With the UK parliament in Brexit gridlock, the Labour opposition is calling for a general election. Although its policy over Brexit and a second referendum is causing splits in the party, the Labour party is generally agreed that pubic expenditure on health, education and transport infrastructure needs to increase – that there needs to be an end to fiscal austerity. However, to fund extra public expenditure would require an increase in taxes and/or an increase in government borrowing.
One of the arguments against increasing government borrowing is that it will increase public-sector debt. The desire to get public-sector debt down as a percentage of GDP has been central to both the Coalition and Conservative governments’ economic strategy. Austerity policies have been based on this desire.
But, in the annual presidential address to the American Economics Association, former chief economist at the IMF, Olivier Blanchard, criticised this position. He has argued for several years that cutting government deficits may weaken already weak economies and that this may significantly reduce tax revenues and potential national income, thereby harming recovery and doing long-term economic damage. Indeed, the IMF has criticised excessively tight fiscal policies for this reason.
In his presidential address, he expanded the argument to consider whether an increase in government borrowing will necessarily increase the cost of servicing government debt. When the (nominal) interest rate (r) on government borrowing is below the nominal rate of economic growth (gn), (r < gn), then even if total debt is not reduced, it is likely that the growth in tax revenues will exceed the growth in the cost of servicing the debt. Debt as a proportion of GDP will fall. The forecast nominal growth rate exceeds the 10-year nominal rate on government bonds by 1.3% in the USA, 2.2% in the UK and 1.8% in the eurozone. In fact, with the exception of a short period in the 1980s, nominal growth (gn) has typically exceeded the nominal interest rate on government borrowing (r) for decades.
When r < gn, this then gives scope for increasing government borrowing to fund additional government spending without increasing the debt/GDP ratio. Indeed, if that fiscal expansion increases both actual and potential income, then growth over time could increase, giving even more scope for public investment.
But, of course, that scope is not unlimited.
- What do you understand by ‘fiscal illusion’?
- What is the justification for reducing government debt as a proportion of GDP?
- What are the arguments against reducing government debt as a proportion of GDP?
- Explain the significance of the relationship between r and gn for fiscal policy and the levels of government debt, government borrowing and the government debt/GDP ratio.
- Under what circumstances would a rise in the budget deficit not lead to a rise in government debt as a proportion of GDP?
- Does Blanchard’s analysis suggest that a combination of both loose monetary policy and loose fiscal policy is desirable?
- Under Blanchard’s analysis, what would limit the amount that governments should increase spending?
Household borrowing on credit cards and through overdrafts and loans has been growing rapidly. This ‘unsecured’ borrowing is now rising at rates not seen since well before the credit crunch of 2008 (click here for a PowerPoint of the chart below). Should this be a cause for concern?
Household confidence is generally high and, as a result, people continue to take out more loans and so household debt continues to increase. Saving rates are falling and, at 5.1% of household disposable income, are the lowest rate since 2008, mirroring the high levels of spending and borrowing.
But as long as the economy keeps growing and as long as interest rates stay at record low levels, people should be able to continue servicing this rising debt. Indeed, with generous balance transfer offers between credit cards and many people paying off their full balance each month, only 56.6% are paying any interest at all on credit card debt, the lowest level on record.
But there could be trouble ahead! Secured borrowing (i.e. on mortgages) is at record highs as house prices have soared, limiting the amount people have to left to spend, even with ultra low interest rates. Student debt is growing, putting a brake on graduate spending.
With economic growth set to slow and inflation set to rise as the effects of the lower pound filter through into retail prices, this could initially boost borrowing further as people seek to maintain levels of consumption. But then, if unemployment starts to rise and consumer confidence starts to fall, real spending could decline, putting further downward pressure on the economy.
Confidence could then fall further and we could witness a repeat of 2008–9, when people became worried about their levels of borrowing and cut back on consumption in an attempt to claw down their debt. The economy was pushed into recession.
The Bank of England is well aware of this scenario and wants banks to ensure that their customers can afford loans before offering them.
Bank governor Mark Carney warns on household debt BBC News, Brian Milligan (30/11/16)
Credit crunch: Household debt is rising just as the economy’s future is uncertain The Telegraph, Tim Wallace (10/12/16)
Bank of England publication
Financial Stability Report, November 2016 Bank of England (30/11/16)
Money and lending Bank of England Interactive Database
United Kingdom Households Debt To GDP Trading Economics
Household debt OECD Data
- What determines the amount people borrow?
- What would cause people to cut back on the amount of debt they have?
- Distinguish between secured and unsecured borrowing and debt.
- Why has secured borrowing risen? Does this matter?
- What is meant by the term ‘re-leveraging’? What is its significance in terms of household borrowing?
- Find out what the affordability tests are for anyone wanting to take out a mortgage.
