UK: Deloitte Monday Briefing: A Brief History Of Government Debt

Last Updated: 15 October 2013
Article by Ian Stewart

Most Read Contributor in UK, August 2017

The crisis over the US debt ceiling shows how the prosperity and stability of nations is bound up with government borrowing. This week's Monday Briefing looks at what lessons history has to offer the US.

Governments have borrowed to finance wars since time immemorial. It was in the Italian city states in the thirteenth century that markets for state debt first developed, with cities seeking funding to fund battles against each other.

The first government bond to be issued, by England, in 1693, was to finance a war against France. Until the twentieth century governments generally sought to balance the books in peacetime.

The ratio of debt to GDP in the UK is about 90%, the highest level in more than 40 years. But this looks modest compared with the 170% of GDP reached in the First World War, the 230% during the Second War and the 280% reached in 1815, at the end of the Napoleonic Wars.

But deficits accrued through wartime are only temporary and subsequently fall in peacetime. Japan's debt ratio hit a wartime peak of over 200% of GDP in 1945 and then fell to about 5% by the late 1960s. America's stock of debt reached 120% of GDP during the Second World War. By the mid-70s this was under 40%. Indeed, for most of its history America balanced its budget except in time of war. 

During the twentieth century public sector debt has been driven by two additional factors, the growth of the state and recessions. 

In the last 100 years the role of government in most rich countries has expanded to encompass social security, health and education.

This growth has made the public finances more cyclical. When recession strikes, welfare spending surges and tax receipts slump. The result is higher levels of government debt.

In the last five years, war, recession and the growth of welfare spending have all taken their toll on America's public finances.

For the first time in peacetime America's debt is equal to over 100% of GDP. There is no simple threshold beyond which debt becomes unsustainable. Japan, for instance, has the world's highest debt levels, equal to 220% of GDP, yet has no problems raising debt at low interest rates.

But as the experience of the countries including Greece show, markets change their minds about the solvency of nations. Most Western countries, including the US, are now seeking to reduce public debt to avoid such risks. 

There are four ways in which a government can reduce its debts.

It can run budget surpluses to payoff past debts as happened in the UK in the 1950s and 1960s. A milder variant of this is to keep growth in the deficit below the growth rate of the economy, which allows the debt to GDP ratio to shrink over time. These are orderly ways of reducing deficits which protect bondholders by putting the burden of debt repayment on taxpayers.

More arbitrary solutions are default, as happened in Germany in 1948, or inflation, as in 1920s Germany. Inflation reduces the value of the debt that has been issued relative to other assets and prices. These methods protect taxpayers at the expense of bondholders.

Wars and recessions are often protracted, but ultimately finite. By contrast the secular growth of government entitlement spending is seen by current and future beneficiaries seen as permanent.

America's recession ended four years ago and it is winding down its military presence in Afghanistan. These factors have led to a reduction in America's deficit, though this has only slowed the rate of growth of the stock of debt outstanding.

For the US, as for most Western economies, the most intractable problems relate to entitlement expenditure – on health, pensions and care for older people. 

Debts incurred to finance such spending are difficult to deal with through inflation or default because the expenditure is continuing. One solution is to reduce the entitlements. But having spent several years working as a Special Adviser at what was then the Department for Social Security I witnessed the enormous political challenges of doing so. 

If the growth in America's debt is largely due to war and recession then peace and economic growth should sort things out. Sadly, that probably won't be enough. The International Monetary Fund estimates that a substantial chunk of the US deficit is, without changes in expenditure or taxation, here to stay. The same holds for some other richer nations.

The baby boomers that paid into the welfare systems for much of the post war period are increasingly drawing on health, pension and care entitlements accumulated while in work.

Government must decide how much of this is affordable and who will pay the bill. The bond market may baulk at financing long run entitlements indefinitely. It may be that taxpayers and beneficiaries will have to share more of the costs.

America's debt crisis is about who gets what and how it is financed.

MARKETS & NEWS

UK's FTSE 100 rose by 0.5% over the week, with markets ending the week strongly in response to seemingly positive developments in the US budget crisis.

