Over the past century, many governments have become increasingly dependent on borrowing to finance public spending. In the last two decades alone there has been a dramatic increase in borrowing by governments—nearly £30 trillion, more than three times the level of public debt in 2001. This public debt expansion was made possible by a vast monetary expansion over the last decade, underpinned by loose monetary policy and quantitative easing, which has suppressed interest rates.
As professional accountants, we recognize that borrowing can be a valuable tool to finance capital investment, for example, in infrastructure, which creates economic and social benefits. However, it has increasingly become standard for governments in well-developed economies to borrow to pay day-to-day operating costs—that is, deficit spending. In the past, tax revenues growth was roughly correlated with domestic economic growth. Consequently, running a small deficit was a workable economic policy in periods of strong economic growth.
Unfortunately, in recent years that economic growth has faltered in many well-developed economies. There is some evidence to suggest that due to structural changes in well-developed economies, the correlation between economic and tax revenue growth is not as strong as it was. There is also a demographic impact—almost well-developed nations’ populations are aging, which presents a double impact on public finances. This means that there is a decrease in the percentage of the population actively in the workforce at the same time as an increase in the demand on public services, such as pensions, social care for the elderly, and healthcare. Without some form of change in policy or a substantial increase in the tax revenue, social provisions on the current scale is not likely to be sustainable over the long term.
With the reversal of quantitative easing and interest rates beginning to rise, there are real questions about whether governments will be able to manage their public debts. The exposure to changing macroeconomic conditions is real. Taking the UK as an example, over £700 billion of public debt will have to be refinanced in the next five years; quantitative easing has “swapped” a large proportion of fixed-rate gilts into deposits paying floating rate; and over a quarter of our £1.7 trillion of public debt is index linked.
The traditionally response to unsustainable public debt has been to use inflation to “inflate away” debts so they fall relative to the size of the economy. This policy choice comes at a cost as it erodes the value of saving and investments in domestic currency. It may also be harder to realize in a more interconnected world where central banks have been mandated to keep inflation low.
We believe accountants add value. The current system of measuring public debt is based on economic statistics with a wide range of measures in use—the UK alone publishes 12 different measures for public debt—and comparing public debt between countries is difficult.
There is also little requirement for governments to demonstrate their resilience to economic shocks. Economists like to compare debt to GDP as a measure of sustainability. We believe this is a flawed approach. Aside from there being significant problems with the way GDP is calculated (or, we should say, estimated), it is also prone to manipulation. GDP does not represent a sum of money available to a government to service its liabilities; it is, at best, a distant proxy and takes no account of the different fiscal structures between countries. France has a higher public debt burden as a proportion of its economy but it also raises more tax as a proportion of its economy than the UK. So is better able to cover its public debts. A little accounting expertise to improve both of these situations: the ratio of government revenues to balance sheet liabilities or to annual debt service are far better measures.
We believe the accountancy profession has a role to play in helping governments formulate policy in response to the whole question of debt sustainability. Our recent report, The Debt of Nations, is written from a public interest perspective and highlights some of the issues relating to public indebtedness and provides a range of analysis and reflections on borrowing by government. In doing so, we aim to improve public understanding, improve the quality of public debate about public debt, and call for a more robust approach to its management.
We believe we need a better public understanding of how public debt is measured and managed to know whether borrowing by government is truly under control and if our economies will be resilient in the face of future economic crises.
For other reports in ICAEW’s Better Government Series, please go to www.icaew.com/publicfinances