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The biggest bill in history

The right and wrong ways to deal with the rich world’s fiscal mess

THE worst global economic storm since the 1930s may be beginning to clear, but another cloud already looms on the financial horizon: massive public debt. Across the rich world governments are borrowing vast amounts as the recession reduces tax revenue and spending mounts—on bail-outs, unemployment benefits and stimulus plans. New figures from economists at the IMF suggest that the public debt of the ten leading rich countries will rise from 78% of GDP in 2007 to 114% by 2014. These governments will then owe around $50,000 for every one of their citizens (see article).

Not since the second world war have so many governments borrowed so much so quickly or, collectively, been so heavily in hock. And today’s debt surge, unlike the wartime one, will not be temporary. Even after the recession ends few rich countries will be running budgets tight enough to stop their debt from rising further. Worse, today’s borrowing binge is taking place just before a slow-motion budget-bust caused by the pension and health-care costs of a greying population. By 2050 a third of the rich world’s population will be over 60. The demographic bill is likely to be ten times bigger than the fiscal cost of the financial crisis.

Will they default, inflate or manage their way out?

This alarming trajectory puts policymakers in an increasingly tricky bind. In the short term government borrowing is an essential antidote to the slump. Without bank bail-outs the financial crash would have been even more of a catastrophe. Without stimulus the global recession would be deeper and longer—and it is a prolonged downturn that does the greatest damage to public finances. But in the long run today’s fiscal laxity is unsustainable. Governments’ thirst for funds will eventually crowd out private investment and reduce economic growth. More alarming, the scale of the coming indebtedness might ultimately induce governments to default or to cut the real cost of their debt through high inflation.

Investors have been fretting on both counts. Worries about default have been focused on weaker countries in the euro area, particularly Greece, Ireland, Italy, Portugal and Spain, where the single currency removes the option of unilateral inflation (see our special report). Ireland’s debt was downgraded for a second time on June 8th. Fears of inflation have concentrated on America, where yields on ten-year Treasuries reached nearly 4% on June 10th; in December the figure was not much above 2%. Much of this rise stems from confidence about economic recovery rather than fiscal alarm. Yet eye-popping deficits and the uncharted nature of today’s monetary policy, with the Federal Reserve (like the Bank of England) printing money to buy government bonds, are prompting concerns that America’s debt might eventually be inflated away.

Justified or not, such worries will themselves wreak damage. The economic recovery could be stillborn if interest rates rise too far too fast. And today’s policy remedies could become increasingly ineffective. Printing more money to buy government debt, for instance, might send long-term bond yields higher rather than lower.

What should policymakers do? A sudden fit of fiscal austerity would be a mistake. Even when economies stop shrinking, they will stay weak. Japan’s experience in 1997, when a rise in consumption taxes pushed the economy back into recession, is a reminder that a rush to fiscal tightening is counterproductive, especially after a banking bust. Instead of slashing their deficits now, the rich world’s governments need to promise, credibly, that they will do so once their economies are stronger.

Lord, make me prudent—but not yet

But how? Politicians’ promises are not worth much by themselves. Any commitment to prudence must include clear principles on how deficits will be shrunk; new rules to stiffen politicians’ spines; and quick action on politically difficult measures that would yield future savings without denting demand much today, such as raising the retirement age.

Broadly, governments should pledge to clean up their public finances by cutting future spending rather than raising taxes. Most European countries have scant room for higher taxes. In several, the government already hoovers up well over 40% of GDP. Tax reform will be necessary—particularly in places, such as Britain and Ireland, which relied far too much on revenues from frothy financial markets and housing bubbles. Even in the United States, where tax revenues add up to less than 30% of GDP, simply raising tax rates is not the best answer. There too, spending control should take priority, though there is certainly room for efficiency-enhancing tax reforms, such as eliminating the preferential tax treatment of housing and the deductibility of employer-provided health insurance.

