Wednesday, September 2, 2009

How do we pay for this ‘sugar rush’?

Taxing Problems and a Gilt-y Solution?

A serious analysis of the UK government's options to fund itself. "Tax receipts in several countries are facing headwinds from job losses and structural changes to their economies. The new world of tougher-to-obtain and less abundant credit will impact the composition of tax revenues, and in many cases will reduce the overall tax-take. These effects will persist long after monetary stimuli have provided their temporary ‘sugar rush’. We look at the UK as a prominent example of an economy with potentially many tough years ahead of it."

Posted by mountain goat @ 06:08 PM (648 views)
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4 thoughts on “How do we pay for this ‘sugar rush’?

  • You have to take into account the difference between this recession and those of the late 70s and early 90s. The background of those recessions was overheating, high growth of nominal GDP, high inflation and IRs, requiring the govt to put the brakes on. This recession is the opposite – relatively low inflation and sustained falls in nominal GDP for the first time since the ’30s, putting some onus on the government (in the opinion of most economists) to stoke the economy.

    The high growth in nominal GDP in the 70s and 80s made it possible for governments to run deficits without increasing the debt burden. From 1979 to 1982 nominal GDP rose by 50% and national debt correspondingly fell from 47% of GDP to 30%. In the 70s and early 80s inflation reduced government debt but it meant that UK bondholders were getting a bad deal – bond yields were high (around 12%) but RPI inflation was higher AND the income was taxed. The bond markets consequently lost faith in the UK government and the cost of govt borrowing became very high. Through the 80s and 90s that cost was generally 4% above inflation, even as inflation itself came down. The other problem was that a 25-year gilt issued in the early 80s paid maybe 13%, while during that 25 years inflation averaged 5% or less – a burden for future governments.

    The current situation is far from rosy, but you have to look not only at the gap between government revenues and expenditure or the ratio of debt to GDP but also at the cost of servicing that debt. The real cost of servicing 25-year gilts issued in the early 80s ended up at about 8%, while the cost over the next few years of servicing debt currently issued looks like being about 2%. The government is thinking that with relatively low servicing costs it may as well let debt take the strain of the reduced revenues and increased expenditures that are part of a recession – debt servicing costs in 2006 were about the same as they were in 1996 (£27+bn) depite a 40% increase in outstanding debt during that period.

    This is no defence of Labour policy, but it shows that comparisons with 1976 / IMF are a bit off base. And it’s worth taking all this into account in discussions on this site of the dangers of running up more debt.

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  • mountain goat says:

    Icarus – I am not one for lightly saying the IMF will be called in. I am glad someone like yourself has commented, you seem to have more grasp of the numbers than I have. I think I posted this because I am trying to make up my mind.

    My fears about this being dangerous have to do with QE starting about the same time as markets hit their lows. We all remember how negative sentiment was then, end of the world… So was this clearly thought out or done in panic, likewise bailing out banks? There must come a point when interest payments on the debt can’t be met, let alone paying it back. Your comments seem to say that the interest payments on the new debt will be manageable. Then there is also the point made in the article about there being no appetite for long term government debt, only shorter than 8 years. This means there will be constant requirements to roll-over the debt, which is vulnerable to change in sentiment, if things get worse for the UK. I think the assumption at present is that when things improve the market will happily absorb the debt.

    I work in higher education so I am concerned that Ireland style cuts may be required. The free-to-fall GBP is certainly a plus in this regard though, so maybe we can avoid destructive sudden shut down of key government spending. However, there must be a trade off here, if GBP is allowed to fall too much, interest rates the government has to pay will go up for its right to borrow.

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  • icarus, that is a good post.
    If deflation deepens then the real cost of government debt will be higher than 2% though, and at the same time although the debt may be cheap the revenue base to service it will be shrinking. Also, Mervyn’s arguments against inflation are tantamount to saying that there will be so many poor people in the UK desperate for work that there won’t be any upwards pressure on wages.. but those people aren’t close to the economy, they can’t suddenly jump into jobs and bring down wages, they are going to take ages to soak back into the workforce. If the rates were set at the right level, sterling would not have tanked as it has done.
    I think personally inflation will jump quite rapidly at some point. It is not credible that a devaluation of 20% for an open country does not eventually show up in prices.

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  • mg and stillthinking – I just wanted to illustrate what the Treasury & DMO are probably thinking and to point out that to counterbalance many of the (valid) points made by you and other posters here regarding the govt’s poor debt situation there are two positives – (a) current and near-future (relatively) low-cost borrowing and debt servicing and (b) the legacy costs of high real rates of 25-year govt borrowing in the 70s and early 80s have worked themselves out of the system. (It may have been the latter that gave Gordon the idea around 2001 that he could go on a spending spree.) Of course this doesn’t mean that the UK is in a comfortable position – the government debt strategy very much depends on this recession ending in the next year or so, and in my view that’s not too likely.

    mg – the discussion of gilt maturity should include yields and spreads – reluctance to buy long-term gilts should be reflected in their yield rather than quantity issued? And why don’t the two kinds of gilt (0-7yrs and 8+yrs) add to 100%?

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