Debt and Deficit: Differences and Debate

The 'credit card analogy' isn't perfect, but it is better than thinking we can keep on spending without repercussions.

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The Debt Clock keeps on ticking...
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John Phelan
On 1 July 2011 10:55

The coalition uses the analogy of household debt to describe Britain’s horrendous public finances. The national credit card is maxed out as they say. To some this is either simple minded or dishonest, either way, they say, it’s wrong. Are they right?

The first thing is to highlight the difference between two terms which are often used interchangeably but which actually mean very different things; debt and deficit. The debt is the amount of money owed. The deficit is the amount by which that amount is increasing. It is a simple stock and flow concept; debt is the water already in the tub, the deficit is what is pouring out of the tap.

This is why the argument that the deficit isn’t the urgent problem the coalition says it is because “a large number of national governments run on significant levels of borrowing much of the time” is a red herring.

It is possible to sustain quite a high level of debt if it remains reasonably constant. Problems arise when that debt level starts to rise rapidly, in other words, when there is a significant deficit flow adding to the debt stock as there is now.

It’s only possible to make the argument that a generally high level of debt means a deficit is not a problem if you have no idea what the words debt and deficit actually mean.

Another argument is that “our creditors are unlikely to come banging on our doors demanding repayment any time soon”. Assuming this is true for a moment, it betrays total ignorance of how government borrowing actually works.

When government borrows it issues bonds, or gilts in the UK, with maturities (repayment dates) of 5, 10, 30 or so years. The purchaser of these bonds will, if they hold the bond to maturity, receive both an interest payment at a percentage of the bonds face value for the term of the bond and a payment of the face value on maturity.

So at any given time we are always paying some of our debt off because we have to make the maturity payments on debt issued 5, 10 or 30 years ago.

Typically we borrow to cover these maturity payments. In other words, the country is constantly taking out loans to pay off the last lot of loans. As long as we can borrow the new money this isn’t a problem.

But if a large deficit is pushing up the amount of debt you have to refinance you will hit trouble. Among other factors, interest rates are higher the greater the risk of non-payment the borrower represents. The more debt you have the greater this risk becomes. This means that the interest you have to pay on new loans to pay off the old ones will go up and it becomes more expensive to borrow, exactly the process which is strangling Greece.

So no, we won’t have creditors banging on our doors demanding money, they can just hold their bonds until maturity when they are guaranteed repayment. What we could very well see instead is that borrowing new money becomes so expensive that we can’t afford to pay off the last lot. We do not need to worry about lenders wanting their money back but about them not lending us more to pay them back.

People who oppose the credit card characterisation sometimes like to counter with their own bit of home economics. The debt/deficit (they remain unclear) is less like a credit card and more like a mortgage they say. The government may be taking on debt now but we will be richer for it in the future.

This is such a poor argument you wonder how anyone can make it with a straight face. Wasn’t a lesson of recent years that lots of people, who borrowed to buy houses, saw their prices rise and thought they were rich, in fact, weren’t rich at all?

They’d simply floated in a bubble and splashed down in a puddle of negative equity. Taking out a mortgage does not guarantee a life on easy street at the end of it.

Furthermore, it falls into the familiar trap of thinking that all public spending is good or, in its barely more rigorous form, that public spending equals investment. It doesn’t.

Debt needn’t be bad. If it costs X to borrow the money to buy something that produces a return greater than X then clearly debt is a fine idea. But a lot of the borrowing our government does, and that the last government gorged on, does nothing to increase the productive capacity of the country anywhere other than in the fanciful imaginings of False Economy, the TUC, or the Labour Party.

Instead public sector workers were hired by the hundreds of thousands, their wages raised and their pensions inflated to a unique level. Little of this did anything whatsoever to increase the British economy’s production of marketable goods and services, which is what drives the generation of the wealth the public sector needs to function.

It wasn’t investment any more than £20 spent on beer is investment. There was no increase in your wealth generating capacity to show for it. It was just spending.

The credit card analogy isn’t exact but it does convey an important truth; a nation frantically adding to its debts as we are is in trouble. But for much the same reason as Margaret Thatcher was mocked for her ‘housewife economics’, an unholy alliance of left wingers and academic (never commercial) economists fight attempts to simplify the issue so.

This is less because the credit card characterisation is inaccurate than because the public sector unions and Labour Party find the truth uncomfortable and academic economists wish to preserve the mystique provided by their pseudo-scientific mumbo jumbo. The housewife was right back in 1981but economics is not a humble profession.

 

John Phelan blogs at The Boy Phelan and has also written for ConservativeHome and The Cobden Centre

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