Tackling the coronavirus has caused many countries, including the UK, to institute a lockdown. That lockdown has had a profound effect on the economy and as a result the UK government has both spent more and received less in taxation than it had expected.
Of course, this has resulted in a significant increase in government debt. The Office for Budget Responsibility (OBR) estimates that UK debt will be roughly 95% of GDP by the end of this year and others have suggested even higher figures.
And we are starting to hear voices using alarmist language to suggest that this is a disaster for the UK. One claimed that, “The debts we will have built up by the time the pandemic is over are too big to think about.” If we do not tackle it immediately, the argument runs, the cost of servicing the debt will rise and the government will be, for the first time in history, at risk of default. Even if that does not happen, debt at this level would leave an unjustifiable burden for future generations, “After all, it’s not us that will have to pay this money back, it’s our unborn grandchildren, who bear no responsibility for this mess whatsoever.”
While we may not like it, these voices say, there is no serious alternative to renewed austerity. Some have literally gone so far as to suggest that we are looking at economic Armageddon.
These voices are extremely alarming, and if what they say is true, then the UK faces a dismal future.
But is there, in fact, any validity to these arguments?
Fortunately not. These arguments reflect a profound misunderstanding of the nature and level of government debt:
- firstly, to say that the debts we will have built up are “too big to think about” is in contradiction to British history and to international evidence;
- secondly, the cost of servicing the debt is historically low, and likely to remain low;
- thirdly, no UK government can be forced to default;
- fourthly, it will not leave a burden on future generations; and
- finally, investing in growth, not austerity, is the key to debt sustainability.
For the UK, government debt is not, and will not be under foreseeable circumstances, a danger for the economy. Listening to the debt hysterics and introducing a second round of austerity is the real danger. The debt hysteria is more dangerous – by far – than the debt.
Government Debt Is Not Large by Historical or International Standards
The Bank of England compiles data on government debt. And they have one data set titled ‘a millennium of macroeconomic data’ which contains the following data.
When you factor in a recent forecast from the Office for Budget Responsibility, the end of the graph rises to around 95%.
And other reputable forecasters have even higher forecasts. Depending on how long the coronavirus contraction lasts, it is conceivable that UK government debt to GDP might reach 120% or even 140%.
One of the first things you may notice – perhaps to your surprise – when you look at the graph is that a ratio of debt to GDP of 100% is not ‘staggeringly high’, it’s not even rather high, it is almost exactly the average level of debt that the UK has owed over the last 300 years.
In fact, even if the debt went a long way above 100%, there would still be no reason for hysteria.
First of all, 140% is not unusual. Here is a selection of other countries’ debt:GDP ratios over time. (And of course, they will all be much higher now).
As you can see, the UK is in no way an outlier in international terms. Japan, for example, has run much higher levels of debt for a long time without disaster.
Secondly, it would not be new for us. Just before the Industrial Revolution really took off, around 1820, debt to GDP was over 200%. Immediately before the Golden Age Of Capitalism (the post-war period 1945 – 1980) debt to GDP was over 250%.
And these were the two most successful periods in the UK’s economic history.
Very high debt is demonstrably not an obstacle to growth. And as the first graph suggests, the growth itself reduces the rate of debt to GDP.
The Cost Of Servicing Debt Is Extremely Low
But what about the cost of servicing all that debt, won’t that be a huge drain on the economy? Fortunately not. The yield on UK government bonds (equivalent to the interest that the government has to pay) is at a long-term low. According to Bloomberg, at the time of writing, the UK government would face an interest rate of -0.03% (!) on a two-year bond. It would be paid for borrowing. Even a 30-year bond would only attract interest of 0.61%.
If the government borrows heavily now, with long-duration bonds, it can lock in a low rate of interest for 30 years. Even if the Bank of England were to allow interest rates to rise in 10 years’ time, this would not affect the interest on money borrowed today.
Borrowing is, for practical purposes, free for the government.
No UK Government Can Be Forced To Default
Some countries have defaulted on their debts: Argentina has done it more than once and Greece had a partial default after the Global Financial Crisis – and there are many others in history.
But the UK has never defaulted.
Why not? Well the UK borrows in its own currency (unlike Argentina) which it also controls (unlike Greece). So even if, for some mysterious and unpredictable reason, the Bank of England decided to let UK government bond yields rise dramatically, the government would still not be forced to default – it could simply create money, as the Bank of England has done repeatedly in its quantitative easing (QE) programmes, to service the debt.
