Friday, November 19, 2010

Is Default Now The Only Real Option?


Seemed like a lovely idea at the time... but who was going to pay?

As we've blogged many times, our real National Debt is far bigger than the government officially acknowledges. When we calculated the real debt for the TPA this year, we estimated the true overall total at around £8 trillion, nine times the official total, and over £300,000 for every single household in Britain. Here's the picture to remind us:


Our number picked up a fair amount of flak at the time for including things that are supposedly not real debt, such as pension liabilities. We answered the criticisms here, but one particular objection is worth picking up again in the light of the Irish crisis.

Our debt figure included the gross liabilities of our nationalised banks, amounting to £2.6 trillion. And the objection was that those liabilities are backed by the banks' assets, so just looking at the liabilities is scaremongering.

There is of course some truth in that point, but we argued that taxpayers need to know our total potential exposure. Because in these uncertain times, nobody can be at all sure what the banks' assets are actually worth.

And now we have a real live example of what happens when reality bites. As we noted here, the reason George has had to accept shoring up Ireland is that our banks' have lent the Irish well over £100bn - ie we can't afford to let them go down without risking a £100bn hole in our banks' balance sheets (£80 odd billion of which would be down to the nationalised RBS and Lloyds).

So how does George's decision impact on the National Debt?

An interesting question.

If we lend the cash directly, then it will likely add to the official National Debt. But if we lend it via a guarantee on one of those baffling Euro financing facilities, it will likely not add to the official National Debt at all - it will just be counted as a contingent liability, which the government habitually ignores. Even though in the real world, we are just as fully exposed to the liability either way.

And what about our Real National Debt (RND) calculation? That already includes the full liability supposedly backed by the banks' Irish "assets", so at first blush you might conclude that all we are doing is simply swapping one liability for another. Maybe the total RND doesn't change.

Alas, while that would be the case if the Irish were using HMG's new official loan to repay their existing loan from HMG's banks, that's not what's proposed. Instead, the new loan will simply add to the existing loan, so that the Irish can go on living day-to-day for a few more months. The Real National Debt just got even bigger.

Which is just a prelude to this morning's real question.

Prompted by some fascinating emails from longtime BOM correspondent NL, Tyler has been thinking further about how we can ever hope to escape from under this humongous debt burden.

Earlier in the week we reminded ourselves of the four traditional escape routes for indebted governments, and who ends up paying:
  1. Repayment - ie the government runs budget surpluses. Taxpayers pay.
  2. Default - most likely in the form of a partial default via debt restructuring (aka haircuts, debt for equity conversions, or coupon conversions). Lenders pay.
  3. Inflation tax - where debt is denominated in fixed money terms, governments can work off their debts by engineering inflation - effectively a gigantic stealth tax on debt holders. Lenders pay ( including anyone who has been foolish enough to save their nest egg in a building society account).
  4. Growth - GDP growth is the holy grail of indebted governments. Growth makes a given amount of debt less significant relative to GDP and tax revenues with each passing year. It's a get-out-jail free card for both the borrower and the lender.
NL emailed to object:
"Growth doesn't do anything for the debts. It's a bit of linguistic trickery. The only thing that pays debts in this way is growth in taxation. Politicians don't want to admit that they have to take more and more money in order to pay debts. So they use deceipt. If we take growing taxes and turn the adjective into a noun, who can complain about growth?

So when ever you see growth, it really means we are going to take more money from you in taxation to pay off our mistakes."
And of course, NL is quite correct - "the only thing that pays debts in this way is growth in taxation". It's the growth in tax revenues that floats the government free from the fiscal rocks. Taxpayers do end up paying more.

So how can it be seen as a fiscal get-out-of-jail-free card?

Because compared to an increase tax rates, an increase in tax revenues flowing from higher growth is a lot less painful for most people. They may be paying more tax in money terms, but relative to their incomes it will probably be less - the burden will feel lighter.

We can think of it in the same vein as the increase in tax revenues that we've often seen following cuts in tax rates, For example, when the Thatcher government cut the top rate of income tax, revenue from top rate taxpayers actually increased. And indeed Tyler believes cuts in tax rates now would generate actual increases in tax revenues within a very short period (eg we should cut the new top 50p income tax rate soonest).

But NL is not so easily convinced, and responded:
"There is also the other little calculation.

