Sunday, June 20, 2010

Projections of the UK’s Interest Burden on Gilts as a Percentage of GDP: The Reality Versus the Rhetoric

Most recently, Cynicus Economicus has drawn attention to the fact that the cost of servicing the UK’s interest payments on government debt might become a serious problem. He states in a recent comment on his blog:
As countries like the US and UK approach 100% of GDP, they argue for more borrowing. At what point, really at what point, will they stop asking for this? In the case of the UK, for example, absolute interest on borrowing is already rising to painful levels.

http://cynicuseconomicus.blogspot.com/2010/06/post-keynesian-solutions-reply-to.html
He has made a good point that needs to answered. It might become a problem in the future, but needs to be put into perspective.

Here is what Liam Halligan says in the Telegraph:
Annual interest payments on UK government debt, already £40bn, are set to reach £70bn by 2015.

Liam Halligan, “Budget 2010: Courage and conviction needed to tackle the worst crisis since 1976,” Telegraph, 19 June 2010.
These numbers seem shocking, but notice that Liam Halligan does not give us the true measure of this burden: its percentage of UK GDP.

For this, we need to go to the Office for Budget Responsibility (OBR) report published on the 14 June 2010. The absolutely crucial figure is given on p. 53 of the report:
[the] central government debt interest as a percentage of GDP increases over the forecast period from 2.9 per cent in 2010-11, to 3.7 per cent in 2014–15. The key determinant of this rise is the sustained high levels of borrowing over this period. The average annual growth rate in debt interest payments from 2010-11 to 2014-15 is 12 per cent.

Office for Budget Responsibility Pre-Budget Forecast, June 2010, p. 53
So in fact the burden of interest payments on gilts is projected to be about 3.7% of GDP in 2014–2015. This isn’t a catastrophe – it is less than the burden in the 1980s and early 1950s. And remember that this is a pre-budget forecast, so this is the burden if we assume no austerity measures.

Another blogger has also provided some sober analysis of this burden, and has pointed out that contrary to the rhetoric we hear this isn’t absurdly high, but is less than the burden in the 1980s and the late 1940s and early 1950s (see The Interest Burden in Context, June 14, 2010, Stumbling and Mumbling).

For a realistic assessment of the “burden” of the UK interest servicing, one can consult this graph:

UK Debt Interest as a Percentage of GDP

I advise people to have a careful look at this graph. You have to put the absolute figure of 70 billion pounds into perspective.

It is perfectly obvious that this burden will not be unprecedented and is only at the higher end of the average historical rate. The cost of interest servicing as a percentage of GDP was higher throughout all of the 1980s under Thatcher (at over 4.2%), and in 1996-1999 was about 3.5%, only slightly lower than where it will be by 2015. The UK did not collapse under the weight of interest servicing under Thatcher. Why would it now? Why is a burden of 3.7% of GDP hysterically touted as a disaster, when the burden was higher under Thatcher?

Paying 3.7% of GDP as interest on debt by 2015 is certainly a cost, but then what is the benefit? The benefit is that deficit spending (mainly automatic stabilisers plus some fiscal stimulus) will prevent a catastrophic debt deflationary spiral, a depression and mass unemployment. The benefit easily outweighs the cost, and the cost is fully justified.

There is also the question of taxpayer money being used to repay the debt. Cynicus argues that “each GBP of interest payments has to come from the taxpayers. Each GBP spent on paying interest is not going to be available to pay for other resources.”

One should note that even interest payments can be funded by rolling over debt and bonds that are bought back by the Bank of England are effectively retired.

Since foreigners own about a third of UK government debt, this is a cost. But then two-thirds is domestically owned, as you can see here. So two-thirds of the interest payments are just payments back to British individuals and institutions. They spend the money back into the economy or make it available again for saving or investment in assets. In other words, two-thirds of the interest is just a transfer back into the UK national economy, so the government is just recycling money. This is hardly a serious problem.

All in all, if we put the 3.7% of GDP figure into context, then thoughtful commentators should be saying this: “On recent estimates (and before austerity), the interest servicing of UK debt by 2015 will be less painful than under Thatcher and slightly more painful than under the early years of New Labour, but hardly ruinous. It will also prevent a severe contraction in the economy.”

One important point that Liam Halligan makes in the Telegraph article is that the historically low yields on UK gilts are the result of government policy: these are (1) QE and (2) the banks have been forced to buy UK bonds. This just reinforces the fact that policy tools are available to keep yields low, just as Japan has keep its bond yields low for nearly two decades.

