Economists at the International Monetary Fund have suggested that if governments could choose between running a high or low level of debt compared to GDP, then all else being equal they should travel along the low-level route.
The reason for this is clear. Carrying a high level of debt relative to GDP implies governments must spend vast amounts of tax revenue to service the debt interest and redeem paper that is set to mature.
That is, of course, money that cannot be used on anything else.
In the 2014–15 financial year, the UK government spent £34 billion overall on servicing its debt, amounting to 4.6% of overall spending. Of course, the government also receives interest and dividends on the assets that it holds; taking this into account, spending on net debt interest payments was £28bn, or 3.8% of total spending.
To spend or not to spend, that is the question
If large scale state spending is to continue, then the government will have to seek further access to capital markets as it rolls debt over or borrows even more. The alternative is to impose wider and deeper taxes. These are, of course, usually targeted against the engines of wealth and creativity, i.e. business and high-net worth individuals.
What is often overlooked by governments that view life through a socialist prism is that such taxes are actually a fetter on the economy (for more on this, see last week's TradingFloor.com column
Britain’s big choice
It is now just over two weeks until the UK general election on June 8. The major parties have launched their manifestos and with Labour’s pre-launch leak, the Conservatives' wobbly weekend over social care, and the Liberal-Democrats not making any genuine breakthrough, one clear issue that can divide the parties is their approach to managing the level of debt the UK will carry in absolute numbers and relative to GDP.
Data from Oxford Economics would suggest that while GDP may expand faster under the stimulus that the Labour and Liberal-Democrats seek to deploy, the cost of borrowing – i.e. the yield to maturity on Gilts – will rise by far more than under the Conservatives.
I would dispute the projected growth paths as I do not believe a larger level of state spending or engagement in the management of the economy is more productive. Indeed, under the Labour model the role of more powerful trade unions would be a growth disrupter.
With the Liberal-Democrats, the desire to hold another Brexit referendum may well just lead to even more uncertainty. I wanted to remain in the European Union at last year's referendum, however, we all should respect the democratic answer given by the people of the UK.
Run the debt, or pay it down?
When a government is carrying a heavy debt burden relative to its GDP should it look to tighten the public purse and use austerity to engineer a debt reduction or take advantage of low interest rates to invest?
Of course, the answer one feels in one’s heart will be fashioned according to one’s political will. I would prefer a lower debt level and a smaller state. That does not mean, however, going down the purest route of “laissez-faire”. There is a level of state engagement that is healthy and a net positive contributor to growth. Matters such as defence, law and order, and parts of health and education can be well run by the state and the regions provided there is accountability.
A more appropriate response is to consider the degree of “fiscal space” a government has at its disposal. This is a theoretical concept that evaluates the distance between a government’s debt to GDP ratio and an “upper limit” that has been calculated by Moody’s Investor Services.
The conclusion is that if a nation allows its debt to rise to a level that cramps the fiscal space, it will not be long before radical action will be required to avoid a debt default. Such a measure allows different nations to be ranked depending on how far their debt is from their upper threshold.
Like an extended traffic light signal, the categories for nations is: safe (green), caution (yellow), significant risk (amber) and grave risk (red).
It is best to consider the measure as a good indicator of how proofed or, alternatively, how vulnerable a government’s finances are to a shock.
Source: Moody’s Investor Services
From the chart above one will see that I have placed a three-band subdivision on the green or “safe” category. The UK has precious little room to play with and as the nation’s recent economic history shows, the budget deficit reached a massive 10.2% of GDP in 2009 under Labour’s vast spending programme. It has been brought down to 3.0% at the end of 2016.
I have no doubt some readers may wish to argue with me by pointing out that the UK has seen its debt level (in absolute terms and relative to GDP) rise since the election of 2010. I would respond by pointing to the fact that the IMF analysis classifies the UK as a “marginal green case”, implying the nation does not have much protection in the event of a downturn.
In addition, we have seen from its manifesto that Labour are looking to impose a massive tax hike on business and individuals who dare to earn over £80,000 per annum. The IMF has a warning for Labour in that they calculate that the expected costs of the higher taxation from the disincentives to work created by increased tax rates are likely to outweigh the expected benefits delivered to the economy.
Should the UK raise more debt? As said before, it all depends on one’s political perspective. If economic growth is faster that the growth of debt, then the level of debt relative to GDP will fall and therefore increase the so called “fiscal-space”. However, will lasting growth emanate from a larger state fed by taxes and borrowing that tries to manage the economy from the centre, or from the flexibility of the free market?
Economic history is littered with failed investments from state-run investment banks. Too many programmes get the go-ahead because a political debt must be repaid and inefficiencies mount up. The state should do no more than protect and educate the population while ensuring sensible regulation keeps business operators on the straight and legal path.
The chart above, when coupled with the first, may make one think the best of both worlds would come from the Liberal-Democrat proposal. Let’s me just remind the reader that since April 18 when the election was called, Liberal-Democrat support has fallen from 11% to just 9%. Their refusal to get past the result of the EU referendum last year has not served them well.
I am sure my followers know where I stand, but I will nonetheless state my view, which is that the government should not just borrow because it can to fulfill endless political promises. Rather, the responsible thing is to maintain a safety margin so that when the next crisis comes there is the scope to raise funds and thus smooth out the shock to the system.
— Edited by Michael McKenna