Here are some recent news stories that caught our eye as reflecting key economic themes:

KEY THEMES

  • The Chinese government, which is the biggest foreign creditor of the United States, warned Congress to take "steps to resolve in a timely way the political issues around the debt ceiling and prevent a US debt default to ensure the safety of Chinese investments"
  • The International Monetary Fund (IMF) cut its forecast for global growth for 2013 and 2014 due to weaker growth in emerging markets, although it upgraded its forecasts for growth in the UK
  • The IMF warned that monetary tightening in the US would threaten to expose financial vulnerabilities and lead to a $2.3tn fall in global sovereign bond markets
  • A poll for the BBC showed that 6 out of 10 people surveyed believe the quality of British public services has improved in the last 5 years, despite cuts to local authority budgets
  • US President Barrack Obama officially nominated Federal Reserve vice-chair Janet Yellen to replace Ben Bernanke as the head of the US central bank
  • The director-general of the European Commission's climate divisions caused concern over the future of shale gas in Europe by warning that the methane gasses produced in the fracking process are far more dangerous to the environment than carbon dioxide
  • Fashion brand Jaeger announced plans to bring its manufacturing back to the UK from Asia, in an effort to improve quality and the speed at which clothes can be delivered to shops
  • Edinburgh-based house-builder Cara announced plans to double the size of its business in 4 years, to tap in to rising property prices in the South East of England and parts of Scotland
  • A study by Samsung found that 9 out of 10 large European companies surveyed had experienced some form of security scare in the past 2 years due to worker's using personal mobile devices for work
  • The proportion of commercial property investment in Europe originating from outside Europe rose to 17% in the first half of 2013, its highest level since 2007, according to figures from CBRE
  • The number of first-time house buyers in the UK rose by 33% in August compared with a year earlier, according to new figures from the Council of Mortgage Lenders
  • Santander, Spain's largest bank by assets, bought in to the consumer finance arm of department store El Corte Inglés, its first significant investment in the country since the financial crisis
  • A report by Credit Suisse shows that 1.7m of the 1.8m millionaires created globally in the last year have been in the United States, with American wealth boosted by rising stock markets, asset prices and house prices
  • Financial services companies may have hired up to 10,000 extra staff in Q3 2013, with optimism in the sector surged at its highest level for almost 17 years according to a CBI PwC poll
  • Shares in newly privatised Royal Mail rose by a third on their stock-market debut, with more than 100m shares traded in the first hour
  • Manchester beat London districts such as Chelsea and Kensington to be named Britain's most "vibrant" urban area in Experian's annual "vibrancy index", which uses census and commercial data to identify areas with the most attractive demographic trends
  • A number of US hedge fund investors have begun to invest heavily in Greek banks according to the Financial Times, with American investor John Paulson praising Greece's "very favourable pro-business government" in an interview with the paper
  • Shares in Swedish technology firm Fingerprint Cards rose 50% after a fake press release claimed that Samsung Electronics planned to buy the company
  • The Chengdu Institute of Biological Products won international regulatory approval for a vaccine against a mosquito-borne infection, the first time a Chinese company has had a drug approved to global standards
  • Cargill, the world's largest agricultural trader, reported a 41% year-on-year fall in net profits for Q1 2013, with income hit by the US drought in 2012 restricting the supply of grains
  • Hollywood film studios and music labels have joined forces to sponsor an anti-piracy course to be taught to primary school students in California as part of a broader digital curriculum
  • AO.com, which sells kitchen appliances, became the first retailer to offer a comprehensive same-day delivery service for large items such as cookers and fridges
  • European lawmakers rejected a proposal to expose electronic cigarettes to the same regulations as medicines, although they will be subject to many of the advertising bans of normal cigarettes
  • Official data shows that there has been a 44% annual rise in start-up jobs in the UK, driven by the rise of technology start-ups in areas such as east London
  • The world's largest boiling water nuclear reactor, in Sweden, was forced to shut down after tons of jellyfish blocked the plant's cooling pipes; a problem marine biologists think is occurring more often – nuclear fish-on

Regards,

Ian

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