Commentary: The Burden of the National Debt

Pub. Date
21 October, 2009


Most discussion of the government's fiscal position seems to focus on the immediate risks associated with a rising national debt. There is concern that the UK's credit rating will be reduced and fear that this might lead to a further fall of the exchange rate. It is sometimes suggested that if the budget deficit is not reduced sharply in the reasonably near term there will be a significant risk that the UK might default on its debt.

These concerns are probable exaggerated. As we and others have noted, if the national debt follows our projections it will rise to 93% of GDP by 2015; this is well below the levels that some other countries manage at present and also below the levels experienced by this country for much of the last two centuries. This does not, however, imply that there are no implications of rising debt levels or that these can be ignored; here we focus on the effects of rising and eventually high debt levels making the reasonable assumptions i) that debt levels have few implications for the cost of finance and ii) that for practical purposes there is no risk of a government default.

The Cost of the National Debt

The main cost of the national debt arises from the fact that it crowds out productive investment. If high government borrowing reduces national saving, then the social cost of the debt can be measured not by the interest rate on that national debt but with reference to the rate of return on productive capital. National Institute calculations put the return on productive capital at 4-4_ per cent per annum, well above the real rate of growth of the economy. With this 'shadow cost' of government debt it is clear that, while a budget deficit may support current consumption and current output, there is a long-term cost associated with it. Only those currently alive enjoy the benefits of the deficit while future generations are left to handle the long-term costs. The impact of this is reduced by the fact that each £1 of extra national debt probably crowds out only about 50p of productive investment, but the effect remains.

In essence, by running up the national debt the country has transferred consumption from the future to the present, in much the same way as an individual who lives off capital reduces their future scope for spending. One might puzzle how paper transactions can have an influence of this type on the 'real' economy. The answer is that, although the presence of national debt does not depress output in the short term, it reduces the need for people to accrue productive capital and this has long-term implications.

Other Means of Burdening the Future

It is worth mentioning two other phenomena which have a similar effect of benefiting predominantly people who are currently old at the expense of people who are predominantly young and those who are not yet born. The first is a pay as you go benefit system. This also reduces the need for people to accrue income-producing assets to fund their retirements and thus has to be expected to depress the economy's holding of productive capital. It results, in effect, in a transfer from future generations to the first generation to enjoy them. These people receive the benefits of pay as you go pensions when old without the cost of financing anyone else's pensions when young.

The second mechanism for generating a transfer is the effect of a rise in land prices, at least on the assumption that people rely in part on their holdings of housing wealth as a means of financing retirement. An increase in land prices, whic most people notice as an increase in house prices, (with eventually a parallel rise in rental rates) reduces the amount that those who do not own land have to spend on goods and services other than housing use. But since the total productive potential of the economy is not reduced, all that happens is that consumption is redistributed towards those who currently only land. Since housing/land ownership is much more common among old and older people than among young people, a land price rise also has the effect of generating a powerful intergenerational transfer.

The importance of these points is that, to the extent that policy makers are concerned about the burden of government borrowing and, as we have argued, this is of much greater concern than the idea that the government might find the debt unmanageable, they should be concerned about any economic circumstances, whether the direct result of government policy or not, which transfer resources from future generations to the present. In particular, those who hope to see the economy supported by a buoyant consumption on the back of a recovery to house prices and believe that this is somehow preferable to the economy being supported by budget deficits are living a dangerous and remarkable delusion.

These observations need to be seen in the context of the decline in the nation's produced wealth relative to GDP. Since the mid-1980s this has fallen from about 3 _ to 2 _ times annual GDP, a decline similar to that caused by the Second World War.

Looking ahead, national saving is likely to fall well below the average of the last twenty years for the next two or three years. This is a consequence of the government's fiscal measures to support the economy and has to be seen as a necessary evil. In a recession very low saving has the effect of raising output and is therefore desirable despite its costs. But beyond that there is the question whether policy should be structured so that the costs of the crisis are spread across future generations or whether they are in large part borne by the current generation.

A fiscal tightening of 5 per cent of GDP combined with the exchange rate depreciation we have seen should raise the national saving rate from 4% to 8% of GDP and this, combined with an increased state pension age should put the economy in a position where future generations are not substantially burdened.