U.S. AND U.K. CAN HANDLE DECADES OF DEBT / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

US and UK can handle decades of debt

By Andrew Scott

Published: February 28 2010 20:00

One way the financial crisis of 2007-08 will have a lasting impact on the economy is that government debt will remain high for decades. Short-term forecasts suggest UK gross government debt will double from 47 per cent of gross domestic product in 2007 to 94 per cent by 2011, while US debt will rise from 62 per cent to 96 per cent. The rapidity of this increase, the high levels of debt and the fact that fiscal deficits in the UK and US are expected to still be around 13 per cent and 10 per cent of GDP respectively in 2011 have led to financial and political pressure for urgent fiscal adjustment. High debt is seen as a serious problem – as Adam Smith warned more than two centuries ago: “The practice of funding has gradually enfeebled any state which has adopted it”.

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.

Governments should, of course, look at long-term fiscal solvency and articulate clearly how they intend to achieve debt stability. However, forcing governments to achieve specific numerical targets by certain calendar dates is a mistake. If further shocks occur or the crisis continues it will be necessary to revise these targets. Debt is the means by which governments accommodate shocks – changing policy to meet previously fixed fiscal targets puts the cart before the horse. Too much current debate takes the form of asserting that fiscal discipline is a good thing. Of course it is. But what markets, credit-rating agencies and deficit hawks need to engage in is a realistic debate that recognises that government debt will and should remain at its elevated level for a very long time and the required adjustment is for the long haul. Fiscal discipline and solvency is not inconsistent with decades-long shifts in debt.

Smith may have warned that debt can enfeeble a nation but he also remarked in 1776 that “Great Britain seems to support with ease a debt burden which, half a century ago, nobody believed her capable of supporting”. Debt rose even further in the decades after. Markets and governments in the UK and US have proven before that they can maintain very high levels of debt and should be open to the possibility that they can once again.

The writer is a professor of economics at London Business School

Copyright The Financial Times Limited 2010.