Tuesday, 25 May 2010

Dealing with the UK Deficit - What kind of numbers are we looking at here?

There has  been a great deal of discussion over the last year or so about the scale, and problem posed, by the record UK government deficit that has emerged as a result of the Recession, with the general consensus that this is one of the most important issues facing the UK over the next few years.  The issue of how important this is and if, when and how to close the deficit was a major election issue and a major dividing line between the parties, with a number of different prescriptions for the problem from Conservatives, Labour, Greens, Nationalists, UKIP etc.  Despite this, it was widely taken as read that any government elected would have to engage in large unprecedented cuts in public spending and, some commentators have predicted,  possibly suffer a massive public backlash as a result. 

This week we have seen the start of action on this issue of reducing the deficit, as the Conservative-Lib Dem coalition government announce £6 billion of cuts in public spending, as the Conservatives promised pre-election, as a first step in dealing with the problem. But how large is the actual deficit, how much does this £6 billion contribute to cutting the deficit, and how much of the coming public spending cuts does this constitute?

Just to get a first grip on the type of figures we're dealing with, UK GDP is currently about £1385 billion, having fallen by about 6% from £1460 billion to £1375 billion during the recession and now slightly recovered.  Out of this the government's plan at Labour's last budget in March was to spend £704 billion (or 51%).  However, even on Labour's relatively generous estimates for growth over the next year it only expected to receive £541 billion in tax leaving the £163 billion budget deficit, the amount the government will have to borrow to meet its spending commitments.  This figure is 23% of all government spending and 12% of GDP.

Why does this matter? 

Well, firstly because the government has to borrow money at interest, like anyone else, and this rate can vary depending on how likely international investors think it is that we'll screw up massively and have to effectively declare bankruptcy.  This interest rate is currently about 4%, meaning that, even if the interest rate stays put, once this money is borrowed in every future year the government will have to spend £7 billion just paying the interest, that's £7 billion we can't spend on public services for every year in perpetuity (as there's sod all chance we'll ever actually pay down any of the debt, the general plan to deal with it just to wait for inflation to steadily magic it away). 

Much worse than this though is the current fear about sovereign debt, the generally unthinkable event that countries might actually declare bankruptcy.  See Greece for the current focus of this worry.  What this means is that international investors are getting scared, and if it does not appear that we have a credible plan to get this deficit down, then there is the risk this interest rate will rise putting up the costs considerably, that £7 billion could easily become £10 billion.  Even more wonderfully, because of the way government debt is borrowed, if the interest rate goes up it does not just go up for any borrowing we make in the future, but rather also for all the money we've borrowed in the past as well, thus meaning that the cost of paying the interest on our debt can go up a lot quite quickly, in which case the £7 billion a year cost of all that borrowing could become more like £20 billion a year. 

Lastly, there is the connected problem that partially for the above reasons, a country can only accumulate so much debt.  The other reason for this is that although we don't currently plan to ever pay down our total debt we do only borrow each time for about 10, 20 years, meaning on a constant basis we are paying back our debts by borrowing the same amount of money again to do so.  If it is thought that we have no credible plan for bringing down borrowing then there may come a point when investors simply refuse to lend us the money to do this, except at ridiculous rates of interest, meaning that we can't refinance our current debt and we certainly struggle to increase that debt total (deficit) any further, and have effectively been declared insolvent.  Together these mean there is an effective ceiling of how much debt you can get, before it gets prohibitively expensive to borrow any more, especially in the current fragile economic climate.

Currently our national debt is about 62% of GDP, up from about 40% ten years ago and forecast at current rates to rise to 95% over the next 5 years.  Our government has historically had relatively low amounts of debt as a country, and this is itself beneficial, both because it reduces suffocating interest payments, and because it gives you more room to manoeuvre in the future.  What all this borrowing means is that we are losing our room to manoeuvre in any future crisis and reducing the competitiveness of our economy.  This is bad in the long-term, not to mention the more immediate risk of rising interest rates on our debt that may costs us significant sums over the next years that we will then not be able to spend on schools, hospitals, welfare and everything else the government does.

The media has widely reported that the £6 billion announced yesterday is only a down payment on the cuts that are coming, with varying degrees of sensibility or hyperbole in the language used depending on the source and their political allegiances.  It is important to get the figures correctly in perspective though. Yes, these cuts are only the first small part of what is coming, but not as small a part as some people seem to be suggesting.

£6.2 billion of cuts were announced of which £0.5 billion will be reinvested leaving a £5.7 billion cut this year. At last estimate that brings the deficit down from £159 billion to £153 billion, still extremely high but (partially thanks to better than thought tax revenues) already considerably lower than the £173 billion Labour were predicting for this year at the in the 2009 budget, when the scale of the debt problem first became apparent.

However, that is divided into the cyclical and the structural deficit. The idea is that the cyclical deficit is that part of the deficit effectively ’caused’ by the recession i.e. by the lower tax receipts and higher welfare spending it brings, and will naturally disappear as we return to steady growth (an admittedly reasonably large if).  The structural deficit, however, is that deficit that is not caused by the slump in taxes and hike in welfare due to the recession, but the long term difference between the government's year on year spending commitments to various areas, and the amount it is taking in taxes from the economy.

The Lib Dems and Conservatives before the election both only committed, roughly speaking, to eliminate the bulk of the structural deficit, that part of the deficit that will not disappear even with a return to steady growth, a still considerable £70 billion at last estimates.  (Labour only committed to removing half of the structural deficit)  They have both accepted £12 billion worth of Labour tax rises, put in place by Gordon Brown before the election, such as the 50p income tax rate. They have also made various tax cut commitments, but these are meant to be evened-out by other tax rises brought in, so in theory cancel out for the purpose of these calculations.

This gives us £58 billion of structural deficit not taken care of by tax rises. The Coalition has committed to eliminating the “bulk” of this over the next 5 years. No one has been willing to state precisely what that means, presumably because no-one can predict precisely what growth and hence tax revenues will be over the next few years and, hence, precisely what any given figure will achieve, so, quite understandably, no-one wants to make one. “Events dear boy, Events”, as Harold Macmillan once said. Or, in more technical terms, the margin of error on all these estimates is quite large, making precision not only impossible, but down-right misleading.

However, it is possible to have some idea. Before the Election the Conservatives said they wanted to deal with the deficit by cutting £4 for each £1 raised in extra taxation. Applying this to the £12 billion of tax rises accepted, we get £48 billion of cuts and a total structural deficit reduction of £60 billion over the next 5 years.

So, we’ve had £5.7 billion of cuts out of £48 billion, roughly . Or, given margin of error and government’s usual ability to over-estimate savings and under-estimate costs, about £5 billion out of £50 billion.

Either way, the cuts recently announced amount to about 10% of the total we are going to get over the next 5 years. Leaving £45 billion left over the 4 years after this one, or about £11 billion a year, unless economic growth severely exceeds expectations, or some other fiscal miracle occurs, and considering the difficulty this will cause public services and people who rely on them up and down the country, may we all pray that it will.

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