Monday, April 27, 2009

Does Government Debt Interest Matter?

He's dumb alright, but nothing to do with our real concerns

According to Roger Bootle, people like Tyler worry far too much about the government's mounting debt interest bill:

"This is another example of how dangerous it can be to compare the position of a whole economy with that of an individual. If any of us had equivalently huge debts, we'd be bust, plain and simple.

But this does not apply to the economy as a whole because we owe the Government's debts to ourselves. The common approach to this issue is to imagine that the huge interest payments from the Government will be poured into a black hole. In fact, though, they will be received by all those who hold the extra gilts, namely pension funds, insurance companies and banks, aka all of us at one remove."


If that's right, why worry about government borrowing at all?

If we just owe the money to ourselves, and if we are just paying the interest to ourselves, the government could make us all richer by borrowing to give everyone a handout. It could give us, say, a grand apiece, covering the initial cost by borrowing £60bn, and covering the debt interest by borrowing a bit more on top. According to Mr B, the borrowing and interest wouldn't make us poorer, and we'd all be up a grand on the whole deal.

Excellent. Although why stop at a grand?

If only the real world was like that.

The reality is that nobody except the Straw Man thinks the government's debt interest payments are disappearing into a black hole. We all understand they go to investors (including widows and orphans). But that doesn't stop us worrying about their rapid escalation, and the huge strain they will soon be putting on the public finances.

As we've noted before (eg see this post), the fall in debt interest costs during Labour's first term was absolutely crucial to them. In the five years to 2002, debt interest payments as a proportion of government revenues fell by 4 percentage points. In today's money it was a free gift of around £20bn pa (or 5-6 pence on the standard rate of income tax). And it provided the fiscal firepower to boost spending on schools and hospitals without apparently undermining the budget.

Unfortunately, the wheel has now turned. What was a virtuous circle in the late 90s has now turned decidedly vicious. Increased borrowing means increased interest payments means increased borrowing means... etc etc. And increased borrowing almost certainly means increased gilt yields, as investors demand more protection from future inflation risk (eg see this post).

The Budget forecast a 40% rise in debt interest payments, from £31.5bn last year to £43.8bn next. It didn't give explicit projections thereafter, but based on the debt projection, we can derive our own.

The following chart gives three alternatives, reflecting three alternative outlooks for gilt yields. The low version assumes an average yield of 4.5% - roughly what the Budget assumed, and roughly the level of long-term gilt yields today. The alternatives both envisage higher yields - either 5.5% or 6.5% - reflecting the extreme likelihood of higher inflation, along with a reversal of the Bank of England's recent massive gilt purchases (so-called Quantitative Easing, aka printing money).

As we can see, the outlook is grim under any of the three alternatives, with annual debt interest rapidly heading for £100bn pa under the worst.

Except of course, gilt yields of 6.5% pa is by no means the worst possible scenario. As we've mentioned before, in the dark days of the 70s, gilt yields peaked at over 17%.

Bottom line?

Government debt interest matters a lot. We are rapidly heading back to a situation where interest payments are consuming 12-13% of government revenues, compared to the mere 5-6% we got used to in recent years.

It will be a crippling and long-lasting legacy from Labour's latest debt binge.

And it will hugely increase the temptation for a future government to inflate the problem away.

PS Not quite sure what's happened to Mr Bootle. I'm sure he used to be quite sound, but these days he's gone all 50s Keynesian on us. He keeps telling us to relax about government megadebt and printing press hyperdrive, because the alternatives are all worse. And anyway, our rulers will somehow get things back on track before the inflationary conflagration. Wonder where he stands on fairies behind the potting shed?

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