- What are the greatest risks to UK financial stability?
Yanis Varoufakis, the new Greek finance minister, is also an economist and an expert in game theory and co-author of Game Theory: a critical text. He is now putting theory into practice.
He wishes to renegotiate the terms of Greece’s debt repayments. He argues not that some of the debt should be written off, but that the terms of the repayment are far too tough.
Greece’s problem, he argues, was wrongly seen as one of a lack of liquidity and hence the Troika (of the EU, the ECB and the IMF) provided a large amount of loans to enable Greece to keep servicing its debts. These loans were conditional on Greece following austerity policies of higher taxes and reduced government expenditure. But this just compounded the problem as seen by Yanis Varoufakis. With a shrinking economy, it has been even more difficult to repay the loans granted by the Troika.
The problem, he argues, is essentially one of insolvency. The solution is to renegotiate the terms of the debt to make it possible to pay. This means reducing the size of the budget surplus that Greece is required to achieve. The Troika is currently demanding a surplus equal to 3% of GDP in 2015 and 4.5% of GDP in 2016.
The Syriza government is also seeking to link repayments to economic growth, by the issue of growth-linked bonds, whose interest rate depends on the rate of economic growth, with a zero rate if there is no growth in real GDP. He is also seeking emergency humanitarian aid
At the centre of the negotiations is a high stake game. On the one hand, Germany and other countries do not want to reduce Greece’s debts or soften their terms. The fear is that this could unleash demands from other highly indebted countries in the eurozone, such as Spain, Portugal and Ireland. Already, Podemos, Spain’s anti-austerity party is rapidly gaining support in Spain. On the other hand, the new Greek government cannot back down in its fundamental demands for easing the terms of its debt repayments.
And the threats on both sides are powerful. The Troika could demand that the original terms are met. If they are not, and Greece defaults, there could be capital flight from Greece (even more than now) and Greece could be forced from the euro. The Greeks would suffer from further falls in income, which would now be denominated in a weak drachma, high inflation and financial chaos. But that could unleash a wave of speculation against other weaker eurozone members and cause a break-up of the currency union. This could seriously harm all members and have large-scale repercussions for the global economy.
So neither side wants Greece to leave the euro. But is it a game of chicken, where if neither side backs down, ‘Grexit’ (Greek exit from the euro) will be the result? Yanis Varoufakis understands the dimensions of the ‘game’ very well. He is well aware of the quote from Keynes, ‘If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.’ He will no doubt bring all his gaming skills to play in attempting to reach the best deal for Greece.
Greece’s last minute offer to Brussels changes absolutely nothing The Telegraph, Ambrose Evans-Pritchard (10/2/15)
The next card Yanis Varoufakis will play The Conversation, Partha Gangopadhyay (8/2/15)
Senior European official: ‘The Greeks are digging their own graves’ Business Insider, Mike Bird (10/2/15)
Greece: The Tie That Doesn’t Bind New York Times, Paul Krugman (9/2/15)
Greek finance minister says euro will collapse if Greece exits Reuters, Gavin Jones (8/2/15)
Greece is playing to lose the debt crisis poker game The Guardian, Project Syndicate and Anatole Kaletsky (9/2/15)
Greek markets find sliver of hope Financial Times, Elaine Moore, Kerin Hope and Daniel Dombey (10/2/15)
Greece: What are the options for its future? BBC News, Jamie Robertson (12/2/15)
‘If I weren’t scared, I’d be awfully dangerous’ The Guardian, Helena Smith (13/2/15)
Greek debt crisis: German MPs back bailout extension BBC News (27/2/15)
- Is a deal over the terms of repayment of Greek debt a zero sum game? Explain whether it is or not.
- What are Keynes Bisque bonds (or GDP-indexed bonds)? Do a Web search to find out whether they have been used and what their potential advantages and disadvantages are. Are they a good solution for both creditors and Greece in the current situation?
- What is meant by a ‘debt swap’? What forms can debt swaps take?
- Has Greece played its best cards too early?
- Should Greece insist on debt reduction and simply negotiate around the size and terms of that reduction?
- Are Greece’s new structural reform proposals likely to find favour with other EU countries and the Troika?
The linked article below from The Guardian paints a disturbing picture of the long-term problem of servicing both private-sector and public-sector debts.
With interest rates at historical lows, the problem has been masked for the time being. But with interest rates set to rise within a few months, and significantly over the coming years, the burden of debt servicing is likely to become severe. This could have profound effects both on long-term economic growth and on the distribution of income.
As the author, Phillip Inman states:
The funding gap is growing and with deficits on so many fronts, it is hard to see how promises to pensioners and health service users can be met without a dash for growth that is unsustainable, a switch to dramatic cost-cutting in other areas or higher taxes on those who came through the recession relatively unscathed.