In reality, the free market ideology of the Conservatives will no doubt mean that they will abandon these policies to keep yields low, but that will be a quite deliberate policy choice on their part whose effect the Tories will be responsible for.

It can also be pointed out that Paul Krugman has made the same point about the US debt servicing burden in response to the same type of fear-mongering from US conservatives.

The reality is that today the US interest burden is historically low. As a percentage of GDP, the US interest burden was actually much worse under Reagan and George Bush senior. Here is what Krugman concludes about present projections of US debt servicing:
George Will [sc. said] … that we’re in terrible shape because by 2019 the interest on the debt will be [$700 billion] …. [but] what we’re talking about is a debt-service burden roughly comparable to that under the first President Bush [sc. in terms of a percentage of GDP]. How many of the people now warning about the impossible burden of currently projected debt were issuing similar warnings back in 1992?

Paul Krugman, “The Dogbert Theory of the Debt,” November 30, 2009.
Krugman also provides a graph of the interest servicing as a percentage of GDP in his blog post. The worst period in the cost of US debt servicing was in the 1980s and 1990s: and yet the US was not bankrupted. Even on the worst projections – and these are the worst projections – the cost of servicing US government debt would return to the position it was under Reagan and Bush senior by 2015, and be slightly higher by 2019. But this is hardly a catastrophe, just a return to a higher burden, which the US easily managed then and could now.

I have also been challenged in other comments to provide a “hard limit” to government borrowing.

In fact, for the UK I have already done this before and have said that for the next decade 80% to 120% of GDP is reasonable, if necessary (see my reply to Sobers towards the end of the comments here).

However, I do not believe that the UK needs to push its debt-to-GDP ratio this high. If the basic structural problems of the UK economy were fixed, then a return to growth could be accomplished. I have frequently given solutions to the structural problems of the UK economy. The UK needs to:
1. Audit its banks and clean their toxic assets;

2. Nationalise those banks that took bailout money and have the banks pay it back;

3. Re-introduce effective financial regulation like Canada;

4. Large fiscal stimulus to bring down unemployment and increase business activity;

5. Adopt aggressive trade and industrial policies and rebuild manufacturing and output of tradable goods and services to bring down the trade deficit.
I am often challenged to give details of industrial policy. I have done so recently by showing how the US could rebuild its manufacturing by government policies to encourage better and wider use of automation and technology to increase manufacturing productivity and to lower prices.

The Save Your Factory movement launched by a company called Fanuc Robotics America Inc. should be made a US federal government program (for excellent analysis of it in a 2005 issue of Manufacturing Engineering magazine, see Rick Schneider, “Robotic Automation can cut costs,” Manufacturing Engineering 135.6 (December 2005): 65-72).

The UK could adopt a similar policy. Direct government allocation of credit at low rates or even direct subsidies could be given to domestic manufacturers to challenge low-wage countries and keep manufacturing in the UK and create more industry.

3 comments:

  1. Addendum

    The Office for Budget Responsibility (OBR) report projects that government debt interest will be 3.7% of GDP by 2014–15.
    However, as I pointed out above two-thirds of this debt is held domestically.
    Since 75% of 3.7 is 2.77, by 2014/2015 the UK government will be giving UK residents and institutions 2.77% of GDP in interest payments.

    This is just a flow of money back into the economy, and much of it to people saving for retirement. Looked at this way, it's hardly the burden it's made out to be. It is giving many people the savings they need for retirement and a safe financial asset, as opposed to risky private assets.

    I note that Paul Segal in the Guardian says that 80% of UK government debt is owed to the British people, although I am not sure that this is correct:

    http://www.guardian.co.uk/commentisfree/2010/jun/17/fiscal-deficit-threat

    ReplyDelete
  2. Evgueni in HorleyJune 23, 2010 at 5:07 AM

    2/3 = .6(6) and 75% is 3/4. Also 75% of 3.7 is 2.775 which rounds up to 2.78. Does not ruin the point of course..

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  3. Addendum 2

    Evgueni in Horley, yes, my mistake!
    Corrected figures:

    The Office for Budget Responsibility (OBR) report projects that government debt interest will be 3.7% of GDP by 2014–15.

    However, as I pointed out above two-thirds of this debt is held domestically.

    Since 66.6% of 3.7 is 2.46, by 2014/2015 the UK government will be giving UK residents and institutions 2.46% of GDP in interest payments.

    ReplyDelete