As governments around the world take on huge quantities of debt in an effort to support their economies, two questions repeatedly arise: won’t all of this borrowing be inflationary? And how will it be afforded and paid back? In this article we address the affordability question.
This is two questions in one. Firstly, is the debt affordable? Many people focus on just one statistic, the ratio of government debt to GDP, a focus given extra impetus by an influential paper issued some 10 years ago by Carmen Reinhart and Kenneth Rogoff in which they argued that national debt dynamics worsen notably once this ratio exceeds 90%.
This figure has the merit of simplicity (and because of this was very widely quoted), but we think it is too narrowly focused. For a country which retains creditworthiness (that is, people do not seriously expect it to default on its debt), the relevant figure is not the absolute level of debt but the debt servicing ratio: how much the debt costs each year. And today’s extremely low interest rates mean that even very elevated levels of debt can be financed with acceptable and sustainable financial cost.
There are several countries where even before the corona-crisis the current level of debt as a percentage of GDP was well above the Reinhart and Rogoff 90% threshold – in Japan it is well over 200% and has been for some time without obvious sustainability issues. And lest current conditions be seen as exceptional, a look at the experience of the United Kingdom shows that at various times in the last 300 years, debt levels have been much higher than they are now.
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As governments around the world take on huge quantities of debt in an effort to support their economies, two questions repeatedly arise: won’t all of this borrowing be inflationary? And how will it be afforded and paid back? In this article we address the affordability question.
This is two questions in one. Firstly, is the debt affordable? Many people focus on just one statistic, the ratio of government debt to GDP, a focus given extra impetus by an influential paper issued some 10 years ago by Carmen Reinhart and Kenneth Rogoff in which they argued that national debt dynamics worsen notably once this ratio exceeds 90%.
This figure has the merit of simplicity (and because of this was very widely quoted), but we think it is too narrowly focused. For a country which retains creditworthiness (that is, people do not seriously expect it to default on its debt), the relevant figure is not the absolute level of debt but the debt servicing ratio: how much the debt costs each year. And today’s extremely low interest rates mean that even very elevated levels of debt can be financed with acceptable and sustainable financial cost.
There are several countries where even before the corona-crisis the current level of debt as a percentage of GDP was well above the Reinhart and Rogoff 90% threshold – in Japan it is well over 200% and has been for some time without obvious sustainability issues. And lest current conditions be seen as exceptional, a look at the experience of the United Kingdom shows that at various times in the last 300 years, debt levels have been much higher than they are now.
Chart 1: UK Government Debt is Not Unduly High by Historical Standards
Source: HM Treasury and Llewellyn Consulting [1]
So, the absolute levels of government debt are neither exceptional nor, we would argue, unaffordable in the short term given current interest rates. But at some point, the government will want to – and will certainly be under pressure to – reduce the ratio. What can we learn from past episodes of debt reduction?
The first thing to note is that there is more than one way to reduce the debt-to-GDP ratio. While politicians and commentators alike might instinctively reach for the toolkit marked “austerity” (lower expenditure, higher taxes, narrower deficits, maybe primary surpluses, etc.), it is not the case that the only way to reduce the ratio is to reduce the numerator, the absolute level of the debt. The ratio is just that, a ratio, and the other way to reduce it is to increase the denominator, nominal GDP. And this is possible in one of two ways: increasing nominal GDP by increasing real GDP (“grow one’s way out of debt”), or increasing the price multiplier (“inflate one’s way out of debt”).
Let us return to the UK’s experiences over the last 200 years and examine four separate episodes of debt reduction.
In 1815, after the Napoleonic Wars, UK government debt was over 260% of GDP. Over the course of the next 100-odd years, it was reduced to 30% or so of GDP. The actual stock of debt itself did not change much – it fell in nominal terms only by about 20% – and the big change was the 7 or 8-fold increase in nominal GDP over the century of British Power. Moreover, this was all real growth; the general price level in 1914 was about half that of 1815. This was therefore an example of debt reduction by growing the denominator in real terms with considerable success, albeit over an extended period.
In 1918, after the First World War, UK government debt was back up to 130% of GDP. The post-war government introduced an aggressive austerity programme (called the “Geddes Axe”, after Sir Eric Geddes, Chairman of the Committee on National Expenditure). The combination of tight fiscal policy and tight monetary policy, with high real interest rates, was successful in the narrow sense of reducing the debt. But it did so at the expense of a deep recession which firstly caused great social unrest and division in society (including the 1926 General Strike), and secondly undoing all the debt reduction as the economy slowed – indeed debt as a percentage of GDP was higher at the end of the 1920s than at the start. This was an example of debt reduction by reducing the numerator through austerity, with limited results and at considerable cost to social cohesion.
In 1945, after the Second World War, UK Government debt was well over 200% of GDP. This time, remembering the bitterness of the austerity 20 years before, the government used higher government expenditure to generate a recovery in GDP. Inflation, mostly mild, also helped swell nominal GDP, and in the 50 years to 1995, the debt ratio was gradually brought down to about 40%. This was an example of debt reduction by growing the denominator in nominal terms; there was real growth, but more than half the contribution came from decades of inflation, usually low (especially in the first 25 years of the period) but persistent.
Lastly, in 2010, after the financial crash, UK Government debt rose sharply and approached 80% of GDP. In historic terms, this was not an unduly high figure, as the 300-year chart shows, but the combination of the Reinhart and Rogoff paper (then just issued), plus the Euro-area’s fixation on 60% debt as the acceptable maximum (as set out in the Maastricht criteria) changed perceptions on what was tolerable for national debt and forced the Cameron-led coalition government into an aggressive austerity programme. This was once again then debt reduction by reducing the numerator through austerity as in the 1920s. And, as 90 years earlier, it proved both a restraint on GDP and (when combined with QE which inflated asset prices and so the wealth of asset owners) highly socially divisive.
The Takeaways
We are well aware that we have here sketched the outlines of only the four most recent high debt periods in the UK’s history and that circumstances for each were very different. For one thing, Britain will never again be the world’s economic superpower as it was for 100 years after 1815. But we draw three conclusions from even this very cursory assessment:
- The level of government debt as a percentage of GDP that the UK will face as a result of the current support for the economy is neither particularly high in historic terms nor, given current very low interest rates, unaffordable. The government should avoid being pressured into over-hasty measures to rein it back.
- When the UK government does turn to reducing the debt levels, it should not concentrate exclusively on reducing the numerator of the debt to GDP ratio. It should also actively pursue measures to increase the denominator, nominal GDP; these may prove less damaging to society and social cohesion.
- The best outcome would be for nominal GDP to grow through real GDP growth (as in the 19th century). But growing nominal GDP through long-term mild inflation (as in the period after 1945) should not be ruled out of hand completely.
The debt being incurred all over the world will one day have to be addressed. But we hope that governments, especially the UK government, do not just once again reach for the austerity axe.
[1] This chart, and the discussion that follows, draw on a paper by Llewellyn Consulting entitled “The Burden of Sisyphus”. I am grateful to them for permission to do so; for more information and the full paper, contact them at https://www.llewellyn-consulting.com/contact
John Nugée has over 40 years of professional experience. Currently, he’s an independent consultant and commentator on key financial, economic and political issues. Prior to this, he was Senior Advisor at OMFIF, Senior Advisor at MEFMI and Chief Manager at the Bank of England.
On the private side, he set up State Street Global Advisors’ Official Institutions Group in 2000 and oversaw the company’s investment management services.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)