The Debt Fallacy

Because this blog has a strong political theme, it might surprise you to learn that I don’t watch Question Time very often. Partly this is because I’m usually in bed by the time it comes on, but if it were called “Answer Time” and the politicians were forced to give proper answers to the questions I would probably be compelled to stay up late once per week and watch it. Instead it is generally an hour of politicians indulging in their favourite pastime of evading, misrepresenting and misleading and to be honest, I get enough of that already.

Still, I did watch some of it a few weeks ago and noticed that in pretty much every answer the Conservative or Lib Dem gave they managed to blame having to take lots of “difficult decisions”, such as cutting benefits for poor people and cutting taxes for rich people, on…

The mess we inherited from the Labour government

The government seems to believe that this is some kind of carte blanche to do whatever they want without any accountability; a Get Out of Jail Free card that they never have to give back. It isn’t though. It’s the political equivalent of saying, “OH MY GOD, WHAT’S THAT BEHIND YOU?” then running away when you turn around. That particular favourite phrase is not what I am going to spend time talking about because no one believes it anyway. Despite the government’s best efforts, no one is actually dumb enough to agree that they don’t need to be accountable for their policies.

They did come up with another favourite line, however, that narks me even more than this one because a lot of people do actually believe it. When someone mentioned government spending they said something like this:

It was the irresponsible spending of the last government that got us into this mess in the first place…

And the thing that annoyed me more than them wheeling out this spin-doctor nonsense for the thousandth time was that no one else on the panel directly challenged it. If I’d been on the panel, (I was on holiday so they had to go with Steve Coogan as the non-politician), I would have directly challenged it. I would have directly challenged it because it isn’t true. It is a lie and when politicians say it they are lying. This, ladies and gentlemen is The Debt Fallacy, the widely-held belief that UK government debt caused the financial crisis.

Before we delve into what actually did cause the “mess”, let’s see why this is a fallacy by looking at UK government debt between 1997 when Labour took office and 2007 when the financial crisis started. (Source IMF)

National Debt of G7 Countries as % of GDP

National Debt of G7 Countries as % of GDP

Yes, not only was borrowing significantly lower in every single year than everyone else in the G7, it was actually lower in 2007 than when Labour took office ten years earlier. Staunch Conservatives will no doubt be hugely disappointing that there is no marked increase in UK government debt in that graph. Don’t worry, just for you I’ve done another one for just the UK with the previous five years under John Major added in. Now you can see a government who did oversee a marked increase in the national debt. I’m nice like that. Don’t mention it.

UK National Debt as % of GDP

UK National Debt as % of GDP

So you can see why the government’s claim about a debt-fuelled spending binge is a lie. This level of public debt clearly didn’t cause the financial crisis. So what did?

The cause is actually fairly simple. Banks make profits by borrowing money and then investing it. Their profit comes by getting a higher return on their investments than they have to pay on to the people from whom they borrowed the money. For example if I put £100 in a bank account the bank might pay me 1% interest and then invest that £100 in in a scheme that makes them 5%. Simple enough.

Banks though, like any other businesses, want to compete against one another – they want to make the biggest profits for their shareholders and show everyone that they are the best bank. This is what caused the crisis.

Over time, banks became increasingly competitive and concerned themselves more with trying to make the biggest profit and less with the risks associated with what they were doing. With the £100 I put in my bank account they could invest it in something safe and make 5% or they could invest it in something risky and make 10% or 15% or 25%! The more risky the investment the more return it could yield. No bank was going to invest in something risky if its likely return was less than a safer alternative and so risk equalled reward. Competition between banks, all vying for the biggest profits, led to riskier and riskier investments and nowhere was this more prevalent than housing. It became possible for people to borrow crazy amounts of money to buy a house, even if they had poor credit worthiness. This irresponsible lending fuelled housing bubbles all over the world. Here’s how Florida house prices changed in the four years prior to the financial crisis.

Florida House Prices (Q4 2002 = 100)

Florida House Prices (Q4 2002 = 100)

In just four years they increased by almost 80% and people’s wages were definitely not increasing at anything like that rate. In short it was unsustainable. There is a useful principle in economics called Stein’s Law after the late American economist Herbert Stein and I wish more people had paid attention to it in the pre-crisis years. It says simply this:

If something can’t go on forever, it will stop.

Stop it did and we all know the rest. In hindsight it’s easy to look back at this and say that the banks were lending irresponsibly but much harder to say why they didn’t they realise it at the time. The only explanation I can offer is that they were too concerned with out-performing one another and not concerned enough about the risks involved until it was too late. Like a gambling addict who’s had a good night but doesn’t know when to quit, the banks didn’t want to think about Stein’s Law.

