Austerity & debt stabilization

Alex is right. David Cameron's speech on the deficit yesterday consisted of "intellectually lazy lies". This, in particular, is dubious:

The choice is clear: staying on the road to recovery – or choosing the path to ruin. Competence or chaos.

To see what's wrong with this, remember the basic maths of government debt dynamics. This tells us that the primary deficit (that is, the deficit excluding interest payments) necessary to stabilize the debt-GDP ratio is:

d * [^(r-g)/_(1+g)]

where d is the debt-GDP ratio, r the real interest rate and g the real GDP growth rate.

d is currently 0.804: debt is 80.4% of GDP. Real long-term interest rates are around minus 1%, and the OBR estimates potential output growth over the next five years to be 2.2%. Plugging these numbers into our equation gives us minus 2.5%. In other words, we can stabilize the debt-GDP ratio with a primary deficit of 2.5% of GDP. This is a slightly higher deficit than the OBR expects next year, and much higher than the surplus of 3.2% the government plans by 2019-20.

In other words, more borrowing than the government plans would be quite consistent with stabilizing the debt-GDP ratio at around 80%.

What's more, if the government can borrow at less than four per cent - and nominal ten year gilt yields are now only 1.6% - then debt interest payments would be under 3.2% of GDP. That means we'd spend less as a share of GDP on debt interest (pdf) than we did in the Thatcher years.

This is not chaos. We can achieve debt stabilization with much less austerity than Cameron plans.

Of course, things will be different if borrowing costs rise sharply. If they do, though, it would come as a big surprise to the gilt market. The real yield curve is quite flat, which implies that the market is pricing in negative yields for a long time. It's odd that a Conservative government should be basing policy upon the idea that the Man in Whitehall knows better than the markets.

Now, this does not necessarily mean that there's no case for fiscal tightening. You could argue that a debt-GDP ratio of 80%, even if stable, is an unfair burden on future generations - though it's odd that a government which charges £27,000 for a university place and which presides over huge house price inflation should worry so much about intergenerational justice. And you could argue that such a ratio gives us less room to relax fiscal policy when the next downturn comes.

It's not clear, though, that these arguments are a case for a lot of austerity soon. As Frances says:

The aftermath of a severe negative shock is no time to be worrying about "structural" deficits. Better to restore the economy first, by every means available. Dealing with what would be better named the "residual" fiscal deficit is a job for the good times.

Comments

[Luis Enrique]

also, unhelpful to conflate austerity with borrowing or deficit.

first government decides how much to spend (austerity - the instrument) then we find out what happens to the deficit.

conflating the two obscures fact that cutting £1 from a department budget does not cut £1 from the deficit, and hence that Labour could potentially ease the pain without much raising the deficit.

[Ralph Musgrave]

“We can achieve debt stabilization with much less austerity than Cameron plans”. For the umpteenth time, in the simple case of a closed economy, no austerity whatever is needed to cut the debt: we just print money and buy back chunks of debt. No austerity there. (And incidentally the equation in the above article assumes a closed economy).

“Unfair burden on future generations..”. What burden? If government incurs debt (still assuming a closed economy) then an asset (government bonds) as well as a liability (obligation to repay bond holders) gets passed on to “future generation”. The net burden passed on is zero.

[gastro george]

He also showed that he knew just as much about technology (http://www.theguardian.com/commentisfree/2015/jan/13/cameron-ban-encryption-digital-britain-online-shopping-banking-messaging-terror). The word omnishambles comes to mind.

[gastro george]

Sorry, malformed link. Try this: http://www.theguardian.com/commentisfree/2015/jan/13/cameron-ban-encryption-digital-britain-online-shopping-banking-messaging-terror

[Nick Rowe]

Chris: "You could argue that a debt-GDP ratio of 80%, even if stable, is an unfair burden on future generations..."

I hate to say it, but if you think those estimates for r and g are correct (and that r < g for ever), you are being a little too conservative.

A permanent increase in d, given those assumptions, would make all (current and future) generations better off. Because that's the condition for a Ponzi scheme being sustainable.

[An Alien Visitor]

More proof, if it were needed, that austerity is an ideological pursuit.

But looked at another way, we could say the rising and staggering levels of inequality are what will lead to chaos. I guess for those visiting food banks they are already there.

[Toby]

Absolutely: with r massively negative across the I/L gilt curve a reasonably chunky primary deficit would stabilise debt levels.

I would be interested in your thoughts on that most basic of questions: why transversality is important, and what actions you would consider unacceptably risky for a monetary sovereign.

