EREP 2 Debt & deficits basics - Prime Economics

Jeremy Smith, 23 February 2015

BRIEFING 3

Public debt and deficits ? back to basics!

Jeremy Smith, Policy Research in Macroeconomics

This is a briefing from Economists for Rational Economic Policies.

These address major current issues affecting the UK economy, in particular those associated with counterproductive "austerity" policies.

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Jeremy Smith, 23 February 2015

Introduction

This is the second of two linked briefings on the theme of austerity, deficits and debt.

This one looks in a little more detail at the definitions and misconceptions around public debt

and deficits.

Public Debt

Public debt (most but not all of which is central government debt) is a stock that has cumulated over time.

It is measured in two ways:

(a) As a sum measured in ?s, (b) As a percentage of Gross Domestic Product.

Within the UK, it is generally net debt that is measured, but for purposes of EU law and accountancy (the Maastricht criteria, which are not enforceable on the UK), it is gross government debt that is published.

Gross debt means the total stock of debt owed; net debt is the total debt minus the financial assets of government (e.g. interest payments due to government). UK net debt is at present some 10% less than gross debt.

In May 2010, when the Coalition Government took office, net public debt (excluding public sector banks) was ?974 billion.

In December 2014, it had risen to ?1483 billion.

As a % of GDP, in May 2010 it was 62.7%, and by December 2014, it had risen to 80.9%.

It is worth noting that, until the global financial crisis hit, the Labour Government had overseen a level of public debt that (as a % of GDP) was low by historical standards, as this chart (1945 to 2014) shows:

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Jeremy Smith, 23 February 2015

In 1997/8 public debt was 39.3% of GDP, in 2001/2 it had fallen to 29.3%. By 2007/8, it was 36.7%.

What caused it to rise was the shock of the global financial crisis from 2008, and its economic aftermath.

It should also be recalled that the debt figure includes borrowing for essential long--term investment (capital) purposes, e.g. on schools, hospitals etc.

The OBR (December 2014) forecast was that central government total expenditure in 2014/15 will be ?704 billion, of which interest on the stock of debt is estimated at ?48 billion (around 6.7% of government spending).

The interest payable on the central government debt stock rose in cash terms from ?33 billion in 2009/10 to ?47 billion in 2010/11 (the year the Coalition government took office).

In real terms (i.e. after allowing for inflation, and at 2013/4 prices), central government debt interest was ?47 billion in 2010/11 and again ?47 billion in 2013/14, according to the Public Expenditure Statistical Analyses 2014.

Despite higher debt, after an initial sharp rise in the wake of the global crisis, annual interest payments have not risen significantly in real terms since 2010/11.

Moreover, as a percentage of GDP, UK interest charges on its debt have not risen significantly, in historical terms.

European Commission statistics tell us that in 1995, during John Major's government, interest payments were 3.5% of GDP.

Under the Labour government, the ratio had fallen to just 2% of GDP before the crisis, and it has since risen to just 3% of GDP in 2012 and 2013.

So despite the crisis, the ratio of UK interest payments to GDP is still today lower than that achieved and bequeathed by the last Conservative government after 18 years in office!

Therefore, the increase in public debt caused by the global financial crisis has not made that debt significantly more expensive for government or tax--payer in real terms, or as a share of the national "cake". One reason is that the Bank of England agreed in 2012 to pay Government interest earned on its holding of ?375 billion Government debt purchased under the "quantitative easing" (QE) programme.

Between April to January in 2013/14, ?31.1 billion was transferred from the APF to central government. By contrast, only ?10.7 billion was transferred in the same period in 2014/15.

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Jeremy Smith, 23 February 2015

The Public Budget Deficit

The public budget deficit ? which is mainly the central government deficit ? represents the difference between government income (revenue) and government expenditure.

It can be measured at the end of (usually) a monthly or annual period, and fluctuates according to the precise relative movements of income and expenditure.

Because the deficit (like the fluctuating day--to--day level of your overdraft) is a shifting flow of funds in and out, government cannot just decide to "pay down" or "pay off" a deficit (as some leading politicians still mistakenly suggest). This is because the deficit is not a given stock of debt (like e.g. your mortgage principal).

It is dependent on constant movements in the income/expenditure relationship, not all of which by far are in government's power to control

As with debt, the deficit can be measured in two ways:

(a) In absolute terms, i.e. as the nominal (cash) amount in ?s -- as a snapshot at a given time

(b) Or it can be calculated as a share of the British economic `cake' as a whole, i.e. as a percentage of GDP

Recent Conservative Party posters have mixed these two up in a way designed to confuse voters. The posters claim that "the deficit has been halved".

This is untrue, since in cash terms the deficit is down by only one--third.

But the deficit has been almost halved (to 45%) -- as a percentage of GDP.

Not only that ? but the deficit remains two and a half times as large (as a % of GDP) as was planned by the Coalition government in 2010.

So let us look briefly at each way of looking at the deficit:

(a) In cash terms

A deficit can increase if income remains stable whilst expenditure rises, or it can increase if income declines while expenditure remains stable. Similarly a deficit can reduce if income rises while expenditure remains stable, or if income remains stable and expenditure falls.

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Jeremy Smith, 23 February 2015

(b) As a percentage of GDP

As the economic `cake' (total GDP) expands ? i.e. as employment and other economic activity rises ? tax revenues pour into the Treasury and the deficit (if unchanged in cash terms) falls as a share of economic output.

Equally, as the economic `cake' contracts (or is deliberately contracted by `austerity') so tax revenues contract, and the budget deficit (if unchanged in cash terms) rises as a share of economic output.

To reduce the deficit, therefore, by contracting economic activity via austerity, is perverse. It is to look through the wrong end of the economic telescope.

Better to reduce the deficit by expanding activity, in particular decently--remunerated employment. "Look after employment, and the Budget will look after itself" -- said John Maynard Keynes.

The problem in the UK since 2010 is that ? even as overall employment has increased -- wages have fallen by a very large percentage compared to inflation -- some 8%.

This means that the recent small annual % increase in average pay over inflation has still had only the most minimal impact on this overall fall in real pay.

This decline in wages has had a substantial negative impact on government revenues via reduced taxes etc.

So we need not only full employment, but better--paid employment for working people as a whole ? and in so doing, the deficit will reduce of its own accord without major further spending cuts.

This emerges from the recent report of the Institute of Fiscal Studies (Green Budget, February 2015):

Public sector borrowing has not fallen as quickly over this parliament as was expected in 2010. This is not because the coalition government has failed to implement the tax increases or spending cuts that it announced, nor primarily because those measures have raised less or cut spending by less than expected, but rather because economic growth has been lower than forecast, depressing tax revenues.

(Our emphasis)

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