Essentially the positions they took on the housing market assumed that:

  • House prices always go up
  • Mortgage defaults are pretty rare

On the first point the banks thought, “Even if this individual doesn’t repay their 120% mortgage, the house will be worth more than that in a couple of years, so where’s the risk?”

On the second point they seem to have committed a really basic error in their probability calculations. Imagine I have lent to 5 risky individuals. The chances of any one of them defaulting on their mortgage is 5%. Therefore the risk of all of them defaulting on their mortgages is:

5% x 5% x 5% x 5% x 5% = 0.00003125%

But those of you who remember your GCSE maths will recall that you can only multiply probabilities together like this when they are independent. For example if the probability of a person having a beard is 20% and the probability of someone being female is 50% the probability of a lady having a beard is not 10%. (Unless of course you work in a circus.)

Similarly, the chances of individuals defaulting on their mortgages are not independent. When an economic downturn occurs, unemployment rises, incomes drop and lots of people all suddenly can’t repay their mortgages at the same time.

Banks, in their bid to out-profit each other, took huge positions on the housing market. They were betting that economies would grow and house prices would go up. It had been so long since the economy had been through a really serious downturn that they had forgotten the lessons of the past. The resulting crisis shows that so confident were they in endless economic prosperity, that none of them had a Plan B in the event of a downturn. The global economy isn’t like that though and if economic history has taught us anything it is that bad things have always eventually found a way to happen and by the time the banks spotted the bubble was about to pop it was too late.

Banks weren’t just lending irresponsibly on mortgages though. People took cheap loans and were able to borrow more than ever before on their credit cards. Banks were so desperate to lend that they offered amazing deals to secure our credit card debts. Fee-free transfers, interest-free balances for 12 months etc etc and the same thing happened – all of a sudden lots of people were unable to make repayments at the same time and the banks had no fallback.

This had a short term effect of making the banks insolvent and governments world-wide were forced to bail them out. While this solved the short-term problem there was another problem that almost six years later remains unsolved.

When economies around the world turned bad, people were left with mortgage debt, loan repayments and credit card bills that were ridiculously high. Those lucky enough to keep their jobs switched overnight from not worrying about their personal debt to worrying only about their personal debt. The thousand pounds they had on their credit cards was no longer something they could kick into the long grass and assume they would just pay it off later. Seeing their friends and co-workers losing their jobs made the risk of redundancy a reality.

This shock led to a very sudden and very dramatic change of behaviour. People moved almost overnight from spending to reducing their debt. Even those who had avoided running up debt became very worried about how little they had tucked away for the hard times and moved from spending to saving.

In the economy your spending is my income and my spending is your income. When everyone stops spending at the same time the consequences can be catastrophic. I say “can be” because a responsible government could plug the gap by increasing public spending but in most cases they didn’t, hence it was catastrophic, hence the depression. (I like saying “hence”. I think it makes me sound all knowledgable.)

So that’s how it happened and that’s the real reason we are in a depression and it had nothing to do with UK government debt at all.

There is a good argument that the previous Labour government should have spotted what the banks were up to and should have done something to address it. Although the banks caused the crisis, the previous government was asleep on the job while this was going on. If the current government were pushing that argument they would have a valid criticism but they aren’t because although it is the truth, it doesn’t pin all of the blame on the previous government.

Politics aside, the years before and since the crisis really are a shameful and embarrassing period in economic history. A first year economics student taking their first macroeconomics module will learn that government spending increases economic growth and that it works best of all when the economy is suffering from a lack of demand. They will learn that my spending is your income and your spending is my income. They will learn that if your spending disappears my income does too. They will learn about economic cycles – the economy will go down as well as up, so plan for it.

Sadly these are lessons that the current government has either not learned or has simply chosen to ignore. Simple enough as those lessons are, it’s sadly far more convenient for them to just propagate The Debt Fallacy.

RedEaredRabbit

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About RedEaredRabbit
My name is RedEaredRabbit, King of Kings. Look on my works ye Mighty and despair.

27 Responses to The Debt Fallacy

  1. umacf24 says:

    I think the ‘Mess left by the Labour Government’ argument is not about the national debt. The problem was with the deficit — the annual difference between tax take on one side and and government spending and debt interest payments on the other. It should have been a surplus (as these were good years up to 2008) and it should have been structurally sustainable (so that the deficit in bad years would have paid off when things turned good.) The cuts, if we ever see any (as opposed to a small slowdown in spending increases) are about restoring a sustainable deficit before the interest payments become a self-perpetuating component of the budget.
    As always, the direction and speed of travel is much more important than the current location.

