At the UK Debt Management Office, an outpost of HM treasury in the City of London, business is done in an atmosphere of professional calm. On a recent Monday morning, several dealing screens and desks were unmanned. Robert Stheeman, chief executive, had plenty of time to explain how he will keep Britain solvent.
You would not have thought that this unostentatious operation will issue more interest-paying government bonds in the next couple of years than in the entire 20th century; or indeed in all the centuries since the advent of parliamentary government in the middle ages. This time last year, Stheeman was told he would have to sell £80bn of government bonds, known as treasury bills and gilt-edged securities, in the year to 5th April 2009. Last October, with the banking system on its knees after the collapse of Lehman Brothers, that was increased to £110bn and the following month to £146bn. In the budget statement in April, the goal for 2009-10 was set at £220bn. In his six years since joining the Debt Management Office, Stheeman's annual remit has risen nearly tenfold.
Beneath the air of lassitude, Stheeman is busy. Every couple of mornings a privileged pool of 26 banks are asked to bid for a few billions of conventional or inflation-indexed stock. Even the grouse-shooting season in August, hitherto a holiday spared the financing of the British government, is now spattered with auction dates. And new methods of getting the bonds away—bank syndication, voluntary top-ups, mini-tenders and so on—are all being tried.
Unlike simple loans, bonds are securities that can be bought and sold. They pay a fixed rate of annual interest or "coupon." A change in interest rates is accommodated in the bond's price. If rates rise, the price of the bond falls, and vice versa. Most British government bonds end up with insurance companies and pension funds, which need reliable sources of income to meet payments to policyholders and pensioners. About a third are held by foreign banks and private investors.
The cause of all this recent borrowing is not the banking crisis itself. The bonds required to fund the banks taken into state administration, a mere £37bn, were issued last autumn. No, Stheeman's headache comes from spending by government departments (without accompanying tax rises) over the last nine years and is to be traced in the policies and misfortune of a single man, Prime Minister Gordon Brown.
The approved practice of modern public finance is to accumulate modest surpluses in good times, which turn into modest deficits in bad times as tax receipts fall and more money is spent to pay for higher unemployment. So it was in the first two "good" years of the 1997 Labour government. Then in 1999, Brown, as chancellor of the exchequer, launched a programme of public spending unparalleled in British peacetime. Public spending rose from 36 per cent of GDP in 1999-2000, to 41 per cent in 2007-2008. Then, in early 2008, business began to contract all over the world. The banks and investors of the City turned from lucrative sources of tax into demoralised petitioners for state funds. In the year to next April, the treasury expects tax revenue to drop 10 per cent (and public spending will rise to 48 per cent of GDP).
Determined to keep money in people's pockets, the treasury says expenditure in 2009-2010 of £671bn will exceed income of £496bn by £175bn. That difference is over 12 per cent of GDP. Brown thought that the profits of the City would finance a new welfare state that would be a monument to him more lasting than bronze. He was mistaken.
Buried in the budget report of last April are passages of statistical terror. According to the treasury the economy will not merely contract by 5 per cent this year. The slump has impaired Britain's productive capacity by a further 5 per cent. If the treasury is correct (which it may not be, Britain often bounces out of recessions more energetically than expected), it means that even if confidence returns to business, companies and households Britain will still not pay as much in taxes relative to national income as in early 2008. So the government will have to raise taxes, cut its spending or inflate the currency to make its interest payments worth less or worthless. Even then, the budget is not expected to come close to balance until 2017-2018.
