David Cameron has caused a bit of a stir by warning of the possibility of default. I can see the political case for saying so, given that the overwhelming balance of probability is that it will be his government that has to cope with that threat. After a company sacks its chief executive one of the first acts of the new one is to acknowledge what a mess the company is in. The reasoning is simple. You don’t want to get blamed for the mistakes of your predecessor, and you want to get the credit if you manage to turn the ship around. Mr Cameron is not quite the chief executive designate, but you see the point.
But in reality it is not what politicians or indeed journalists think about the deficit that matters. It is what the markets think, and so far they have been pretty sanguine about it. The situation is dreadful. The deficit this year is heading toward £200bn. Tax revenues for the first four months of this fiscal year are running nearly 13 per cent down on last year, while spending is running around 6 per cent up. For every £100 the government spends, it gets in only about £75 in tax. Yet the Government is still able to borrow to borrow for 10 years at about 3.6 per cent. That is higher than the US, Germany or France, but lower than Italy, which has to pay more than 4 per cent. If people really thought the country would not repay, they would hardly want to lend us money at those rates, would they?
It is a genuine puzzle, and it deserves an answer. There is a short one and a long one.
The short one is that lenders assume that the next government will correct the deficit by cutting spending and increasing taxes, and the debts will accordingly be serviced. Compared with other similar countries, the UK is still creditworthy.
The longer answer starts with that proposition too, and it ends up with the same conclusion, but there are several wobbles on the way.
Start with the politics, because in a way they matter more than economics. This is an issue about willingness to take tough decisions rather than actually ability to pay the interest in the debt. Not only will there be a new government next year and the markets, rightly or wrongly, are comfortable with the idea of a Conservative chancellor. But even the present government has a plan of sorts to get borrowing back under control, and in the unlikely event of it getting back, it is generally accepted that it would have to tighten that plan rather further. Surprisingly to those of us in the UK, Gordon Brown still commands respect in financial circles abroad.
There are, however, two qualifications to that. One is the danger of a hung parliament, which might result in a government too weak to be able to take charge. So far, the markets have not factored that in. The second is that there might be the sort of sudden collapse of confidence in the country as a whole that occurred in 1976. The Chancellor then was Denis Healey, and as a result of a run on sterling he had to turn to the International Monetary Fund for an emergency loan. The IMF imposed the spending cuts and tax increases that the government had hitherto resisted. Ironically the IMF loan was needed despite the fact that the UK fiscal and current account deficits had started to improve, albeit slightly, so you can have a sudden loss of confidence even if the situation is no longer deteriorating.
If that sounds alarmist, note how share markets last year lagged behind the deteriorating world economy, but then suddenly collapsed in the autumn. They only hit bottom in March this year, the point at which we know now that things were starting to pick up. Markets make mistakes, but if you have to borrow £200bn a year from them, you have to accept their judgements.
The next point in the argument concerns the contrast between the stock of UK debt and the rate at which we are adding to it. To put this in perspective, have a look at the two charts. One shows the stock of national debt, relative to GDP, in the main developed economies ahead of the present recession. The UK was bottom of the pile, which of course was an admirable position in which to be. But look at the flow. In the boom years running up to the present crisis we were still adding to our debt rather faster than most other developed countries. We were not doing quite as badly as Japan or Italy, but we were worse than the US, France and Germany, and much worse than Canada.
So we went into this downturn in an unfavourable position. Now, thanks to the spending policies of this government and greater weakness of revenue than it had appreciated, we look like adding to our debt faster than any other large developed country. So how long can we go on like this?
I think the best way to understand the situation is to think of us as having a relatively small mortgage on an expensive house, say £200,000 on a house worth half a million. We are in a mess, lose our job, but want to keep on spending, so we remortgage, adding £50,000 to our loan each year. To start with, there is no problem, and the Northern Rock (or whoever) is happy to go on lending more. As a result we look like increasing our mortgage over the next four years to £400,000. That is all right, but towards the end of that time our lenders might start asking for a higher interest rate. And if the loan looked like going above £400,000, there would be huge pressure for us to get another job.
It is not quite like that, because there is no hard ceiling for national debt as there is for a mortgage. Both Italy and Japan are above that level already. We were above it for much of the past century, as a result of having to pay for two world wars. But what it indubitably does mean is that future governments will have to worry much more about servicing national debt and we as taxpayers will see more of our money paying interest and less available for all the other things governments have to do.
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