    • The UK’s debt in the graph between 1997 and 2007 is pretty much flat so there was no big deficit being run then. The deficit is big now but it’s important to distinguish that the the big deficit was a result of the financial crisis and not the other way around.

      • Philip Vaughan says:

        This is not correct – the British government were running a “current account” deficit in the 3/4 years prior to 2008. Debt (whatever the level was) should have been edging down during the “good years” when tax receipts were higher than expected and well above spending.

        That said, it is correct to say the largest part of the recent debt and deficit was caused by the banking crises and subsequent drop in growth. Though, arguably, the deficit would not have been so large if spending hasn’t been funded by debt in the 3/4 years before 2008 (though by a relatively small percentage).

        As to whether the government should adopt a Keynesian style policy of spending during a low growth period; that simple – they already are! Spending growth has just slowed, not been cut, and the government (BoE) are buying their own debt!

        The government need to continually highlight their “cutting” agenda to re-assure the markets that they are in control of spending to keep bond rates (and interest payments) low – and that is mainly about confidence than it is the actual numbers.

        As to whether the government should borrow (even) more for infrastructure investment depends on two things – whether you think the bond market will reward or punish the government for borrowing more (if they punish, it would be disasterous because of the amount of money we are currently borrowing to live). And whether you think money is most efficiently spent by the public or the private sector.

        While the second point is likely question of your politics, the first is something of a gamble – with potential consequences far worse than the current situation.

      • Charlie says:

        “The great bond vigilante myth has been exposed. The idea that bond investors will revolt against any nation with high sovereign debt has been shown to be incorrect. And a funny thing has happened as the US, the UK and Japan have continued to accumulate higher levels of government debt – their bond yields have remained low. The reason for this lies in the importance of being a currency issuer rather than a currency user.”
        http://goo.gl/oRXH6

      • andydavies says:

        The reality is that Labour ran a deficit during the six years before the banking crisis happened and as every Keynesian should know that’s when you are supposed to run a surplus.

        http://datamarket.com/en/data/set/18ff/#!ds=18ff!lgo=1:lgp=3&display=line

        Yes, the banking crisis made the deficit worse but who was busy not-regulating the banks – Labour.

        You may not have much faith in the current lot but you can’t excuse the mess that Brown left behind by saying it was all the banks fault.

      • I agree that Labour should have been running a modest surplus as opposed to a small deficit but this post was about what did and did not cause the crisis and that small deficit they were running did not.

        As I showed in the post, John Major’s government ran a larger deficit and also did that during a period of economic growth. That didn’t cause a financial crisis either.

        I also agree that Labour should have been tighter on banking regulation but deregulation has been much more widespread and been going on for much longer than just in the UK, just under that government. Also, I don’t recall too many loud voices from the other side of the house calling for it.

      • Also regarding surplus vs deficit. Spain ran a big surplus in the years running up to the crisis. It didn’t seem to help them deal with things any better.

  2. Owners says:

    A lovely essay, I agree with all except the summary. Your conclusion that the answer is for government to increase spending- the issue would be what the money is spent on. If the gov simply took my taxes ( which I have to spend on stuff ) and gave it to pensioners to spend – minus the cost of the transfer – there will be no gain!
    However, I don’t have a Plan B to counter your Keynesian demand theory…except that those lying wotsits cannot be trusted !

    • Thanks. You’re right I didn’t specify what we should spend on. I have done in previous posts though. My favourite is renewable energy. We need to do that anyway.

  3. I wish the government would just get on with sorting it out (if they can) – it’s only in the world of politicians and small children that the endless fault and blame game appears to matter.

  4. Rob says:

    @umacf24 The coalition willfully and deliberately confuses deficit with the stock of debt. For example saying that Labour maxed out the country’s credit card is a particular favourite. But of course Labour didn’t: there was very little on ‘the country’s credit card’. They just started borrowing on ‘the country’s credit card’ aggresively because they had to bail out the banks and the economy collapsed. That’s the same banks that George Osborne thought Labour over-regulated by the way.

    I spoke to a Lib Dem Parliamentary candidate this year who actually didn’t understand the difference between national debt and the deficit, but happily repeated the economically illiterate nonsense handed down by Danny and George and their soundbite writers.

    • I’ve seen George Osborne being interviewed and saying, “We are paying off the nation’s credit card”, which suggests he doesn’t know the difference between the debt and the deficit either.

