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Archived: Unknown Knowns – Public Sector Debt – Fred Alldridge

Originally published on May 4th, 2020

In my last piece I introduced the Rumsfeld Matrix, which was most famously used as a framework to help make the case for US entry into Iraq following the 9/11 attacks in New York City (Justo, 2019). However controversial this application may be, at its base, it is useful for comprehending uncertainty (Tercan, 2019) and for choosing which variables to analyse when considering a complex situation – such as the global economy. The version of the matrix I am using approximates ‘known knowns’ as the economic short-run (where all factors of production are fixed), known unknowns as the medium run (when some factors are variable, but not all) and unknown knowns as the long-run or the very long-run (where all factors are variable). In a stable economy, one might be able to say somewhat (emphasis on somewhat) assuredly what the state of the economy might be throughout the short-run, and with decreasing levels of confidence based on how far into the future one looks. In my first piece and clarification to it, I gave the generally Keynesian conclusion that the driving force of the economy to bring us back to pre-crisis levels would be the rallying of the stock market and a massive increase in investment once financial and human barriers gradually lift. This is crucially conditional to barriers being lifted when there is a sufficiently low risk of second wave, as a large rise in cases and deaths that necessitates a second lockdown would be devastating. Confidence and certainty (however much of it we can get) is key.  In relation to the ‘known knowns’, I used the term ‘short-run’ to describe the economic state from when it was written up until a period of general economic recovery. I shall now move towards the medium run of the economy, or in the context of my appropriated Rumsfeld Matrix, the unknown knowns. Throughout my first year at university I have gained the theoretical knowledge of what the medium run of the economy entails, with regards to Okun’s law (in the US), the Phillips Curve and the AD/AS relation (Madeira, 2020), although here I shall focus on the length of time rather than those relations. However, whilst I shall focus on a general time period, the essence of the medium run is crucial as well – the transition to the long-run. The economy is always in a period of transition (Blanchard, 1997), and comparing decades of significant economic strife to the current day could potentially enlighten us on how industries might expand and potentially disappear over the next decade.  

So, what could happen? Initially, I was going to try to identify the key variables that will be instrumental in determining the economic state of the 2020s, however, it seems abundantly clear that above and beyond all of these will be the astronomical levels of debt incurred by the state, and how it begins to gets serviced. Focussing on the UK, the total debt will be so large relative to debt accrued from other crises because of the time in history this outbreak is happening in – only ten years after the financial crash that recquired the UK debt as a percentage of GDP to be doubled due to the implementation of costly stimulus packages (Office of National Statistics, 2020). Of course, what precedes very high debts are very high deficits and the Director of the Institute of Fiscal Studies said the budget deficit was likely to reach £260 billion in the fiscal year 2020/21 (BBC, 2020), up from a relatively paltry £32.3 billion in the fiscal year 2018/19 (Office for National Statistics, 2019), increasing more than 8-fold. Public sector debt as a percentage of GDP also hasn’t dropped since the financial crisis, remaining stable at 80% of GDP (Office of National Statistics, 2020). The pre-crisis level of debt wasn’t necessarily a problem as UK government bonds have a high credit rating, either being ranked as having a prime or high-medium credit rating by 4 different ratings agencies (World Government Bonds, 2020). However, as the debt incurred in the UK from the largest financial crash since the Great Depression hasn’t been reduced, the amount taken on over the next few years will just be added on top. This will result in the total burden of public debt to be the sum of two of the largest peacetime stimulus packages ever (Morales, Meakin & Anderson, 2020), likely rising to at least 155% as a ratio to GDP (Tooze, 2020), the highest since the recovery after World War II (Chantrill, 2020).  The debt detailed above only includes what’s likely to be accumulated in the short run and is essentially fixed, with the amount that the government will need to pay out in benefits and furloughing schemes. In estimating what the state of the economy for the next 10 years, debts which are variable are perhaps more important and they are likely to be significant over the long run. Even before the pandemic, the attitude of the public towards austerity was waning. In 2018, 62% of respondents to a Deloitte survey wanted an increase in spending even if that meant an increase in taxes (Deloitte, 2018), whilst the sheer scale of the crisis has introduced substantial feelings for the first major revision in the social contract since World War II (Financial Times, 2020). This will likely include pay rises for public sector workers across the board, and a large rise in funding for the NHS, and this is likely under a conservative government, not even taking into account the increase in spending that would come under a Labour majority government. At the moment, this is just pure speculation what sectors the spending would go into, but it is very likely that there is a greater role for the state in the economy after the crisis, relative to before. The British Government will not be able to cut spending significantly and fall back on ‘fiscal responsibility’ – the public doesn’t have the stomach for it – any party that wants to stay in power will have to produce a manifesto promising to spend and borrow at truly unprecedented (peacetime) levels for the next few years. Finally, to quote French sociologist Auguste Comte – ‘demographics are destiny’ – the UK has an ageing population, with the mean age expected to rise 2 years to 42.4, and this means more government spending will have to go towards state pensions. Simply put, I cannot envision a scenario in which the UK government doesn’t come out with a much larger role to play in the economy.   

