At the moment, the stimulus debate shapes up something like this: all parties recognise the need to eliminate the deficit (i.e. the rate we add to our debt), but think we should do this without fundamentally harming the recovery in the short-term. Those who advocate more spending than planned think the current rate at which we are (trying) to close the deficit is too quick, whereas the Government thinks it is about right. Both of these views would see a significant increase in our debt over the course of this Parliament, but the former group are willing to add more to it than the latter.
The latter ‘austerity’ crowd have been labelled ‘economic masochists’ – a critique which usually comes from people who believe the incoming Government was overplaying its hand by comparing the UK’s position to that of countries like Greece. These critics argue that the risks of over-indebtedness are overstated and, besides, countries like the UK are still able to borrow at very low real interest rates. If the markets aren’t worried, then why should Governments?
Economists Rogoff, Reinhart and Reinhart have published a paper which looks at this in more detail. Their results are worrying. They find that debt episodes (where public debt to GDP exceeds 90 per cent for five years or more) are associated with much slower economic growth. In the countries looked at, real GDP growth averages 3.5 per cent per annum where debt/GDP is less than 90 percent; compared to 2.3 per cent when over 90 per cent (or 1.2 per cent lower than the low debt periods).
This finding is not just a market interest rate effect. In fact, four out of the six cases where real market interest rates were low during high debt periods still saw significantly lower growth. Likewise, four out of the five cases where real interest rates were similar before and after the high debt period also saw significantly lower growth during the high debt period.
They conclude that the threat of high debt levels is real. Boasting about low real interest rates alone right now misses the point. The high debt in itself appears in some cases to be a factor in significantly slower growth which takes years to unshackle. And our current crisis might be even worse, due to simultaneously high private debts.
In the UK context this has two main implications. First, we appear to be sailing very close to the wind in terms of our official debt/GDP ratio. Our public debt figure is forecast to peak in 2014/15 and 76% of GDP. But under the Maastricht definition, Treaty ratio debt is due to hit 92.7%, even before all the off-balance sheet items are accounted for. Second, George Osborne would be wise not to get too excited about very low interest rates – historical evidence suggests growth can still be damaged by high debt levels even when borrowing rates appear low.