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So is Britain bust? Well, the country is not about to be invaded at the urging of irate foreign bondholders, as occurred in Mexico in the 1860s or Egypt in the 1880s. Nor is it yet subject to the civilised modern equivalent, last seen here in 1976, when the government of the time agreed to restrictions on its spending devised by the International Monetary Fund (IMF). But there have been anxious moments in recent months at both the treasury and the Debt Management Office. An auction of £1.75bn in super-long gilts on 25th March did not attract enough bids. Stheeman also suffered a bad quarter of an hour on 21st May when the rating agency Standard & Poor's lowered its assessment on British sovereign debt from "stable" to "negative." Yet Britain can borrow, and in its own currency, at 4 per cent interest and an average maturity of nearly 15 years which only a handful of countries in history have ever been able to do. The foreign appetite for the sterling liabilities of the British government is rising not falling. This appetite has not been soured by recent falls in the sterling exchange rate, which at points exceeded the great devaluations of 1931 and 1949, and the lesser of 1967 and 1992. "My opinion," says Stheeman, "is that this thing has nothing to do with an excessive supply of gilts. It is to do with the market's perception of the UK economy, which is not as dire as it was three months ago."
Moreover the accumulated British national debt in relation to GDP—at 75 per cent—is still lower than in powerful trading countries such as Germany (about 78 per cent) and Japan (about 190 per cent). It is also lower in relation to the productive wealth of Britain than after the two world wars of the 20th century or in the elongated 18th century between the glorious revolution of 1688 and the battle of Waterloo in 1815.
During that period, England and then England and Scotland ran a national debt far higher in relation to its trade than the IMF would tolerate in a developing country today. The best minds in England and Scotland—Swift, Bolingbroke, Hume, Smith—forecast national bankruptcy. As if in mockery of their reasoning, Britain emerged from the field at Waterloo the richest and most powerful state on earth. The only time when Britain came close to grief was, perversely, when it attempted to liquidate the national debt in the speculation known as the South Sea bubble in 1720-21. In short, debt is as British as the village green or the public house.
The difference is that the 18th century was a period of almost unremitting warfare with France. It is as if, during the Brown ministry, we had not hired a few tens of thousands of extra doctors and teachers but had been fighting a powerful and resourceful enemy. We have burdened our children with debt not for captive new export markets or to crush rebellion, but to create a hungry state establishment that employs every fifth person, makes up half the economy and is very, very hard to reduce. Restricted in our room to manoeuvre, we are vulnerable to natural catastrophe and enemy action and must trust to providence or improvisation. Think of a British Katrina or 9/11 with the revenue already overspent.
The crisis in the public finances, in the year before a general election, has paralysed the government and engulfed both the treasury and Bank of England in poisonous politics. At the treasury, ministers are tormented by political indecision. Few have any experience of an old-fashioned "hard spending round," in which the treasury cuts and slashes at the darling projects of spending departments. Frustrated by the treasury's inaction, the Bank has abandoned diplomatic language. Treasury ministers mutter that Threadneedle Street has fallen to a Tory fifth column. Across two-and-a-half miles of London traffic, there is a steady small-arms fire and the occasional mortar round.
We face not merely what Robert Chote of the Institute of Fiscal Studies, calls "two parliaments of pain." As Chote puts it: "I don't think the public has internalised just how large the economic bill will be. They'll say: we'll vote out these fellows, and then it will be all right. But it won't. Even after the election, there is a huge task." The most important task is to convince foreign and domestic creditors over many years that the government will be punctilious in paying interest on its debt (which will rise £40bn a year by the end of 2009) and protecting the principal against inflation. Otherwise, the interest rate will rise and consume ever more of the government's revenue which could swiftly lead to a collapse in investor confidence, possibly a run on sterling, and a return to 1976 conditions.
Until recently, "quantitative easing" created an artificial demand for government debt and thus kept the rate of interest on the public debt down. Since 11th March, the Bank of England has bought £105bn of gilts—with money printed for the occasion—from the banks and credited their accounts at the Bank with new cash. The purpose of such quantitative easing is to encourage the banks to lend to industry and the public. (This programme has now been suspended, at least until August.) Yet the Bank's task is not to ease the government's pain but to maintain price stability and at some point not far off, and after informing Stheeman, it will put quantitative easing into reverse. That is the Maxim gun in Threadneedle Street. Brown must curse that day in 1997 when, at the summit of his power, he renounced the pleasure of sacking the governor of the Bank of England.