The next step is to boost the credibility of these principles with rules and institutions to reinforce future politicians’ resolve. Britain’s Conservative Party cleverly wants to create an independent “Office for Budgetary Responsibility†to give an impartial assessment of the government’s plans. Germany is poised to pass a constitutional amendment limiting its structural budget deficit to 0.35% of GDP from 2016. Barack Obama’s team wants to resurrect deficit-control rules (see article). Such corsets need to be carefully designed—and Germany’s may prove too rigid. But experience from Chile to Switzerland suggests that the right budgetary girdles can restrain profligacy.

Yet nothing sends a stronger signal than taking difficult decisions today. One priority is to raise the retirement age, which would boost tax revenues (as people work longer) and cut future pension costs. Many rich countries are already doing this, but they need to go further and faster. Another huge target is health care. America has the most wasteful system on the planet. Its fiscal future would be transformed if Congress passed reforms that emphasised control of costs as much as the expansion of coverage that Barack Obama rightly wants.

All this is a tall order. Politicians have failed to control the costs of ageing populations for years. Paradoxically, the financial bust, by adding so much debt, may boost the chances of a breakthrough. If not, another financial catastrophe looms.

In a British context, I reckon that in a decade or two, only the cash rich will be able to retire. The rest of us will just have to accept that an ocean of blue wash and badly grey hairs will be working for a menial wage until they drop.

Of course, nobody wants to do anything about this problem, or even talk about it, as it is only house prices today which matters. Right?

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Limits to inflating away debt and political commitments to future public spending

In response to my previous blog, “The fiscal black hole in the USâ€, ‘Peter’ makes the comment that much of the unfunded ‘liabilities’ under social security and Medicare are index-linked and cannot be inflated away. This is an important point. Inflation reduces the real value of nominal liabilities. If these nominal liabilities are interest-bearing, and have fixed market-determined interest rates that mas or menos reflect the rate of inflation expected at the date of issuance of these liabilities over the maturity of the liability, then only actual inflation higher than the inflation expected at the time of issuance actually reduces the real value servicing that liability. If longer-maturity nominal debt instruments are floating rate securities, whose variable interest rate is linked to some short-term nominal rate benchmark, it becomes very difficult to inflate the real burden of that liability away.

If the liability is index-linked, it is impossible to inflate its real value away. The same holds if the liability or the commitment is denominated in foreign currency, something that is uncommon in the US, but common elsewhere. Only a change in the real exchange rate can affect the real burden of foreign-currency-denominated liabilities.

Formally, some of the unfunded liabilities, including current social security commitments to future benefits, have indexation clauses attached to them - sometimes to CPI inflation, sometimes to the inflation rate of average earnings. Political commitments to health care provision are no doubt, in the minds of the public, commitments to a given standard of care, which amounts to index-linking to earnings growth and the growth in the cost of other health care inputs. But the legislation and rules covering these future commitments do not, as far as I know, contain any explicit indexation rules and formulae. If the political determination to renege on these commitments is there, it can therefore be achieved quite easily through actual inflation - it would not even require unexpected inflation. This is what was done in the UK with the real value of the state pension - the UK’s social security retirement benefit. As a result, the UK now has the least generous state-funded basic pension of any western country.

Of course, the true savings for the budget achieved by eroding the real value of the state pension in the UK is smaller than the reduction in the value of the state pension. The poverty in old age created by the very low state retirement pension leads to higher public expenditure in other budgetary categories. Examples of this are the Winter Fuel Payment in the UK (which amounts to throwing a discretionary payment at the elderly around Christmas, to stop them from freezing to death), or the free TV license for the over 75s, which stops the elderly from going out, rioting and blockading Parliament to demand a less stingy basic state pension. Such examples of the Haile Selassie welfare state ( named after my father’s description of watching the late Emperor of Ethiopia drive through Addis Abeba throwing bank notes from the window of his limousine) taking over when a systematic approach to welfare threatens to become unaffordable can be found all over the world.

So yes, to the extent that any liabilities, whether they are formal contractual obligations or political promises or commitments are de-facto index-linked, they cannot be inflated away. This does not mean that governments will not attempt to inflate them away. The history of hyperinflations tells us what happens if neither the anticipated inflation tax nor the unanticipated inflation tax can fill the budgetary hole. Hyperinflation is not in the US future, however, as any conceivable US government would default on its formal obligations and renege on its political commitments before letting that happen.