      • mayfairman says:

        Perhaps he is just trying to over simplify for the benefit of listeners who are not as well informed as the contributors to this blog, just as Mrs T used to with her household economics. Brown, Osborne and Alexander are all highly intelligent men and it is implausible that any of them did not understand these issues in great depth. Backbench MPs on the other hand (and the candidates trying to become them) may be a different matter. Keep up the good work!

  5. boots_honk@yahoo.co.uk says:

    Excellent analysis as ever. as the old saying goes “why let facts get in the way of a good story”

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  8. Richard Turner says:

    My guess is that the coalition’s policy of cutting down the size of the state is not the means to an end, but the end itself. Their Ayn Rand utopia is an omelette that can’t be made without breaking eggs, so when they say that the economy is moving in the right direction, they mean it. They count their success in broken eggs.

  9. ap says:

    Interesting to use ‘debt as percentage of GDP’. So a flatline indicates debt is rising/falling at the same rate as GDP. During the early 2000s, GDP was artificially driven by the cheap debt made available to the public, the blog touches on this. Therefore it stands to reason that the government were on debt fuelled binge of the same proportions. The question this raises is if GDP (and therefore tax revenue) were rising at such a rate, why did the government need to borrow more? Wouldn’t this have been the perfect opportunity to pay some debt off, in preparation for the inevitable crash that follows an artificial debt fuelled boom, like Australia, for example?

    • Hi Andy. Although debt as a proportion of GDP is the most common measure when comparing the debt of different countrie there are some good reasons for using it here. An important one is that this is the measure that the government uses itself. So George Osborne’s pledge for this parliament was not to reduce the absolute level of debt in terms of £s but to reduce it as a proportion of GDP. At that time though he was expecting GDP to go up, which it hasn’t so he now agrees that he will miss this target.

      The most important reason though is that an absolute measure of a country’s debt means little without comparing it with the size of the country’s economy. For example Germany’s debt is more than five times the size of Greece’s if we look just at the number of Euro that they owe but the German economy is more than 15 times the size of the Greek economy which explains why Germany don’t have the same problems.

      (Another smaller reason is that debt as a proportion of GDP naturally excludes inflation which I would otherwise have to take out but that’s more one of convenience.)

  10. James says:

    Great piece. But an important element not mentioned is fractional reserve lending – the banks are able to lend considerable more money than they actually have.

  11. sheryl says:

    how many millions are being spent on statutory redundancy and benefits payments because companies are going bankrupt every day. Since the month this government came to power my income from my retail business has gone down by 70% and I now qualify for tax credits which has filled the gap. Thus I now take more from the public purse than I put in. That pattern is repeated millions of times over.

  12. allyhunted says:

    Gordon Brown ran a lower deficit, as a proportion of GDP, than the one he inherited from Ken Clarke for the entire period he was Chancellor. Unfortunately he also took part in the global race to the bottom on banking regulation that fuelled the unsustainable credit bubble: light-touch regulation that most Conservatives argued was still too stringent!

  13. Your analysis is very interesting and well written, but it doesn’t tell the whole story. It is true that, “After a period of financial restraint, from mid 1990s, National debt at a % of GDP fell to 29% of GDP by 2002.” [http://www.economicshelp.org/blog/334/uk-economy/uk-national-debt/]. This was the period of Gordon Brown’s affair with Prudence. After a while he got bored with her and changed tack, “From 2002 – 2007 , national debt increased to 37 % of GDP. This increase in debt levels occurred despite the long period of economic expansion; it was primarily due to the government’s decision to increase spending on health and education…There has also been a marked rise in social security spending.” [loc. cit.].
    The analysis continues, “Since 2008, National Debt has increased sharply because of:
    Recession (lower tax receipts, higher spending on unemployment benefits) The recession particularly hit stamp duty (falling house prices) income tax and lower corporation tax.
    These cyclical factors have exposed an underlying structural deficit.”
    There lies the problem. The decisions to increase spending on health, education and social security created a structural deficit, over an above the cyclical deficit caused by the recession. The government believes that in order to address the structural deficit, there must be structural cuts, otherwise we will end up in the Japanese situation where the structural deficit is so large that government stimulus ceases to have any discernible effect.
    Whether or not you agree with government policy, you must at least recognise where it is coming from.

    • Hi Jonathan,

      Yes, I agree with pretty much everything you’ve written. We certainly do need to address the structural deficit but we don’t need to do it today. Give me a healthy economy and I’ll be first in line to raise taxes and cut spending but not in the middle of a depression.

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