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When Prince William of Orange landed in Devon on 5th November 1688, he brought with him from the Netherlands not just an expensive quarrel with the French monarchy, but also some Dutch ingenuity in how to pay for it. In the penny pamphlets of the time, there was a new way of looking at money. There was, it seems, in London, with its population of half a million souls, a so-called "fund of credit." That meant two things. If the crown had reliable revenue from, say, an excise on malt for making beer, it could direct that revenue to pay an 8 or 10 per cent annual interest payment on a substantial loan, which could be sent straight across the Channel to pay the soldiers. Meanwhile, the merchants and new insurance and trading companies established since the civil war had cash surplus to their stock-in-trade or working capital. That need not sit as dead weight in their strong boxes but could be lent at interest to a reliable borrower. Only a fool or a brave man would lend to an absolute monarch, but a parliamentary government was quite another matter.
The appetite for these new government loans soon revealed itself. In 1694, in ten days of glorious late June weather, and in return for a banking monopoly known as the Bank of England, a group of City merchants subscribed £1.2m at 8 per cent to fund Prince William's war. According to the ledger still held at the Bank, the first £300,000 was inscribed in a single day. In launching the public or national debt, it helped that there was no competition: no manufacturing industry, no railway debentures, no building societies, no collateralised debt obligations, and no more than a couple of dozen joint-stock companies such as the East India Company, which were themselves obliged to subscribe to government loans in return for their monopolies.
In the course of the "long" 18th century, spanning some 127 years, England and Scotland fought seven foreign wars and two full-blown rebellions and were at peace for just 50 years. For much of the time, more than 200,000 men were in arms, about the same number as today. According to Adam Smith, the public debt was £21m at the Treaty of Ryswick (1697) and £54m after the Treaty of Utrecht (1713).
After the South Sea fiasco, there was no further attempt to liquidate the British public debt, which became perpetual. Each retiring bond was paid for by a new one. By the time of the Peace of Paris (1763), Britain's debt was £136m. That year, Smith conjectured that national consumption was about £10 per head of a population of 10m, giving a total of £100m or far less than the debt burden. The debt continued to climb to £232m after the American war (1783) and to £900m after the Napoleonic wars (1815). Until the last years of the 18th century, there was no income tax to help pay off the debt.
It was in thinking about public credit that the 18th century refined its ideas about civil government and society into the school now known as political economy. At first many people feared that the public creditors would become accomplices of the court, finance pointless foreign wars, extort pernicious trading monopolies or degenerate into an idle and selfish class of rentiers. The funds would feed a parasitic civil service and, above all, divert scarce capital from the land which was then thought to be wealth in a very particular and privileged sense (rather like car factories in my childhood). Here was a primitive version of the current debate over "crowding out," in which a ravenous government takes all the public's savings that might be used for private purposes.
David Hume's essay "Of Public Credit," 1752, is a piece unique in his philosophy, and indeed in British philosophy. Its tone is lurid, even hysterical. Hume conjures a nightmare in which a ruling class of creditors engrosses all the debts of the public and its property. Liberty, hierarchy, even value and meaning dissolve, and a supine public abandons all attempts to maintain the balance of power in Europe or preserve its own independence. "Either the nation must destroy public credit," he says, "or public credit will destroy the nation." It is strange to find one the greatest minds ever to have reasoned in these islands thinking like the Daily Telegraph.
Adam Smith, always a more cautious philosopher than his friend, none the less saw funded debt as pernicious, promoting warfare and sapping the nation. From his unrivalled knowledge of ancient and modern history, he concluded: "When national debts have once been accumulated to a certain degree, there is scarce… an instance of their having been fairly and compleatly paid. The liberation of the publick revenue… has always been brought by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment." By pretended payment, he meant a debasement of the coinage, or what we now call inflation.
Looking back on this period in 1855, lapped in Victorian probity and the international gold standard, the historian Thomas Babington Macaulay jeered at these Scottish fusspots: "At every stage in the growth of that debt the nation has set up the same cry of anguish and despair. At every stage in the growth of that debt it has been seriously asserted by wise men that bankruptcy and ruin were at hand. Yet still the debt went on growing; and still bankruptcy and ruin were as remote as ever."