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Of course, nobody wants to do anything about this problem, or even talk about it, as it is only house prices today which matters. Right?

In my case, yes, it is. Half the reason I refuse to mortage myself up to my nostrils is I'd like to be able to put something away for the future. What's more, it's not as if compulsory second pensions would be viable either there just isn't the cash going around in the younger half of the population to make it work, and the high cost of housing is instrumental in this.

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Except it's not the biggest bill in history.

National Debt as a percentage of GDP was over 100% between 1918 and 1962, topping off at 237% in 1947.

http://www.ukpublicspending.co.uk/uk_natio...debt_chart.html

Wasn't there something about the period leading up to 1918, and up to 1947 that meant the British government had to borrow quite a bit of money?

I've heard it said (by Niall Ferguson) that we are currently borrowing at world war rates, but without the world war.

Y

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Yes, but in those days the National Debt was more than compensated for by private savings.

Quite the reverse is now true.

Just out of curiosity in 1947 when National debt was at it's height 237% of GDP and we had just come out of WW2 what was the level of private savings as a percentage of GDP?

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Just out of curiosity in 1947 when National debt was at it's height 237% of GDP and we had just come out of WW2 what was the level of private savings as a percentage of GDP?

Google has let me down and so have the indexes of the three fat Corelli Barnett books on the shelves in which I know the figure lurks.

OTOH, leafing through one of Barnett's books I was reminded how both Marshall Aid and theft-through-inflation helped out.

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I've heard it said (by Niall Ferguson) that we are currently borrowing at world war rates, but without the world war.

Y

This time we are borrowing first and having the war second and seeing if the debt fairs any better.

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Except it's not the biggest bill in history.

National Debt as a percentage of GDP was over 100% between 1918 and 1962, topping off at 237% in 1947.

http://www.ukpublicspending.co.uk/uk_natio...debt_chart.html

Except there wasn't an off-balance sheet public sector pensions deficit in 1947 of around a trillion that should make the real debt around 160% of GDP not the 80% quoted when it tops out in about four years..

I would rather deal with a 237% deficit with 1947 demographics than a 160% deficit with an ageing population.

Edited by crashmonitor

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Except it's not the biggest bill in history.

National Debt as a percentage of GDP was over 100% between 1918 and 1962, topping off at 237% in 1947.

http://www.ukpublicspending.co.uk/uk_natio...debt_chart.html

Is that net debt at market prices or something else.

ECORDS of public spending in the United Kingdom for the half century from 1900 to 1950 are not readily available.to the researcher. To assemble an approximate data series we have combined tables of current spending from National Income, Expenditure, and Output in the United Kingdom 1855-1965 (NIEO) by C.H. Feinstein with tables of spending published in The Growth of Public Expenditure in the United Kingdom by Alan T. Peacock and Jack Wiseman.

From National Income, Expenditure, and Output in the United Kingdom 1855-1965 we have abstracted the values of total central government current spending for 1900 to 1950 from Table 12, Current Account of Central Government (including National Insurance Funds), 1900-65. From Table 13, Current Account of Local Authorities, 1900-65 we have abstracted the values of local authority current spending for 1900 thru 1950.

From The Growth of Public Expenditure in the United Kingdom we have abstracted public spending by function for the period 1900 to 1950. But the spending data in Growth is only available for selected years: 1900, 1905, 1910, 1915, 1917, 1918, 1920-38, and 1950-55. You can view the entire text of Growth here.

To assemble a continuous data series for each government function we have used the NIEO continuous series of total central government and local authority current spending as a guide for overall spending in the “gap†years. The following procedure is used.

1. Total government spending for each gap year is derived by imposing the trend of NIEO spending over the gap years.

2. Non-defence spending (including debt interest) is assumed to trend smoothly at a fixed percentage over the gap years.

3. Defence spending is calculated by subracting all other spending from total spending.

Here is how this works for central government spending in the period 1900-05. The period starts with elevated military spending for the Boer War.

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Is that net debt at market prices or something else.

Pitty we can't have a like for like comparison with 1947 before Gordy embarked on criminal off balance sheet accounting Enron style.