[James]

silly question, but how do we get -2.5% as the deficit to stabilize debt/GDP? Using that formula it seems like we get -0.94%. Am I misinterpreting something?

[chris]

Sorry James. There's a typo there. Real long term interest rates are of course around -1%, not 1%. The correction's made.
@ Nick: you're right. I think I was bending over backwards to be fair to the Tories: maybe it would be rash to assume negative rates will last forever.
@ Ralph - you're right. I would once have argued that printing money to buy debt might be inflationary, but this isn't a problem now. Think of this piece as claiming that austerity is unjustified, even within the narrow confines of orthodox economics.

[Fred Fratter]

@Chris - If I've plugged the numbers into the formula correctly then those r and g allow primary deficits for very low values for d - eg d of 25% gives a primary deficit of 0.78%. So I can have a long-term reduction in d and a permanent sustainable deficit?

[Cityunslicker]

Typical leftyism on show sadly. The debts can wait for the recovery.

But we never have a recovery. Even now Labour are saying there is no recovery. We are 7 years since 2008, much closer to a new recession on all historical measures.

If the debt is 80% now, a new recession will hit and then the debt will be say 110%. But still those who argue against any kind of sound finance say fine. Print from the magic money tree, all will be well.

But is won't, interest rates are changeable, debt is real. At 110% the Country will be paying a huge amount of tax to service debt forever. And the ratio will never come down, becuase, there are always diabled people to help (or for some balance, tax cuts to be make) or schools to repair. Or indeed countries to go to war with which we always seem keen on.

Putting off to tomorrow the pain of today is the mantra of this leftist approach to monetary policy. There is never a reckoing, all will be well.

[Ralph Musgrave]

Cityunslicker,

Re the idea that 110% debt is a problem, Japan has a debt double that, yet inflation is nowhere to be seen in Japan, and the Yen has shot up relative to other currencies over the last 9 months.

Re your claim that rising interest rates would be a problem, a sudden rise in rates has no effect whatever on the amount of interest government pays on its EXISTING debt. Interest on that debt is determined when that debt is first issued. The only potential problem comes with debt due for rollover. But if creditors demand too much interest, a government which issues its own money can simply print money, pay off the debt that reaches maturity, and refuse to borrow anything more. That might be too inflationary, in which case the relevant government can raise taxes and “unprint” money collected. The deflationary effect of the latter will negate the above inflationary effect. Problem solved.

Re your claim that “At 110% the Country will be paying a huge amount of tax to service debt forever” the important consideration is the REAL or “inflation adjusted” rate of interest. Between 2011 and 2013 the real rate of interest on UK debt was NEGATIVE. I.e. far from the UK government paying interest on its debt, creditors were paying the UK government for the privilege of lodging their spare cash with the UK government.

[chris]

@ Fred - yes, if r is low relative to g. It is, however, rare for this to be the case for very long.

[ThomasH]

It is always a good time to reduce expenditures whose discounted present value of costs exceed those of benefits. It's never a good time to reduce expenditures whose discounted present value of benefits exceed those of costs. The former is good management. The latter is "austerity."

Because borrowing costs are low during a recession (and possibly opportunity costs of some project inputs less than their market prices) spending will in general rise, so a recession is an especially bad time for "austerity."

[Cityunslicker]

@Ralph, I never mentioned interest rates.

Permanent higer levels of debt expose us to permananet higher levels of repayments.

To cite Japan is super. Who on earth would want that as their model for the economy? It exists only because Japanese save at home - the UK does not save at all!

One of your solutions is to print money - genius. I am sure pure monetisation will be just fine in the real world. Works every time in history.

The other solution is to not issue any more debt. Hmm, that was the eventual problem that I want to prevent - you know, the sudden urgent need to run primary surplus. The Greece Scenario.

[Bob]

City Unslicker:
https://petermartin2001.wordpress.com/2014/09/16/the-japanese-own-their-own-debt-so-they-dont-have-a-problem-right/
If anything it can cause more problems.

[Bob]

Also, this "the UK will become like Greece" stuff is total bollocks. Greece borrows in a foreign currency, the euro. Greece actually has a primary surplus and still there are problems, many caused by the quest for surplus. A surplus for the govt means a deficit for everyone else. Greece should really withdraw from the Euro, let the currency devalue and implement land value taxation so they have low cost labour rates (no income tax) and no tax avoidance. That way they have cheap housing and become popular tourist place, also huge boost in exports, more like the German model.