Only in America, land of republican virtue, did the legacy of Hume and Smith survive and there not for long. Under the Jackson administration in 1835, the US national debt was paid off. But as always battle changed everything, and with the outbreak of war with the Confederacy in 1861, debt grew rapidly to 40 per cent of GDP. All the philosophising over debt resolved itself into a truism: you can borrow as much as the credit markets will lend you and not a penny more.
Britain's £900m debt of 1819 was not matched until 1915. But by the end of the first world war, debt was £7bn, and after the second world war was £21bn, or three times a depressed national income (compared with about three-quarters of national income now). Government spending fell after the world wars in relation to GDP, but not back to its old level. By the end of the second world war, 14m people were paying income taxes. That wide expansion of the tax franchise, more than anything, seems to have broken British inhibitions about government spending.
Enthusiasts of public borrowing like to claim that the war debts of 1945 did not deter this country from creating a universal medical service and welfare state and enjoying the best part of 30 years of improving material standards of living. In reality, the welfare state was financed by the peace. Spending on defence, as a percentage of state expenditure, fell from over 25 per cent at the time of the Korean war in 1953 to just 5 or 6 per cent today. A general improvement in the material conditions of the poor or poorish came to replace what Winston Churchill called "the diversions of an imperial people." The greatest empire in history deflated to a metropolitan remnant, where a few monumental institutions—the monarchy, the British Museum, the public schools, Wimbledon, the turf, the City of London—commemorated the past while the welfare state pointed to the future.
Annual budget deficits became the norm. A drastic rise in consumer prices in the 1970s and 1980s eroded the value of the public debt and dragged taxpayers into higher brackets. Even so, the era was punctuated by sterling crises—1967, 1976, 1992—when financial markets came to doubt the ability of the British state and public to pay for their spending. The 1990s saw a period of consolidation to the point where, at the turn of the millennium, the government paid off more gilt-edged stock than it issued. At that moment, Brown, as chancellor of exchequer, began to spend money to create "world-class" public services and to reduce inequalities of income.
Money poured into health and education and although waiting lists fell and exam results improved, not all of it was well spent. In a notorious case, the National Audit Office reported in 2008 that a new contract for general practitioners had led to an annual drop in productivity of 2.5 per cent, as doctors paid themselves more and worked fewer hours. One of the pleasures of rural life is to watch country doctors attempting to conceal their new prosperity and their intercontinental vacations. At my local village primary school, £2m is being spent to restore a serviceable Edwardian building for 126 pupils. It is a ratio of capital expenditure to pupils that would be the envy of Harvard College. "We got some value for money," says Richard Jeffrey, chief investment officer at Cazenove Capital in the City of London. "A large increase in public spending produced some improvement in government services. But much too much leaked out into public-sector inflation."
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Economists have a concept called trend growth, which is the rather slow expansion that a rich and long-established country such as Britain can expect to enjoy. The treasury argues that this trend growth was as high as 3.5 per cent at the turn of the millennium before abating to 2.75 per cent. What is happening now, it says, is not just a temporary slump beneath this imaginary trend (of 5 per cent) but a kink downwards in the trend itself, after which growth will resume but at a reduced level of prosperity. The cause, says the treasury, of the permanent reduction is a rise in risk premiums—that is a reluctance to lend—from chastened banks, a fall in the size of a productive and tax-paying City of London, and fewer immigrants.
This is a rich and leisured country where employees work only two days out of three—less than the God of Genesis—and many people do no work at all. Strong trend growth in these circumstances is implausible. More likely is that the trend growth was overstated in the 1990s when the financiers of the City thought they were making profits. The wave of immigration that is now receding was a symptom of uncontrolled boom. In short, the government lost control of the British economy.
