UK soon reaching the ‘threshold of debt intolerance’
A huge number of column inches have been devoted to the issue of debt to GDP ratios and ‘fiscal austerity’. But the numbers quoted – bad enough as they are – take no account of unfunded liabilities.
Large chunks of government budgets are funded on a pay-as-you-go basis, i.e., no resources are set aside to pay for future expenditure. Spending on pensions will increase, but there will be fewer workers to pay for these benefits as the bills come due: UK dependency ratios (the number of elderly economically inactive/people of working age) are forecast to rise from one in four (2005) to one in two by 2050. So the difference between the projected cost of current UK government programmes and net expected tax revenues stands by some estimates at 442 per cent of GDP; small consolation that this is better than France at 549 per cent .
If European governments saved roughly an extra 8 per cent of 2005 GDP from today and continued that saving till 2050, they could pay for their pension promises. Is this realistic? Probably not. And if not, the risk of default rises. Default in economic terms is the failure to repay creditors the real value of their claims. While the Greeks, for example, have a long track record of overt default (just over 50 years between independence in 1829 and 2006 were spent in default or rescheduling ), other countries with seemingly unblemished records (and AAA ratings) have not been saints, with default accomplished by inflation or exchange rate depreciation.
This is not ‘in the price’ of US, German, British and Japanese government bonds. Furthermore, various studies have found that an increase in deficits by 1 per cent of GDP raises long-term interest rates by 0.3 to 0.6 per cent, while an increase in the debt to GDP ratio of 1 per cent is associated with an increase in interest rates of between 0.02 and 0.07 per cent. Again, this does not seem to be in the price. Instead, government bonds are priced for minimal GDP growth and for governmental buying via further quantitative easing.
Yet surely we will soon reach the ‘threshold of debt intolerance’: the point at which investors start to demand a much higher yield to compensate for the risk of holding government debt, having been quiescent before. As Hemingway describes it in The Sun also Rises – “How did you go bankrupt?” Bill asked. “Two ways”, Mike said. “Gradually and then suddenly”.
Author: James Codrington
James Codrington heads the charities team at Barings and is a member of the targeted Return Group.
He joined Barings in 2002 and has 14 years' investment experience.
He has an MBA in Mordern History from Oxford University and is a regular speaker at charity events.
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