Lets take a million unemployed. 13K a year in benefits. They all get minimum wage jobs, so they pay 2.5K a year in taxes. However they will still get housing benefits. That's 5K a year. All relatively round numbers. Net increases in taxation / reduction in benefits comes to 13 - 5 - 2.5 = 5.5K per person.

So for each million that gives 5.5 billion. Even getting all those not in work, back to work, isn't going to close the deficit."
Tyler loves practical calculations like this - they really bring things into focus.

Let's take NL's assumptions as correct, although we reckon his arithmentic needs tweaking (ie by getting these unemployed back to work the government saves £8k pa in benefits - £13k minus £5k HB - plus it gets an extra £2.5k in tax revenue, equals £10.5k total improvement in the fiscal position). The overall saving from returning one million to work is £10.5k times one million, equals £10.5bn.

And given that there are currently well over 5m adults of working age living on benefits, that would suggest we could save over £50bn pa - if we could get them all into paid employment.

Now, a £50bn pa saving is not bad, not bad at all.

Except that we'll never get all 5 million back to work. And against a Real National Debt of £7.9 trillion, even a £50bn pa saving not really all that much. At £50bn pa it would take 158 years to pay off the debt. Tyler will have long since departed. The junior Tylers will have joined him. And the as yet unhatched junior junior junior Tylers will likely have gone too.

Hmmm. Maybe growth isn't quite such a get-of-jail free card after all.

Well, what about the good old inflation tax?

Unfortunately NL is pessimistic there too:
"On the inflation front, look at the £6.9 [7.9?] trillion number for true government debts.

What percentage is linked to inflation? Almost all of it. OK the CPI to RPI change cuts 15% off the debts linked to RPI. However, even the borrowing has a lot that is RPI linked. The PFI deals have RPI kickers. (Lender can convert to RPI at their choice).

ie. It's a myth that inflation deals with government debts."
You know what? He looks horribly right there too. As we ourselves have previously noted:
"Default via inflation only really works on the government's official debt. The much bigger £4 trillion unfunded pension debts will be trickier to deal with, since most of the pension payments are formally linked to the inflation index - higher inflation simply means higher payments."
So that's £4 trillion of the indexed pension debt, plus a quarter trillion of index-linked gilts, plus those largely indexed PFI contracts. Which means well over half our Real National Debt cannot be inflated away.

Uggh.

So what were those other two escape routes again?

Ah yes, repayment - that must be it.

Except, hang on - that's not an escape route at all. That's just the harsh cold turkey of taxpayers handing over more in taxes than they get in public services for years. Years and years and YEARS. The Tylers, the junior Tylers, the junior junior junior Tylers, everybody. Yea, even unto the nth generation.

Wait. The Major - who has been reading this over Tyler's shoulder - has just loaded his service revolver and wandered off alone into the woods. Surely things can't be this bad!

Well, there is one other final escape route left - default.

And the more you think about it, the more you realise that default is now pretty well inevitable.

And here's how it will work.

First, and most important, HMG has to step back from those £4 trillion of pension liabilities. Yes, they are liabilities to actual and future public sector and state pensioners that have already been incurred against past pension contributions and service. And yes, HMG has made solemn promises.

But the plain fact is that taxpayers can't afford to honour those promises. The pension age must be raised to at least 70 right across the state and public sector board right now. Either that, or the indexation promise must be abandoned, which would be much less fair on the real elderly.

Second, HMG needs to restructure the banks soonest, split wholesale and retail banking (as blogged many times), and withdraw from all guarantees explicit or implicit on the banks' wholesale liabilities. RBS and Lloyds should be split and flogged off pronto. Yes, the banks' shareholders and wholesale creditors will scream, but that's too bad.

The inflation tax? Well, as we've blogged before, we fear that's already out of the traps, and doubtless it will play its usual part in eroding the real value of HMG's unindexed fixed money debt.

And despite what we've said above, we still think growth will help by generating higher tax revenues from given tax rates.

But when you sit down and do some arithmetic, it does look horribly like default is the only real way of cutting the debt as much as it needs to be cut. Default on all those grandiose pension promises made by successive generations of politicos since Lloyd George launched the state pension one hundred years ago.

Never ever trust politicians who claim they can give you something for nothing. Try to remember that in future.

PS And here's how it looks from Dublin:

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