Manageable? Perhaps. Desirable? Far from it.

Civitas, 17 January 2011

George Santayana wrote ‘those who cannot remember the past are condemned to repeat it’; Ed Miliband would be wise to heed Santayana’s warning in formulating his administration’s economic policies, however evidence so far is that he hasn’t.

That Labour’s economic policies need to be rethought is accepted by Mr Miliband, he has stated that his party has ‘a job to do to win back economic credibility’. However, in the same interview he stated that annual state borrowing of 2% of national income was ‘manageable’. I think that this is debateable, but I think the more important question is: is it desirable? The financial crisis and in particular the continuing problems in the Eurozone have stoked interest in national debt and deficits. The UK currently has a national (public) debt of £971.0 billion at the end of November 2010, or 65.2% of GDP. It has been forecast that in 2010 the UK ran a budget deficit of over 11% of GDP or £19.9 billion. Coupled with this the UK is a net debtor country according to its international asset position, that is the UK’s debts to foreigners exceed the debts of foreigners it holds.

To recap then, the UK has a steadily growing level of debt, and last year it added to this debt by running a large deficit. The question is: can we expect the UK to continue to increase its level of debt? Well if previous performance is anything to go by then yes. Since the last recession in 1992 the UK economy has grown every year, yet every year except for 4 years between 1998 and 2002 the UK has run a current account deficit, that is it has added to its debt.

Now then, is a 2% annual deficit, financed by borrowing, in Mr Miliband’s words ‘manageable’? Perhaps one way to judge this is to look at countries whose debt and deficits are clearly not manageable, for instance, Ireland, Greece and (debatably, but increasingly likely) Portugal. These three cases are different, however, in all three cases it is possible to say that the country’s debts were judged to be unmanageable because they were too large in relation to the country’s expected growth prospects. Creditors, or possible creditors, look at a country and assess whether it is a good idea to lend it money. Reducing this to a simple but relevant illustration, if you decided to lend someone £20 then you would need to assess whether they could possibly pay this money back. If the person had an income of £20 a day and outgoings (on rent and food) of £10 a say then clearly they would have enough money to pay you back relatively quickly. However if they had an income of £0.01 a day and outgoings of £10 a day then you would expect them to have trouble paying off your debt and may decide that they were too risky to lend to.

This is what many creditors felt about Greece, and are starting to feel about Portugal. They felt that Greece’s income (its growth prospects) were too low in relation to its outgoings (its deficit and debt levels). The question is: will creditors start thinking this about the UK? The current Government clearly hopes not, and its austerity measures are supposed to indicate that the UK is committed to reducing its deficit.  Evidence, such as the cost of borrowing for the UK, suggests that international creditors are still not too wary about lending the UK money. In this sense if the Government lowers the deficit from 11% to 2% then one can assume that the UK will still be able to attract creditors to finance its deficit, it will have a ‘manageable’ deficit.

However, I contend that this situation would be far from desirable. The previous Labour administration ran deficits at a time of high economic growth, propelled by Britain’s comparative advantage in financial services, which occurred at a boom time for the industry. The country’s future growth outlook is not so rosy, financial services will struggle to achieve previous levels of growth, and there is a great deal of uncertainty about the growth rates of British manufacturing and services. The seemingly casual way in which Mr Miliband assumes that annual state borrowing of 2% is manageable suggests that, like his predecessors, he will endorse borrowing regardless of Britain’s growth prospects.

If Mr Miliband wants to ‘win back economic credibility’ he would be wise to reject the previous Labour Government’s default acceptance of deficits, and concentrate on producing credible economic policies to stimulate British growth as this will determine what is a ‘manageable’, and indeed desirable, level of UK borrowing.