The profits from the City and the housing boom were productive of taxes, but were too transitory and unreliable for the funding of expensive and long-lived institutions such as schools and hospitals. The government, and much of the public, mistook rising values of real property, the stock market and commodities for long-term prosperity. Brown, radiating prudence, rashly announced the end of "boom and bust," that is the cycle of feast and famine in business affairs that has been recognised since classical antiquity.
Chote is more generous to Brown than many others: "Of course everyone now agrees that we should have had more effective macro-prudential policies, to head off the boom. But that is easier to say now than it would have been to do then. With the economy growing steadily and inflation low and stable, it would have been a brave government that proclaimed that the good times were unsustainable." By macro-prudential policies, Chote means that the chancellor and governor should have looked for symptoms of inflation not just in consumer prices but in assets such as houses. They should have ended the party in full swing, not when many of the revellers were face-down in the gutter.
The result is that Britain is paying more in interest on its public debt—some £40bn per annum—than on any department of state except the big three of health, education and social security. More than a third of this sum passes out of the country into the hands of foreign banks and bondholders.
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So what is to be done? For the moment, or rather for the next two years, the treasury intends to keep spending, and has so far enjoyed the backing of its creditors. "We need to give the British economy a breathing-space," says Jeffrey. "There will be a temptation for the authorities to attack both revenue and spending. But after a severe recession, you want to encourage wealth creation, not burden it with taxes." Anyway, to return the budget to balance at once would require a rate of income tax of over 50 pence in the pound, not just for the highest earners, but for all earners. In a country that already enjoys powerful disincentives to work, that is not recommended.
There is nothing in civil or natural law that prescribes that Britain's budget must be in balance in 2017-18. Why not 2018-2019? Yet each year that prospect recedes, the country is exposed to the whims of the public creditors (many of them foreigners thanks to our low domestic savings rate) and the tyranny of the unforeseen. New liabilities are appearing as public contractors such as the operator of the London-Edinburgh railway, National Express, unable to make money in a recession, walk away from their obligations leaving the government to take up the burden. At some point, there will appear investments more lucrative and reliable than the liabilities of a middle-ranking industrial power. That is the Humean nightmare of the 21st century.
What about inflation, which pardons all errors of business and government? As economist Anatole Kaletsky says, there isn't much. "All previous recessions of the last 40 years were accompanied by inflation… This is the only one where weak growth is matched by low inflation." That cannot be taken for granted: renewed credit expansion, rising commodity prices and increases in Chinese wages could stir inflation again.
But even if inflation does rise, the main burden after next year's election will have to be carried by spending restraint. If health and social security are deemed too sensitive for the knife, other departments will be fortunate to see any increase. The best guess is that capital spending on roads, bridges, hospitals and so on will revert to the level of the early 1990s and may not cover the wear and tear on existing stock, which is not exactly the last word in elegance. Thus the foreigners' picture of Britain as a place of private opulence and public squalor will be unaltered by the Brown boom, unless it happens that a long recession creates, as in the 1970s, squalor all round.
Yet it may be that the new mediocrity of British circumstances will cause the country to think a little harder about what it is doing. For example, in March 2007 parliament voted by a majority of 248 to order four more nuclear-powered submarines to replace the current Vanguard class boats that carry up to 48 nuclear weapons each. The cost was thought to be about £20bn in today's money. There was little debate. Now that £20bn is hard to find, parliament may be inclined to question whether we really need these doomsday machines, with untargeted missiles, to cruise the Arctic and Atlantic Oceans as a general expression of British power.
But why should health and social security be sacrosanct? A government that truly wishes to reduce its annual deficit will have to restrict payments to the doctors, nurses, featherbedded private finance initiative contractors and drugs companies that have created such an inflation in the cost of healthcare. If these departments are to be out of bounds, then the debate will not proceed beyond generalities and we will have to convince the public creditors over many years that we can sustain debt of 70 or 80 per cent of GDP. No doubt, Britain will once again muddle through.
Is Britain bust?
For 300 years our best minds have fretted over the threat of national bankruptcy. As government debt surges upwards, they are doing so again. How worried should we be?
July 26, 2009