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I would rather deal with a 237% deficit with 1947 demographics than a 160% deficit with an ageing population.

I would have thought that just after a war the proportion of young men was rather low, and so there would be a decidely elderly age profile.

Not as old as now because life expectancy has increased, but surely elderly in the context of the time.

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I would have thought that just after a war the proportion of young men was rather low, and so there would be a decidely elderly age profile.

Not as old as now because life expectancy has increased, but surely elderly in the context of the time.

It's all a bit moot though, isn't it?

whether we are worse than then or not?

If I remember from what my parents told me, and from my childhood, we didn't get out of it by borrowing money off the Chinese so we could give the money back to them in payment for plasma TVs.

They got out of it by not spending too much and making do with the money they had.

A period of austerity is Mervyn King's best outcome I seem to recall. Although as GOM always says, watch what they do not what they say.

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Assuming the forecasts are correct.

And of course it already looks like Alistair Darlings forecast for this year are way out......

He was far too pessimistic ;-)

Alistair Darling will be able to announce in the autumn pre-budget report that his forecasts for growth and the public finances were too pessimistic. The chancellor said in the Budget that he did not anticipate growth resuming until the final three months of 2009: there is now a realistic possibility that gentle expansion is already underway. Higher oil prices and a rally in the stockmarket could mean that the deficit this year comes in below the expected £175bn.

http://www.guardian.co.uk/business/2009/ju...-brown-spending

News I'm sure would result in much gnashing of teeth round these parts.

Edited by Flash Gordon

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Did you read the whole article?

Yes I did, are you referring to this....

Darling has finessed things as best he could. Mistakes have been made, but when it came to the crunch last October, the Treasury's handling of the banking crisis was exemplary.

You have a point I should have mentioned it, after all if Osborne & Tip Top Toff Cameron were in charge last October recovery in Q2 2009 would not be a possibility.

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Did you read the whole article?

He obviously didn't.

In the early stages of the crisis, Brown used to boast about how well placed Britain was to ride it out, but as John Lanchester noted in the London Review of Books last month, there are four things a country doesn't need in this crisis: a boom based on a property bubble; a boom based on a credit bubble; an economy based on financial services; and a government that has been on a spending spree.

The fact that Britain had all four is evidence of New Labour's flawed business model. Just like Adam ­Applegarth at Northern Rock or Sir Fred Goodwin at Royal Bank of Scotland, Brown seemed unstoppable in the good times, ­exhibiting a brash self-confidence before deep-seated defects in the economy were exposed by the recession.

*sigh*. Trolls.

troll.giftrain.gif

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He obviously didn't.
In the early stages of the crisis, Brown used to boast about how well placed Britain was to ride it out, but as John Lanchester noted in the London Review of Books last month, there are four things a country doesn't need in this crisis: a boom based on a property bubble; a boom based on a credit bubble; an economy based on financial services; and a government that has been on a spending spree.

Oh but I have read it, given your point above that the four things a country doesn't need in this crisis we had in spades and that we are the first to come out of the Recession, it shows you despite everything being stacked against GB & AD how well they and the BofE have done in averting an economic meltdown.

Far from detracting from the point it enhances it.

Now do you wish to shoot your other foot?

Edited by Flash Gordon

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Except there wasn't an off-balance sheet public sector pensions deficit in 1947 of around a trillion that should make the real debt around 160% of GDP not the 80% quoted when it tops out in about four years..

I would rather deal with a 237% deficit with 1947 demographics than a 160% deficit with an ageing population.

The trillion deficit is an extrapolation of the entire pension liability for all public sector workers over a period of approximately 35 years. The liability won't ever become due in such a way and is only being presented in such terms in order to make a political case to axe public sector pensions and shift billions into private pensions.

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Oh but I have read it, given your point above that the four things a country doesn't need in this crisis we had in spades and that we are the first to come out of the Recession, it shows you despite everything being stacked against GB & AD how well they and the BofE have done in averting an economic meltdown.

Far from detracting from the point it enhances it.

Now do you wish to shoot your other foot?

If they had done nothing except tell the truth, it would have been over much quicker. We would be using a different currency though ;)

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