Why America should heed Mr Micawber
The US is currently deciding what to do with its surplus: pay back debt or cut taxes
Friday 06 August 1999
"Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, expenditure twenty pounds nought and six, result misery."
Mr Micawber's surplus or deficit was merely 2.5 per cent of income - a deficit that would have complied with the Maastricht criteria - but a 2.5 per cent deficit still resulted in misery.
Happiness, by contrast, is a surplus. The United States is currently in the agreeable position of trying to decide what to do with it - whether the priority should be to pay back debt to cut interest costs, or whether it should be to cut taxes.
Or will it? The announcement this week that the US would pay back debt before it matured created a bright spot on an otherwise dull Wall Street - understandably so, since it will be the first time this century that the US has paid back debt early. But it raises questions as to how durable the move of the US into fiscal surplus really is.
In the late 1980s the UK was running a surplus and we blew it during the early 1990s recession. At the beginning of the 1990s Japan was in surplus; now it has a public sector deficit of nearly 10 per cent of GDP, larger even than we had in the dark days of 1976 when we had to call in the IMF to bail us out.
So we know enough about what has happened to public-sector surpluses in the past to know that they are fragile creatures, liable to disappear if a harsher economic climate dawns. Nevertheless, it is so much more pleasant for governments to be able to discuss how a surplus might be spent than it is to explain how a deficit can be bridged that you wonder that more of them don't try and go the surplus route. In particular, will Europe?
At the moment there are a handful of European governments running surpluses - for example, Sweden, Denmark, Finland and Ireland. But the region remains, by world standards, a big government zone: public spending in the European Union is the highest in the world. Deficits have come down dramatically since 1996, partly as a result of genuine efforts to meet the Maastricht limits, but partly also because of creative accounting. Still, the core European economies seem now to be picking up at last, and a bit of growth should ease the fiscal pressures. Meanwhile low global inflation is cutting debt servicing costs, so there is a prospect, not of surpluses, but at least of deficits significantly lower than the growth of GDP. As a result national debt as a proportion of GDP can fall.
But will it? Or will it to any significant extent? The investment bank PaineWebber points out in its latest newsletter that while the autumn budget round in Europe will not be as difficult as last year's, politicians have failed to tackle the longer-term issue of mounting welfare payments for the growing army of the old. Already 65 per cent of Italy's welfare spending goes on pensions, against only 26 per cent of Ireland's. And the fiscal impact of the ageing of Italy has only just begun to strike.
One of the strangest things is that these long-term fiscal issues have had hardly any effect on the bond markets. Italy (or for that matter Germany) can still borrow 20-year money on broadly the same terms as the US (or for that matter the UK) despite the much less favourable fiscal position. The intriguing question is whether the US move will change the sentiment.
Long-term bond yields might in theory be determined by inflationary expectations and perceptions of fiscal probity or otherwise. There have been times when market fears have driven bond yields to extraordinary heights: gilts yielding 15 per cent at the worst of the 1970s scare about this country's fiscal management. But in more normal times the determining feature is very simply the demand for the assets from the investment community and the supply from the government and other borrowers.
So rates are determined by questions such as these. Do the pension funds need more 30-year assets to match their 30-year pension liabilities? Do governments want to lock in present rates for that sort of term? How desperate is the government for money?
The US payback changes the game. Instead of US institutions facing a supply of government stock stretching out into the middle distance, there is the prospect of a shrinking pool. The faster debt is paid back the faster interest costs drop, enabling debt to be paid back even more swiftly. We are nowhere near that point. US 30-year debt yields 6 per cent, which would a century ago have been thought very high. If prices are to be more or less stable over the next 30 years - something that is by no means impossible - it is very high, far too high in fact. By contrast, European bond yields are probably too low, given the much greater fiscal pressure their governments face over the next quarter-century.
In the coming months the background noise in the financial markets is going to be too loud for us to hear any clear signals pointing to long- term trends in public finance. People are going to be preoccupied by the interrelationship between US share prices and the dollar, by strongish pre-millennium growth everywhere, by the prospect of higher interest rates and by concerns about a post-millennial fallback in economic activity associated with year 2000 computer problems.
If the world economy in general and the US economy in particular do slow sharply, then the "what to do with the surplus" debate will be overtaken by events. But the idea that governments should try to pay back debt has been suddenly given a higher profile. If President Clinton's genius as a communicator can push home the message that paying down debt helps US families more than unfocused tax cuts, then the effects will go far beyond the States. Mr Micawber would be proud of him.
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