Unsustainable debt is
when you owe someone something but you may not be able to pay it back – this is
bad. Debt just means you owe someone
something – this is neither good nor bad. In fact, I am not sure I would like to
live in a world without debt…
Imagine a world with
no debt
To understand why debt can actually be good, imagine a world
where there is no debt (this was one of the lyrics to a popular John Lennon song
until he realised how bad a world without debt would be). So in this world, no
one can borrow any money. What you have in your bank is all you can use to pay
for things. On the face of it, this seems great: no one will become bankrupt,
no maxed-out credit cards and everyone has to be financially responsible.
However, what if you wanted to start a business? What if you wanted to buy a house? Well the
way to go about it would be to save up for years and years before you have
enough money. This sounds like a responsible thing to do surely?
The important thing to remember here is that without debt
you won’t get any interest on your savings. You would just be stockpiling money
under your bed; the money would sit there and do nothing. Banks would only
exist as a safe place to store your money. It would actually cost you to store
your money! And if inflation happens you are completely screwed.
In reality, there is a reason why banks give you interest on
your savings. This is because they are able to lend your savings out to people
who want to borrow.
People talk about having debt as being like a “slave” to
the lender, that the lender owns you.
But it might be better to think of it as savers investing in you. These savers are the lenders. They don’t want to
own you: they want you to succeed so they can get a return on their investment
(or interest on their savings). If you go bankrupt and can’t pay the money back
it isn't good for the lenders because they cannot retrieve the money they
invested in you! This is why economists
talk about savings being essentially investment, without this, the economy
won’t move forward. Without debt some of the UK's most successful companies would never have been created as most entrepreneurs start out with just a small business loan.
In a world without debt, the only way you could obtain
finance would be via a gift. So unless your Mummy or Daddy have enough cash to
give you to start your own business or go to university, then it isn't going to
happen.
What about government
debt, isn't that too high?
The UK Government debt is currently £ 1.51 trillion. That is
1,510,000,000,000. Wow, look at all those zeros! It is too high, we are in too
much debt - PANIC! Quick, what is the number for that company who consolidate
your monthly loans?
OK, deep breath…and calm. We have seen that debt isn't a
problem as long as we can pay it back. In fact, debt can be quite good. What
matters is the relative size of the debt compared to your income.
Imagine if I told you I was going to buy a house for 2
million. You would think that debt is pretty high. But if I told you I was a
professional footballer earning 6 million a year then you would think that 2
million doesn't seem so high after all.
But wait, what is the income of the government? Well, the
income of the government comes from tax.
What affects how much tax revenue you get is basically how much the
economy is growing. Think about VAT, the more purchases there are within an
economy (which would increase if the economy is growing), the more the government will take a part of whatever is spent.
So what matters is not the size of debt for governments, it
is the size of debt relative to output. Economists call this the debt to GDP
ratio. But for use we can think of it as the size of the government debt to the
government income (from now on, whenever I refer to output, think of government
income).
The output of the economy is standing at £1.7 trillion. That
is 1,700,000,000. Wow, look at all those zeros, we are rich, rich I tell you! We
have so much money- PARTY! Quick what is the number for a travel agents?
As you can see, thinking of the debt in absolute terms is a
silly as looking at output in absolute terms. This is why we should always talk
about debt in the context of our ability to pay it back. Talking about debt
without talking about income is like a Saturday night ITV show starring just
Ant (apologies to non-British readers).
So looking at the
debt as a percentage of output, the total debt is about 90% of output. The big
question is this debt level unsustainable? Italy has been running with this percentage of
debt to output at over 100% since the 1990s. So what is the right level of debt
to output? This is a bit of a tricky question and if you are interested you may
want to read this. But let us just say that our current level of debt to output
is unsustainable debt and we need to bring it down.
So how do we make
this debt to income ratio smaller?
There are two main ways for governments to decrease the size
of debt as a proportion of income. One is to stop borrowing as much and start
repaying back the debt. This is why the coalition government has been saying we
need austerity. In other words, we are going to have to stop borrowing as much and cut
some of our government spending so we can start repaying back the debt.
