a democratic society the debt problem generates a vicious circle that has no solution under price stability, price stability will go out of the window. After World War II, the national debt in Britain hovered around 150 per cent in an environment of gradually rising inflation. By the 1970s, usefully helped by the 1973 oil price shock, inflation accelerated. With the agony of the Labour government prior to the 1979 election of Margaret Thatcher, inflation peaked at 25 per cent. The vicious circle was broken by a brutal reduction of the national debt in real terms. From its much deflated level, further reduction during the Thatcher years became feasible. Before the New Labour government started “investing” in public services at the turn of the century, the debt ratio looked quite safe at 30 per cent. Double that level and the safety is gone, and an emergency can push it beyond the threshold where the vicious circle can take over and run away with it.

None of this means to say that inflation is not a thoroughly bad thing. It does mean to say, though, that given the numbers and the political realities of the collective will, one must reckon with its highly probable onset from 2011 onward.