Thursday, 21 May 2009

Breaking the habit of public debt

The row over public debt rumbles on. Private equity boss Jon Moulton weighed in yesterday with a blistering attack on Alistair Darling’s record as chancellor. Piling excessive debt on top of a crisis caused by debt is apparently “entirely analogous to giving heroin to a heroin addict. It makes them happy for a short period and guarantees that it will be worse in the future," he said. Moulton is worried about a return to the crazy economics of the 1970s, when the public sector dominated our GDP. Right now, says Moulton, “only the south east has a public sector worth less than half the economy.”

And spiraling debt equals loss of control, he warned. The interest payable on a debt equal to the size of the UK’s GDP would mean “that money going out of the economy will actually exceed the growth of the economy.” Worse, “if foreigners decide they want a higher interest rate [on gilts], [domestic] interest rates will go up without any intervention from the Bank of England being possible.”

Those pesky foreigners may well have their way if Standard & Poor's carries out its threat to downgrade our precious credit rating. Without that Triple-A badge of honour, foreign investors would very likely start behaving exactly as Moulton predicts, requesting more bang for their buck, further depleting UK coffers. But don’t panic, says the BBCs Robert Peston, we’re still selling gilts.

“The Debt Management Office has this morning completed the biggest ever auction of gilts in history. And it sold the lot very comfortably indeed, with far more bids than it needed…”

Peston continues:
“Putting British sovereign debt on negative outlook is not as bad as being assessed for possible downgrade, which almost always leads to a downgrade….”

That’s because a negative outlook from S&P is only ever followed by a proper downgrade in a third of cases. More often than not, the victim recovers. S&P will make its assessment as soon as the result of the next election has been decided, and a new (or similar) public debt reduction strategy is in place. If the UK shows signs of reducing its debt burden, S&P might let us keep our AAA rating after all. If not, those gilts are going to start getting expensive.

David Cameron has already made it clear that debt reduction is a priority; Brown continues to believe in a Keynesian solution. But will the PM risk playing chicken with S&P? It's all grist for Cameron’s mill—if he’s smart enough to grab the opportunity.