Independence and Government Debt
The text of this paper was submitted to the Scottish Parliament’s Finance Committee in May 2014
As the UK Government has recognised, there will be no legal obligation on the government of an independent Scotland to accept any share of UK government debt, since Scotland, as a legal entity, was not party to incurring them. However, the present Scottish government has expressed its willingness to accept an ‘equitable’ share of that debt. How large should that share be? Different people will have different views, and the final outcome will be negotiable. This paper argues that Scottish negotiators should take a hard line on financial freedom. The huge size of the present debt is largely the result of the poor stewardship of the economy by successive UK governments, and in particular by their appalling mismanagement of the public finances.
The size of the debt
The most commonly used measure of government debt in the UK is ‘public sector net debt’. In the year to April 2015 public sector net debt is expected to be some £1,355 billion, equivalent to 77 per cent of gross domestic product. In 2000 net debt was 31 per cent of GDP, so the ratio will have more than doubled in fifteen years. The Office of Budget Responsibility (OBR) has forecast that net debt in cash terms will continue to rise at least until 2018-19, reaching £1,548 billion. This liability amounts to about £50,000 for every family in the country.
At the present low rates of interest, the annual cost of servicing this debt exceeds £50 billion. This is the amount that the government has to find every year just to pay the interest, never mind the principal. It is more than the entire annual defence budget. When interest rates return to a more normal level it is likely that the burden of servicing the debt will be impossible to sustain without additional increases in taxation and cuts in public expenditure beyond those already announced.
Even these very large numbers significantly understate the size of the UK’s fiscal imbalance. The officially published measures of national debt, what might be called the explicit debt, are backward-looking measures. They do not reveal the extent to which the government’s unfunded future financial commitments, the implicit debt, cannot be met by future receipts on unchanged policies. No funds have been set aside to meet these commitments, yet they represent government liabilities and therefore prospective indebtedness. They include promises to pay future pensions to public sector workers, state pensions and future healthcare spending, as well as legacy PPI/PFI liabilities, Network Rail expenditures including HS2, ROC, new nuclear liabilities and all other future government commitments that cannot be financed on current tax rates and policies.
Revealing implicit debt
The government does not produce forward-looking accounting measures that adequately reveal the size of this implicit debt, even though some of these commitments may actually be more predictable than the government’s explicit debt. We are therefore generally in the dark about the true extent of total government indebtedness. Estimates put the size of the implicit debt at over five times the size of the explicit debt. Like an iceberg, that part of the government’s indebtedness that is visible is only a fraction of the total. Even if these estimates are only roughly accurate they underline the urgency of creating an environment for sustained economic growth in Scotland in order to generate the increasing tax revenues required to maintain our public services.
The size of UK government debt, explicit and implicit, seldom appears to be the subject of serious debate at Westminster. A run on sterling could be precipitated at any time. It might be triggered by financial markets’ perception of a reluctance on the part of the British political class to face up to the difficult decisions that have to be taken, or it might follow another downturn in GDP, perhaps after the Westminster elections of 2015.
How we got here
In the year, 2000 UK net debt stood at 31 percent of GDP. Then, for the next seven years, despite strong economic growth, the public finances deteriorated significantly. In 2000 the UK ran an estimated ‘structural’ budget surplus, (i.e. a measure of the budget surplus adjusted for the business cycle), equivalent to 2.4 per cent of GDP. But by 2007 that surplus had turned into a structural deficit of 5.2 per cent. This was the result of unsustainable spending commitments entered into by the government of the period, as well as persistently over-optimistic forecasts by the Treasury. In 2007 the UK had the largest structural budget deficit among the G7 economies. Across the 35 advanced economies monitored by the International Monetary Fund, only Ireland and Greece are estimated to have had a larger structural deficit in that year.
Because of the Treasury’s pipe-dream of `no return to boom and bust’, its self-imposed fiscal rule of delivering a current account budget balanced over the cycle made no provision for the risk of recession, and was too slack by about 3 per cent of GDP. The UK was therefore poorly placed to deal with the fiscal consequences of the recession that began in 2008.
Efforts to recover but with continuing growing debt
The coalition government has spent the four years since 2010 trying to put the public finances in order. There have been tax increases and cuts in planned spending. Despite these measures, the government’s debt has continued to grow. George Osborne is going to add an estimated £530 billion to the national debt in just five years. That’s more than Messrs Brown and Darling added in eleven years. In short, despite all the talk of ‘austerity’, the present government is going to almost double the national debt in cash terms in just one parliament.
What are the reasons for this huge increase in debt? The politicians responsible are quick to shift the blame. They claim that in 2007 the British economy was hit by an `external shock’, a `global financial crisis’. In fact, the financial crisis that began in that year was neither external nor global. It was not global, because it was confined to Europe and the US. Not a single bank in Japan, China, South-east Asia or even India failed or suffered a run in 2008. It was not external, because, unlike a meteorite strike, a financial crisis is a wholly man-made phenomenon. Governments themselves made the crisis, together their central bankers, Treasury officials and regulators in London and Washington, as well as bankers on Wall Street and in the City.
Bank of England officials, Treasury civil servants and their political masters all share responsibility for having led the British economy into the financial crisis of 2007-8 and then allowing it to languish in recession for four more years. Right up to the beginning of the crisis, the policymakers at the Treasury and the Bank of England refused to recognise there was a problem. The opening sentence of the Bank’s Financial Stability Report in April 2007 read: `The UK financial system remains highly resilient’. Four months later, in August, the run on Northern Rock began.
Policies that stoke up trouble
The fact is that British economic policies have aggravated rather than dampened the business cycle. In the years preceding the financial crisis, mortgage lenders were encouraged in the name of social inclusion to make loans to people who couldn’t afford to pay them back. In the same period monetary policy was kept too loose for too long, stoking up bubbles in the price of houses and other assets. The mortgage market was barely regulated, while wholesale financial markets were not regulated at all. When the house-price bubble finally burst, bad property loans did even more damage to the UK banks than did trading in exotic derivatives. No legislative provision was made for dealing with insolvent banks. Successive governments led banks to believe, correctly as it turned out, that they were too big to be allowed to fail, thus underwriting their reckless behaviour.
No politician or civil servant in the Treasury or the Bank of England has accepted responsibility for these mistakes. Instead, it is ordinary people who have been punished. After allowing for inflation, average wages in Britain in 2012 were back to where they were ten years earlier. It will take until perhaps 2019 before they return to pre-recession levels. Under the ‘protective umbrella’ of the Union, average living standards in Scotland have fallen in each of the past five years. We have become poorer together.
There is another possibility
Look at the contrasting experiences of Scotland and Norway. Despite oil tax revenues from the Scottish waters of the North Sea having contributed some £160 billion to the UK Exchequer since 1980, the imprudent policies of successive UK governments have meant that every family in Scotland has ended up with a debt of some £50,000. In Norway, on the other hand, the Government’s management of that country’s oil tax revenues has resulted in the accumulation of a national financial asset, a sovereign wealth fund that in 2012 was worth some £450 billion, or about £200,000 for each Norwegian family.
If Scotland remains within the Union then its citizens will continue to be saddled with a burden of government debt for decades to come, a burden that will be very difficult to shake off because of the existence of additional implicit fiscal liabilities. We bear no responsibility for the policy errors and unfulfillable political promises that have largely contributed to the present situation. If we vote for independence there is no reason why the UK government should get a permanent subsidy from us to help them clear up a mess of their own making.
The money would be better spent on building up a reserve fund to protect us from the next downturn. Although we can’t know when that will be, we do know it will come.