And while right now government debt is over £1,800 billion, around £745 billion of that is owed by the government to its off-shoot, the Bank of England. It is money the government owes to itself.
Ah! But what about inflation? Well, total QE now stands at £745 billion (roughly one third of GDP) and that has caused no problem of inflation – despite many predictions that it might.
I realise that many people reading this will feel a bit queasy. The idea that money can be created out of nothing, even though we know it is true, feels very alien to most of us. The idea that it might be safe to do so even more so.
For that reason, QE, how it works and when it might lead to inflation are complex topics, so we have written a companion article on the topic of Inflation Hysteria.
The Debt Will Not Leave A Heavy Burden On Future Generations
The idea that, because debt may take generations to pay off, it constitutes some dreadful burden on our children and grandchildren is also nonsense.
The (second world) war debt to the US and Canada was not repaid until late 2006.
Even more remarkably, the UK did not finally redeem the last of its consols – perpetual bonds issued first issued in 1751 and last used in the First World War – until 2015.
For most of my life, I have quite unknowingly been bearing the burden of the debt incurred by my distant ancestors – how dare they! Fortunately, I didn’t notice it. Even more remarkably, the same is true for anybody over the age of 10.
The reason we don’t notice debt, of course, is that the economy has grown out of all recognition since 1751.
If you think about it, the same is true with companies: here is the way that BP’s debt has grown in recent decades.
As you can see, BP’s debt is huge relative to the level in 1975. But then so is BP overall. Yes, its liabilities have grown dramatically, but so have its assets, its revenues and its profits. Just looking at the debt tells us nothing about BP’s financial health.
Growth is the Key to Reducing Debt:GDP
The chart below shows, for the last 300 years, how government debt has grown, and how nominal GDP has grown. It has two messages. The first is a simple, incontrovertible mathematical point, and the second is an empirical observation.
The simple mathematical point is that if GDP grows faster than the debt grows, the ratio of debt:GDP will fall. This is illustrated by the green and red areas on the graph below: the green area is where GDP is growing faster than debt, and therefore debt:GDP is falling; the red area is where the debt is growing faster than GDP and therefore debt:GDP is rising.
The empirical observation is that there is a very clear ‘normal circumstances’ correlation between the growth rate of debt and the growth rate of GDP. While there are some outliers, there are so few of these exceptional years that we can see them individually.
The outliers in the top right of the chart represent the years in which, despite what would normally be considered healthy nominal growth in the economy, debt rose faster than GDP. It is clear that this has only happened in times of national emergency such as the First World War or the immediate aftermath of the Global Financial Crisis, which was described by Charlie Bean, one of the Deputy Governors of the Bank of England, as “possibly the largest financial crisis of its kind in human history.”
There are no outliers in the bottom left — which means that there is no historical evidence of any way of containing Debt:GDP without healthy growth.
What is the relevance of this to our current situation? Well, we are currently in a profound economic contraction as a result of the coronavirus, and of course this means that the ratio of debt to GDP will rise now. It may also rise for a year or two after the virus is eliminated as happened after the Global Financial Crisis.
And then we shall return to the normal circumstances line, or thereabouts. So the policy choice we face is about which end of the line we want to sit.
If we obsess about the debt and fail to invest in growth we shall sit at the left-hand end and, paradoxically, there is a real risk that we will see the ratio of debt to GDP continuing to worsen. If we have the courage to invest in growth, then we shall sit at the right-hand end, and we can be confident that the ratio of debt to GDP will fall.
As Lord Turner wrote, in his book, Between Debt and the Devil,
“Inadequate nominal demand is one of very few problems to which there is always an answer. Central Banks and governments together can always create nominal demand in whatever quantity they choose by creating and spending fiat money.”
If we sit a the wrong end of the line, it is because we have chosen to do so.
The bad news is that government debt will rise. The good news is that this really does not matter. What does matter is that we have the courage to invest in our future. Debt hysteria is far more dangerous than the debt itself.
You now understand more about government debt than most politicians.
If this matters to you, please do sign-up and join the 99% Organisation.
2 comments so far
What this story omits is private debt (household and business) which is now three times the amount of government debt, and far more expensive. Private debt has been getting more expensive while government debt has been getting cheaper, as banks have sought to improve their net interest margin and recover growing compliance costs.
In 1945, there were no credit cards or personal loans. Total bank lending to the private sector was 12% of GDP. The hysteria has the wrong target. About one-fifth of world economic output is spent on interest. How much more can this ratio grow?
Quite right. Private sector debt is much more of a worry. And reducing government debt would drive it up even further.