Spend Your Way out of Debt

Moody’s downgraded the UK’s credit rating one notch from AAA to Aa1 on 23 February.  This can now be added to the long list of sovereign downgrades made by the major credit rating agencies since the start of the recession (which includes the US). This decision mainly stems from a combination of rapidly growing public debt and a poor growth outlook. UK Debt stood at 70.7% of GDP at 31 December 2012, which is equal to £1,111bn. The threshold level for countries entering the Eurozone is 60%.

George Osborne has pledged to use austerity measures to curb the national debt. I will argue that austerity is not the answer. Growth is an automatic stabiliser. The best way to reduce debt within the UK is to spend our way into growth and then consolidate.

Who cares about the Debt?

Why does reducing national debt actually matter at all? The main reason revolves around investor confidence. If investors fear that the UK may not be able to meet their debt repayments, they will demand higher interest rates on UK gilts. This leads to a vicious cycle whereby an increase in interest rates (larger interest payments) increases the national debt thus further increasing interest rates required by investors and so on. If not careful, debt can rise exponentially in an explosive fashion. A high debt therefore leads to a risk of a fiscal crisis and makes conducting fiscal policy very difficult.

What really matters?

The key point to remember is that the raw debt figure is not the important statistic. More important is the ratio of debt to GDP. This tells us whether a government can afford its debt. In others words, we want to know whether national debt is rising too fast relative to the economy’s ability to repay it. This ratio fundamentally depends on the growth rate and the real interest rate. If growth exceeds the real interest rate then, the Debt to GDP ratio can decrease (even with a small budget deficit).

My argument that we should spend our way out of debt revolves around the concept of an “automatic stabiliser”. This is a logical concept. When a country goes into a recession, the budget deficit automatically increases. As unemployment increases, tax receipts falls and government expenditure increases to meet larger welfare demands. Conversely, in a boom period, budget deficits automatically fall. The rule of thumb is that a 1% decrease in output leads to an automatic increase in the deficit by 0.5% of GDP.

Fiscal policy is an important policy and vital to governments experiencing a recession. However it must be used correctly. A cyclically adjusted deficit (CAD) is the annual deficit, adjusted to remove the effect of the “automatic stabiliser” I just described. Over the medium-term we want our CAD to equal zero to maintain a non-increasing debt level. In order to do this and prevent an explosion of debt, a government must run surpluses in a boom and deficits in a bust. In fact, a government can even run a cyclically adjusted deficit in a recession as long as it runs the opposite in periods of high growth. By running a deficit now (spending more than is received), we will certainly increase our debt stock further. However, expansionary fiscal policy can help create growth and growth automatically decreases a deficit. The time to run a surplus is when the economy returns to sustainable growth. 

The problem with trying to run a surplus now is simple. A surplus will NOT reduce our debt to GDP ratio (our important statistic). Austerity decreases an already negative growth rate. The effect of a decrease in growth far outweighs what would be a small (if possible) budget surplus, decreasing our ability to pay our debt and pushing us into a downward spiral.

The NICE decade and Labour’s Moral Hazard

NICE stands for non-inflationary consistent expansion. It relates to the period of high growth, over a decade, prior to the financial crisis. As explained above, in a period of high growth, the government must attempt to run budget surpluses to maintain a constant debt level in the long run whilst allowing for deficits in a bust. Labour was in power from 1997 to 2009. Of the 13 years in power, Labour only ran four budget surpluses (1998 to 2001). More importantly, in real terms, the largest surplus in this period was less than the smallest deficit. Up until 2007, before the first signs of the financial crisis, the Labour government should have done more to curb an increasing debt level. This would have allowed future governments to use expansionary fiscal policy in a downturn without a long run effect on debt.

There is a problem with moral hazard here. No party will choose to run consistent (large) budget surpluses.  Government terms are too short to reap the benefits of being financially astute in the good times. In others word, Labour had no incentive to fix the roof while the sun was shining. The budget should follow the business cycle. Labour certainly did follow this rule and reduce deficits from previous years. The mistake was running deficits in the early noughties.

What’s the solution?

There is a harsh reality in the solution. If we use austerity measures to decrease our debt now, growth will fall leading to lower tax receipts and larger welfare spending. The ability to repay our debt will spiral off into the distance.

However, if we push further and continue to use expansionary fiscal and monetary policy along with quantitative easing, debt will obviously rise but so will growth. Growth leads to an automatic stabiliser. As people move into employment, government expenditure falls and tax receipts increase. The government can finally afford to reign in spending. Only then should the state attempt to run a surplus. More importantly, the state must then run a surplus, many surpluses.

The harsh reality is that eventually taxes will increase and spending will have to be reduced. Then the debate ensues as to whether is it fair that future generations must bear the cost of the recession. It’s not fair but that is the nature of the business cycle that Gordon Brown infamously claimed his party had defeated. The same generation that pays the higher taxes will be enjoying a period of growth. When the next recession comes and it will, future generations after that will bear the cost. The point is, you bear the cost of a recession after the recession.  Given the negative growth outlook and the fourth quarter contraction, we are by no means out of a bust.

Is this credible?

It seems like quite a simple thing to say. Let’s just spend more until we can afford not to. It sounds irresponsible at best. But do not let the wrong statistics sway your decision. The question isn’t whether we should wait for austerity; it is whether we are able to do so. The answer is yes. Our debt is high, but not historically high. In the 1940s, our debt was over 200%! Japan currently has a debt stock of 225% and Italy well over 100%.

The UK is not Greece. We can afford to run high deficits and still borrow long-term, just like the US. The pound is still the third most widely used reserve currency. The UK is still among the highly rated sovereigns.

You only need to look at government bonds to see this. Low interest rates reflect investor confidence. Even though our credit rating was reduced a notch, our 10 year government bond yields 2.2%. This is an increase but compared to Greece (11.07%), or Kenya (13.5%), not one that should scare the government. The US bonds stand at 1.94% and Euro Area at 1.48% at the time of writing and both have experienced downgrades.

UK and US debt is still widely accepted as safe. It will take a lot more debt and quite a few more downgrades for investors to start dumping the pound.

Given the UK’s ability to borrow long-term, the best way out of debt is to spend your way out.