The stage has been set, and the actors inducing mind-boggling levels of public debt introduced, but what will happen over the next decade to try and reduce this, or in Japanese fashion, will we try and reduce at all (Trading Economics, 2020)? The particular question of government borrowing provokes visceral responses across the economic and political spectrum, but at least for the UK, history can give clues for how to proceed. At the moment, assuming the debt to GDP ratio peaks at around 155%, as mentioned earlier, these would be the third most debt inducing series of events in UK history, after the series of conflicts culminating in the Napoleonic wars around the turn of the 19th century, and the two world wars in the 20th (Piketty and Goldhammer, 2014). The UK has a long history with large public debt, and a successful history reducing it, having never officially defaulted on its sovereign debt, albeit with some caveats (Warner, 2019). These caveats both came in the interwar years, with the US forgiving some of France and the UK’s loans during World War I, and in the trough of the great depression, Neville Chamberlain appealed to the country’s ‘patriotism’ to ask 3 million people to voluntarily decrease the interest rates on gilts bought during World War I (Leaviss, 2020). Evidently, however, the UK was able to reduce levels of debt more than 200% of GDP, successfully, not once, but twice. However, it also seems evident that neither will be viable paths for the UK to start to go down in the next 10 years.  To finance many wars from the mid-18th century to the end of the Napoleonic Wars, the British government borrowed heavily, leaving their debt-GDP ratio ten times higher than France (Piketty and Goldhammer, 2014). After this, the century of relative peace afterwards worked in Britain’s favour, allowing successive governments to run surpluses and pay off the interest on the debt (Piketty and Goldhammer, 2014). Another thing to mention is the primary measure I’m using is a ratio – meaning that if GDP were to increase significantly, it would push the ratio down as a result and leave the government with more tax revenue and a greater ability to pay off its liabilities. This is also what happened during the 19th century, as the British economy mechanised and had sustained year on year growth per capita for the first time ever. From 1815 to 1914 the UK population roughly tripled from 15 million to 43 million people (Our World in Data, 2020) and GDP per capita adjusted for inflation more than doubled in the same period from £2,436.80 to £5,485.56 (in 2013 prices) (Roser, 2020), amounting to an overall expansion in real GDP of 545% in that period. All things being equal, that would depress the debt-GDP ratio from an estimated high of 260% (Pettinger, 2020) to only 40%. The previously mentioned continuously ran surpluses helped run it down to only 30% on the eve of the First World War. Onto the debt reduction after the Second World War, which was achieved in a somewhat similar fashion, with high levels of sustained GDP growth, but the post-war governments had another tool that those before didn’t have. Piketty identified that ‘inflation is largely a twentieth-century phenomenon’ (Piketty and Goldhammer, 2014), which could either be the scourge of economies (Post-World War I Germany), or a crucial element in economic recovery. From 1946 to 1975, the average price level of goods and services in the economy increased at an average of 6.5% a year (Qayyum et al., 2019), and loans were taken out from the United States and Canada during the war at a low nominal interest rate of 2% (BBC News, 2006). Due to the nominal interest rate being lower than the inflation rate, the real value of the debts, actually decreased by 4.5% a year in that period, with double-digit inflation in the 1970s peaking at 22.6%, depressing the value of the war debt after the initial thirty years. Along with inflation, it was a remarkable period of growth in the UK and around the world as nominal GDP increased more than 3% year-on-year relative to the average interest rate paid on public sector debt and real GDP grew 2.3% per year (Office For Budget Responsibility, 2013), further decreasing the real value of government debt. All of this, even with the foundation of the welfare state and the creation of the NHS (Brown, 2001), led to an approximate 200% reduction in the debt-GDP ratio (Office for Budget Responsibility, 2013) by the mid 1970s – only 30 years.  

