March 1, 2010


US and UK can handle decades of debt (Andrew Scott, February 28 2010, Financial Times)

The difficulty with this alarmist view is that economics does not tell us what is a “high” level of debt. Without such knowledge, it is impossible to say that debt is too high or to announce that debt reduction should be an urgent short-term priority. It is true that such huge increases in government debt reflect serious economic problems. But, given the enormous financial shock the economy has experienced, we may be better off with high debt for a long period of time. In fact, although economics is quiet on the issue of what it means for debt to be too high it does tell us that in the face of large temporary shocks the optimal response is for debt to show large and long-lasting swings. Debt should act as a buffer to help the government respond to shocks.

The logic is simple. The UK and US governments have the ability to borrow long term and the option to roll over their borrowing. Rather than abruptly raising taxation and cutting government expenditure, they should adjust fiscal policy over the long term. Fiscal adjustment in the short run is not enough to produce a surplus, so debt must rise for a significant period. The required increase in debt may appear unsustainable for years. But, in the very long term, fiscal adjustment brings down the level of debt.

The potential magnitude and duration of these increases in debt can be substantial. Markets have financed much larger levels of debt than are predicted for the UK and US. The largest increases are related to war but, as Japan’s recent experience shows, this is not always the case. In the UK, between 1918 and 1932, debt increased from 121 per cent of gross national product to 191 per cent – it was not until 1960 that debt returned to its 1918 level.

If adjustment occurs over the long run, how is this achieved? The good news from studying the Group of Seven leading industrialised countries over the period 1965-2008 is that very little seems to be done through inflation. Measures of debt, deficit or general fiscal imbalances have no role to play in forecasting inflation at any horizon. The adjustment instead comes from changes in the primary deficit (the deficit excluding interest payments). In Italy, between 1972 and 1997, the average total deficit was 9.6 per cent of GDP and was never below 6 per cent. During this period, the primary deficit fell from a high of 8.6 per cent in 1975 to 3.3 per cent by 1989 and to a surplus of 5.4 per cent in 1997. In other words, adjustment is through the primary balance and over a very long time. In the interwar period the UK only ran a total surplus in five years and even then it was small. However, every year between 1920 and 1938 saw a primary surplus that helped check the rise in debt and achieve longer-term solvency.

Posted by Orrin Judd at March 1, 2010 7:09 AM
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