Debt costs money and the money debt costs, costs more money

20 10 2010

Cllr. Kitkat has written a post on his blog today entitled “Not worth the panic: This deficit is manageable,” in which he argues, in essence, that since on a couple of specific occasions the UK national debt (as % of GDP) was higher than today, that it’s nothing to “panic” over.  Since he prefaces his argument by implying that comparing figures “arbitrarily” can be misleading, I think his choice of example is somewhat ironic: relating our current deficit to that after two world wars isn’t really an appropriate comparison. I certainly agree we shouldn’t panic- but we should be taking action.

His other point is about interest payments- pointing out that the difference is that we have longer repayment terms than say, Spain.  This misses an important point- the longer we take to pay off our debt, the more the cumulative interest is that we will have to pay in addition.  It is misleading to suggest that if we pay our debt off over a longer time that this will cost the same.

To illustrate: currently, as Jason pointed out, the UK national debt is 71% of GDP, that is to say: one trillion pounds, and he quotes interest rates of “between 3% and 4%”.  Calling that 3.5%, we will be paying £35bn in interest this year.  Assuming interest rates stay the same (which I will expand on in my final point), the interest we would pay solely on the interest generated from the previous year would be £1.25bn.  So just because we can pay our debt over a longer period, doesn’t mean we should.

Finally, the entire argument is predicated on “the key issue with debt”- interest rates.  If they stay at their current levels then, ok, we’ll be paying off the equivalent of our education budget in interest each year, but perhaps that’s “manageable” in some people’s opinions (read: not mine).  However this is not a given- the interest rate on our debt has gone down recently as the money markets believe the government is making an effort to reduce the deficit.  Less fervent measures in this regard could cause the interest rate to skyrocket (EDIT: to illustrate: each 0.1% additional rate of interest is £1bn in interest per year, this means that any new bonds issued will be much more expensive for the government.  The government must perforce raise new debt because we are in deficit).  Equally, the current rates of interest on government gilts are being held down by the Bank of England buying them at cost (quantative easing), however this very policy (printing money to pay for debt) will inevitably cause inflation to rise.

The problem with inflation, is that it devalues the value of bonds, people will sell bonds, leading to higher interest rates on bonds and higher debt interest payments. If investors see inflation is getting out of control, people will not want to hold bonds. Foreign investors will sell their securities and this will cause a devaluation in the currency – Tejvan Pettinger

Ironically, Jason’s analogy about starving the family to pay the mortgage (whilst grossly inaccurate as I hope I’ve explained), is nonetheless an appropriate reason to pay the deficit off quickly- I’d rather tighten my belt than lose my home.  Wouldn’t you?

Points for recognising the inverse reference in the title!

[EDIT – For clarification:  inflation causes the future value of bonds to decrease in real terms.  As such, investors do not wish to hold them as they will take a loss.  They sell them.  In response, in order to finance itself, the government must issue new bonds at a higher rate of interest in order to encourage people to buy them.  This then increases the amount the government must pay on these “new” bonds.  Feel free to correct me if this is a misinterpretation].

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2 responses

4 11 2010
Cllr Jason Kitcat

I’m afraid you have misunderstood the bond market in your post. Government bonds are almost always sold on a fixed term at a fixed rate. So changes in interest rates in the bond market wouldn’t affect the interest rates on existing public debt — only the cost of raising additional debt.

The length of time a bond term is for is important, because at the end of it you need to pay back the full value of the bond — which is significantly more cash than the interest.

Once again, as I made the point in my original blog post, government debt is not like mortgages or credit cards which are subject to fluctuating interest on existing debts.

4 11 2010
Gareth

@Jason- the inaccuracy has been edited out. As you say, you can’t relate a % change in interest rate to the absolute payment on current debt- it would in fact be a change in the amount paid on new debt issued. Nonetheless:

1. The government is currently in deficit. That is to say, current income via taxation et al does not cover current expenditure. Therefore the payments for anything else the government chooses to spend on must be funded either by further borrowing (bond issue), or by sale of assets (gold reserves anyone?).

2. The government has a cyclical as well as structural deficit, i.e. they will need to regularly raise money via issuing bonds, even if current debts are repaid.

3. As bonds expire, as you quite rightly point out, the government must repay the maturity. Looking on the UK Debt Management Office, the percentage of debts (gilts et al) due for payment of their maturity before the next general election is 28%. Just for reference, that’s at a cost of £275.5bn. That’s not factoring in the cost of the coupons (biannual payments of between 2% and 8%). Now whilst this is doubtless included in the deficit calculations, it nonetheless illustrates that the government (assuming no changes in total expenditure), would have to raise at least £275.5bn in new debt over the course of this parliament. That means issuing new bonds to cover that debt.

If interest rates in the bond market increase, this will increase the cost of any future (necessary) government lending for this purpose- they will have to offer more favourable terms on new bond issue in order to encourage uptake by the market. So you’re absolutely correct- it affects the cost of raising additional debt. Whilst it’s true that bonds currently in existence are on fixed terms of interest and length of term, their sale and price in the market has an impact on the cost of (unavoidable) borrowing by the government.

The remaining 72% of outstanding debt will continue to accumulate compound interest, which as I’ve pointed out, is not a good thing.

“Once again,” if your original post’s message is that national debt isn’t like mortgages, why do you say

. Essentially the cuts we’re going to see imposed on us tomorrow are like starving your family in the hope of paying your mortgage off more quickly.

?

Perhaps it’s because the comparison is a simplification that makes explanation of the issue more accessible? I can certainly imagine that being useful if say, you’re in government and trying to portray an involved economic issue to the wider public. Just because the entirety of the debt isn’t affected by changes in interest rates (as with a mortgage) doesn’t mean there isn’t a massive associated cost with a raise in interest rates in the bond market.

Still, as you say, national debt and personal debt are certainly very different creatures- if my debt spirals out of control, it wouldn’t create large amounts of inflation and depreciate the value of the sterling.

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