You are probably facing the problem of growing debt yourself. How long, if ever, will it take you to repay your student loans? What impact will this have on your ability to spend and to have a ‘decent’ standard of living? Will you be able to afford a mortgage large enough to buy a reasonable house or flat? Will you be able to afford to do a masters degree or PhD without support from your parents or relatives or without a scholarship? And even if you manage to secure a well-paid job, will you be able to afford a reasonable pension for when you eventually retire?
The article looks at the nature of the problem and its causes. It concludes by saying:
Britain has become expert at putting off decisions and hoping for something to turn up. Without a return to ultra-cheap commodities, another technological/productivity revolution, or a return to more modest living and delayed gratification, it’s a plan that is running out of time.
Trouble in store: the grave future of British public and private debt The Guardian, Phillip Inman (20/7/14)
Fiscal sustainability report Office for Budget Responsibility (10/7/14)
Fiscal sustainability report – Executive summary Office for Budget Responsibility (10/7/14)
Fiscal sustainability report – Supplementary data series Office for Budget Responsibility (10/7/14)
- Why is public-sector debt likely to continue rising significantly over the coming years unless there is a concerted policy to make cuts in public expenditure?
- What factors are likely to lead to a rise in private-sector debt over the coming years?
- What factors have caused a redistribution from the younger to the older generation?
- How have ultra low interest rates affected the distribution of income?
- What is likely to happen to the gap in wages between ‘graduate’ jobs and ‘non-graduate’ jobs? Identify the factors likely to influence this gap?
- What is meant by ‘hire purchase’? Are leasing schemes for car purchase a form of ‘hire purchase? Are there similar schemes in the housing market?
- Does it matter if a country’s debts rise (either public or private) if the creditors are in the same country? Explain.
With all the concerns recently about Greek and Italian debt and about the whole future of the eurozone, you would be forgiven for thinking that the problems of the UK economy had gone away. This couldn’t be further from the truth. Problems are mounting and pessimism is growing.
First there is the problem of a contracting eurozone economy. This will directly impact on the UK as almost half of UK exports go to eurozone countries. Second there is the impact of the government expenditure cuts, most of which have still not taken effect yet. Third there is the fact that, with the combination of inflation over 5% and nominal pay typically rising by no more than 2%, real take-home pay is falling and hence too is the volume of consumer expenditure. Fourth, there is the increasingly pessimistic mood of consumers and business. The more pessimistic people become about the prospects for their jobs and incomes, the more people will rein in their spending; the more pessimistic businesses become, the more they will cut back on investment and economise on stock holding.
Forecasts for the UK economy have become considerably bleaker over the past few weeks. These include forecasts by the National Institute for Economic and Social Research (NIESR), the accountancy network BDO, Ernst & Young’s ITEM Club and the CBI in its SME Trends Survey and November Economic Forecast. The Treasury’s latest Forecasts for the UK Economy, which brings together forecasts by 29 different organisations, also shows a marked increase in pessimism from September to October.
So is it now time for the government to change course to prevent the economy slipping back into recession? Do we need a Plan B? Certainly, it’s something we’ve considered before on this news site (see Time for a Plan B?). The latest call has come from a group of 100 leading academic economists who have written to the Observer. In their letter they spell out what such a plan should contain. You’ll find a link to the letter below and to other articles considering the proposals.
We economists have a Plan B that will work, Mr Osborne Observer letters (29/10/11)
Plan B: the ideas designed to restart a stalled UK economy Observer, Daniel Boffey and Heather Stewart (29/10/11)
Plan B could have been even more aggressive, but it would definitely work Observer, Will Hutton (29/10/11)
The economy: we need Plan B and we need it now Observer editorial (30/10/11)
If tomorrow’s growth figures disappoint, Plan B will be a step closer, whatever David Cameron says The Telegraph, Daniel Knowles (31/10/11)
Plan B to escape the mess we are in Compass, John Weeks (7/11/11)
Plan B; a good economy for a good society Compass, Edited by Howard Reed and Neal Lawson (31/10/11)
- What are the main proposals in Compass’s Plan B?
- How practical are these proposals?
- Without a Plan B, what is likely to happen to the UK economy over (a) the coming 12 months; (b) the next 3 years?
- Why might sticking to Plan A worsen the public-sector deficit – at least in the short term?
- What are the main arguments for sticking to Plan A and not easing up on deficit reduction?
- Find out what proportion of the UK’s debt is owed to non-UK residents? (See data published by the UK’s Debt Management Office (DMO).) How does this proportion and the average length of UK debt affect the arguments about the sustainability of this level of debt and the ease of servicing it?
- If you had to devise a Plan B, what would it look like and why? To what extent would it differ from Compass’s Plan B and from George Osborne’s “Plan A”?