MONDAY, JUNE 28, 2010
Doomsday II - Growth Vs Debt
George may have defused it
Fed up with the Major's rant about overpaid nancy boys betraying the nation, Tyler sought relief in the doomsday machine. Post-George, is it still ticking?
As regular readers will know, the doomsday machine is set in motion when a government's debt interest bill gets so big that the government has to borrow increasing amounts just to pay it.
It's like having a credit card, where instead of paying off the interest each month, you borrow more to cover it. Then, even if you stop using the card to make further new purchases (ie no more new England shirts) the debt still gets bigger and bigger and bigger, right up to the moment when doomsday dawns (ie when the credit card company calls to repossess your children). That's the doomsday machine.
Now, for governments, the key debt total is less the absolute size of the debt incash terms, and more its size in relation to GDP. That's because governments have the power to raise money from tax, and GDP is a broad measure of taxable capacity. So as long as debt isn't increasing in terms of that overall taxable capacity - the argument goes - everything is broadly under control (eg see this blog).
So for governments, what matters is whether GDP is growing faster than the rate at which debt interest is adding to their existing debt.
On that basis, how are things looking for HMG?
Over Labour's last 3 years things have been pretty grim. According to the Office for Budget Responsibility (OBR), over the period 2007-08 to 2010-11, GDP growth averaged just 1.3% pa (in money terms - ie including both real growth and inflation). Against that, the average interest rate on our debt averaged 4.0%.
Which means that interest costs were increasing our debt by 2.7% pa faster than GDP growth - the government's debt was being increased faster than the taxable capacity of the economy, and the doomsday machine was up and running*.
Fortunately, the OBR now expects a big turnaround. Over the next 5 years it projects GDP growth will accelerate to 5.2% pa (in money terms), whereas the average interest rate on HMG's debt will only increase marginally to 4.1%. That 1.1% gap means that debt interest will no longer be driving up HMG's overall debt relative to GDP.
In a nick of time, the doomsday machine has been stopped.
Phew.
Well, phew except for one thing - these are no more than forecasts.
For one thing, they depend on real GDP growth returning to a pretty healthy 2.7% average rate. Sure, that's not as wildly optimistic as Darling's last bonkers forecast, but it's still pretty demanding in the face of a stuttering European recovery.
They also depend on the government's debt interest rate (gilt yields) staying well behaved, increasing only modestly from current levels. That could well happen, but only so long as markets remain unconcerned about inflation - one good sniff of inflationary finance and yields would shoot up.
And history is not altogether encouraging. Over the long haul (back to 1800), gilt yields tend to more or less track the growth rate of nominal GDP. But you don't have to go back very far to find periods where yields have remained above GDP growth for years (as was the case for most of the 80s and 90s).
All of which underlines the need for fiscal caution. George does seem to have stopped the doomsday machine, but one false move and the mechanism could soon trip back into action.
*Footnote. The relationship between GDP growth, gilt yields, and the government debt ratio is discussed further in the OBR's first pre-budget report here. The Economist also has a couple of good articles on sovereign debt, and they have also updated their indebtedness league table, showing us in the second worst position after Spain (but note it's a 2010 snapshot and does not take account of George's budget):
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