Unfortunately, even with the benefit of this knowledge, all this shows us is how hard it will be to get to a point where government debt isn’t considered a problem anymore. It will be much harder to grow ourselves out of the debt like in the 19th century and post war era, and there is no reason to say that inflation will be on our side like in the second half of the 20th century. From this point forward, not only the UK government, but many other governments all over the world will have to come to terms that they’ll need to get creative with their debt. This is the crux of the issue and the reason I wanted to frame this in the medium run rather than the long run – regarding this issue, the tools that can be used seem to all be short run and medium run instruments – like increasing the monetary supply or use of fiscal policy. The long run seems to be working against us. Between 1815 and 1914 the British population increased by nearly 200%, whilst in the next 80 years its projected to have only increased by 15% (Our World in Data, 2020) and unless there is an open border policy in place for an extended period of time (which is extremely unlikely), the prediction is unlikely to change greatly. Increased levels of debt also stifle growth (Belsie, 2020) as governments have to devote a greater percentage of their budget to interest payments, away from infrastructure projects and social services. Population growth was crucial for the rapid economic expansion between 1815 and 1914, with the growing labour force accounting for more than half of all economic growth during that period, being key in driving debt-GDP levels down.  What about economic growth as whole then? This is relatively a much more feasible path to go down, but it will be far more difficult than after World War II. A large factor in this is because of the uncertainty. After World War II the Bretton Woods monetary agreement set within a very fine band, the exchange rates of many of the worlds’ currencies (Amadeo, 2020), whilst we are likely going to see many central banks print more money to try and devalue their currency, increase average price levels and increase their exports; the more economies that do this, the more the effects are nullified. I’m not advocating for currency pegging, but without high levels of global communication and cooperation that was seen with the Bretton Woods agreement, we could see also worldwide monetary crisis in the near future.  

However daunting this looks, going over the history of UK debt reduction, it seems clear what path the government must go down. Counterintuitively, to stimulate as much growth as possible over the next ten years, the government must continue to borrow at high levels. We need inflation to be on our side, decreasing levels of nominal debt, and real GDP growth to be higher than it has been for the last ten years. I concluded in my last piece that increases in investment were crucial to economic recovery, and whilst I believe this to be true, the state has a crucial role in decreasing its own debt, which will facilitate economic growth further down the line. Borrowing by the UK government didn’t go down after World War II, it increased, with government spending each year as a percentage of GDP rising by over 10% between 1945 and 1975, but the increases in inflation and GDP wiped out the real value of public sector debt (Pettinger, 2017). This seems like the only clear path, but politics can get in the way of recovery. I am hopeful that we may reach a political alignment that somewhat resembles the post-war consensus, because we will need an increase in taxes, we will need further borrowing and we will need more government spending to truly recover, that if ideological politics gets in the way of, could really damage the economy in the long term.  

– Fred Alldridge is an economics student at the University of York


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