UK relaxes while others face the debt trap
"Our politicians can happily speculate about the date of the next package of tax cuts while our neighbours struggle to find new ways of raising taxation"
Monday 03 April 1995
Britain is the only developed country in the world, apart from Norway, that has succeeded in reducing its public debt ratio since the late 1970s. Most comparable nations have, instead, watched their debt ratios rise inexorably from one cycle to the next. In 1978, the UK public debt/GDP ratio was 58 per cent against an average of 40 per cent for the developed world. By 1994, the ratio had dropped fractionally to 52 per cent, while that elsewhere had rocketed to an average of 71 per cent.
The fact that the UK has not ended up with a severe debt problem is part- accident, part-design. Although the decline in the UK debt ratio shown in the first graph looks fairly smooth, it in fact came in distinct phases. The initial phase in the 1970s reflects no credit on the government whatsoever, since it occurred only because inflation spiralled out of control and eroded the real value of government debt. Some of this also happened in the early 1980s.
The second phase, up to 1989, was again mainly accidental, stemming from a combination of rising oil revenues (running at 4 per cent of GDP in the mid-1980s) and the runaway Lawson boom, which temporarily eliminated the budget deficit. Some credit should go to the Thatcher government for this, since it failed to find a way of spending all the revenue bulging from its coffers, but external circumstances certainly helped.
The third phase, though, in Britain's improvement relative to the rest of the world, was entirely to the Government's credit. This happened from 1993 to the present, and reflected the tough budgetary decisions taken by Chancellors Lamont and Clarke in 1993. As these decisions have been implemented, Britain's budget deficit has tumbled, and our debt ratio has stabilised at a low and comfortable level.
This will pay dividends. Yet it is only quite recently that debt ratios became the subject of focus and concern. Until the 1970s at least, few economists worried about debt at all. This was partly because debt ratios in both the UK and the US had been driven well above 100 per cent during wartime years without much ill-effect; partly because debt ratios tumbled in the two decades after 1945; and partly because the prevailing Keynesian wisdom did not find much room to worry about debt.
As so often happens, though, academic complacency bred government neglect, and politicians were tempted to take advantage of the short-term popularity which increases in public spending and debt ratios can bestow. In each recession, understandably, budget deficits and debt increased in an attempt to cushion the rise in unemployment. But in the following economic recoveries, less understandably, governments did not pay off the debt incurred during the recession, preferring instead to dispense the revenues created by economic growth in other, more voter-friendly, ways.
This illusory period has now ended with a vengeance. Far from being voter- friendly, rising debt ratios are now instantly punished by the financial markets, which drive up interest rates and dump the currencies of the countries concerned. Several countries, including Italy, Sweden, Spain and Canada, are living through this nightmare at the moment.
They are discovering that, if governments are tardy in their budgetary response to a loss of financial confidence, the eventual adjustment just gets more painful. Rising interest rates makes the public debt burden more expensive to finance, which requires larger cuts in government services to bring the situation under control.
What is worse, interest rates are no longer effective in restoring order to the currency markets, since the markets do not believe that high interest rates can feasibly be maintained in an environment of rising debt ratios. Central banks are therefore powerless to stop the process of currency depreciation and rising inflation, unless, and until, the budgetary authorities take a large enough step towards fiscal retrenchment to restore financial confidence.
The longer they wait, the harder this becomes, and the more likely it is that the budget deficit will result in a surge in inflation. This may help solve the debt problem - since inflation erodes the real value of government debt, which is usually fixed in nominal terms - but in precisely the wrong way. High inflation is not only undesirable in itself. It also raises real interest rates in the future as bond-holders seek protection against the possibility of being robbed by a further burst of unexpected price rises. Once again, this makes the future control of debt more difficult.
This link between budget deficits, currency depreciation and inflation is what is now having devastating effects in the European countries that have devalued most against the mark since the break-up of the exchange rate mechanism in 1992. Initially, there was an eerie period in 1993-94 during which domestic inflation in the devaluing countries, contrary to most previous experience, seemed unmoved in the face of currency depreciation. The extent of the domestic recessions in these economies, and in their labour markets, was so great that the normal inflationary impulse from devaluation was obscured.
However, this is no longer the case. The further currency depreciation which we have seen recently has now started to be reflected in strong upward pressure on producer price inflation. The six-month annualised rates of increase in these factory gate indices have jumped to 6-7 per cent in Italy and Spain, and 11 per cent in Sweden, and this does not yet reflect the full impact of the currency devaluation in 1995.
Admittedly, there is little sign yet of any upward pressure on wages in any of these economies, but a recent research report by my colleagues at Goldman Sachs nevertheless warns that consumer price inflation could pick up sharply in all of them by the year-end. The appropriate policy response in each case is a large and pre-emptive further tightening in budgetary policy, not in monetary policy. Until this happens, the central banks will be powerless to put the lid on inflation, since higher interest rates will only make the currency crisis worse.
What does this imply for Britain? Surprisingly, the excellence of our budgetary and balance of payments situation has not fully protected sterling from being hit by the fall-out from this year's dollar crisis, and the decline of about 6 per cent in the exchange rate has added to upward pressure on producer prices. But the 1993 Budget decisions have left the economy in a fundamentally stronger and more secure situation than many of our European neighbours. Unlike them, our central bank does not find its hands tied in responding to a depreciating currency or rising inflation - it can put paid to both, with complete credibility, by raising interest rates if need be.
Not only that, but our politicians can happily speculate about the date of the next package of tax cuts, while our Continental neighbours struggle to find new ways of raising taxation and cutting public spending. None of this would have been possible without the much-maligned 1993 Budgets, which have worked exactly as intended.
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