Sunday 19 April 2015

Stop hammering nails in with shoes: Why debt is good and unsustainable debt is bad.

If you watched the recent UK election debates you would have seen that the most pressing issue facing the UK appears to be tackling the UK debt. When we hear the word debt we have all these negative connotations: people going bankrupt, falling into poverty and generally being irresponsible with their finances.  This means debt must be bad right? However, we need to make a distinction between unsustainable debt and debt. 

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.

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