This is why politicians are saying they want to “balance the
books“ and reduce the deficit. The government deficit is just like a bank
account. If you spend more than you earn you have to borrow. So any defect adds to the total amount the government owes which is the total government debt. The coalition government has
reduced the deficit, but they are still having to borrow to fund the deficit and hence are increasing the overall level of debt.
However, there is another way to decrease the proportion of
debt to government income - increase output. As mentioned previously,
increasing output increases the government’s income. And the way a government
can increase economic growth is for the government to spend.
But wait, hold on a minute, isn't this a contradiction? I
have just said that governments can fix the debt to income problem by cutting
spending and also by increasing spending.
This seems a little counterintuitive so let’s think of it as
an example. Say you are a builder with unsustainable debts and you want to bring
that level down relative to your income.
One way to fix this problem is to stop
spending as much on your building materials and tools. This seems sensible, but
what if you get offered a job to build a new house. You don’t have enough
cash to buy a hammer so what do you do? You could try and hammer nails in with
your shoe, but borrowing a little more now to get a hammer would be much more
effective in the long run. This will increase your income and hence your
ability to pay back the debt.
So what should we do? Cut or spend? Well this all depends on
how much of a problem the debt to income ratio is…
But who decides what
level of debt to income becomes unsustainable?
The people who really decide whether this becomes unsustainable are the people who lend the money in the first place. The
government’s logic for austerity was that if we didn't show a commitment to
paying back the debt now the markets would get worried we couldn't pay the cash back and it would become really expensive for the UK to borrow any more. This is
what happened with Greece, the market (lenders) were worried that Greece’s
debts were unsustainable so charged Greece a higher price to borrow.
This is what the “calming the markets” arguments is all
about. But as I said, if I am a lender, I really want you to pay back the money
to get a return on my investment. If I force you into bankruptcy by paying back
the debt too early than I am not going to get my money back at all! Greece has
had austerity for a long time now and it is still struggling to meet its debt
obligation. This is why the leather-jacket wearing Greek economist Yanis Varoufakis has tried to achieve a debt
repayment based on when they start growing and earning an income again.
How fast do we need
to repay back the debt?
This really is the key question. When the crisis hit in 2008, this made our
debt go up (we had to borrow more to bail out the banks etc.) and we also
entered a recession (growth in output was falling).
I remember watching David Cameron in the 2010 TV debates
arguing that the debt was too high and we had to pay it back. This obviously
was annoying to me as he failed to mention what the cut in government spending
would have on our income, hence our ability to pay back the debt.
On the face of it, it seems like Cameron’s argument is the
most sensible argument, have a quick burst of pain, like ripping off a plaster,
and move on. British stiff upper lip and that sort of thing. Unfortunately, no
party said what effect cutting the government spending would have on output,
and hence government income, on the economy.
Austerity’s effect on growth is as much use as a cold shower is to a
broken leg. This is especially so when our air conditioning is switched off and
interest rates are already as low as they can go. (As an aside, I feel there is
an element of hypocrisy if you are arguing that government debt is bad but at
the same time encouraging private borrowing by setting interest rates close to zero).
Mr Cameron went on to compare the economy to a household
that when faced with hard times had to cut back a bit. If only someone took
this analogy one step further and said that if the income earner was a builder
then cutting back might actually be like trying to hit a nail in with a shoe
then we may have not had such a long recession.
We cannot pay back the debt back straight away. Even under
the Conservatives plans it will take till 2030 to get the debt to output ratio
back to the level of when the financial crisis hit. We may have ripped off the
sticky plaster with austerity but the debt wound has not healed.
Debt is not a short term thing, recessions, however, are a lot
shorter in comparison. This is why myself and most other academic economists
think the coalition was wrong in their plan to impose austerity.
What I am really concerned about is that this view has not
been broadcast to the public as the media has generally spouted the view of
government. However, this is another blog for another time but if you can’t
wait for my next blog, see Simon Wren Lewis.
In a nutshell
Debt is not a problem, only
unsustainable debt is. Do not let anyone talk about debt without mentioning
income -it is completely meaningless. If the current government debt to
government income is unsustainable, then we need to bring it down. How fast we
bring it down should depend on circumstances that we currently face. As we
currently face a problem where interest rates are ineffective (our air-conditioner is off and it is getting colder) it is not the time to fix the debt.