Cutting the deficit but not spending (nor raising taxes)

By Mark Rowney

So we all know that the economy is in a shaky state and that the need to cut the deficit is a priority for the country. The argument rages about how to do so and at what pace. What taxes to raise? What spending to cut? When and by how much? Yet in business, companies can achieve deficit reduction in their Profit & Loss statements by more innovative means. Labour can and should look to the private sector for inspiration on restructuring the debt. The purpose of this article is to ask for an explanation as to why the debt hasn’t already been restructured.

My apologies to the reader if I’m teaching granny how to suck eggs here, but to explain financial restructuring, it’s necessary to go back to basics.

The problem isn’t so much the debt, it’s the deficit i.e. it’s not that we owe so much money that is the problem in itself, but the amount of interest that is charged on that debt means that our expenditure is greater than our income stream by an amount that is makes our creditors nervous (but it is not of an unacceptable level or even close to such a level – we’re not Greece).

Our creditors are very happy to lend us money and don’t really want us to pay it back. It’s a means of shoring up their balance sheets with one of the world’s most creditworthy debtors. We’re AAA rated and if you recall, the talk at the height of the crisis was not of the UK default, but of our credit status being lowered from truly excellent to simply really good (and this resulting in a rise in interest rates). For the UK government, debt is a way of raising capital for long term projects where the returns will not be received for some time and it is constantly refinancing its debt with more debt. We always will have debt on the country’s balance sheet.

The amount of interest that is charged on the country’s debt is based on the prevailing market rate at the time the coupon is issued which in turn is based on a number of factors but largely it boils down to the likelihood of default by the UK government, notwithstanding that such default is deemed to be highly unlikely (AAA rated remember). And so, the more debt we have and therefore the increased totality we have of debt service costs, we are deemed to be more likely to default on interest payments and so those costs go up further i.e. to issue new gilts we have to offer a higher coupon. It’s a vicious circle which is broken by reducing the amount of debt.

However it is not the only way to break that circle and we should not be focussing solely on reducing the debt, as important as that is. Private companies (particularly when they are geared to the hilt and unable to raise either debt or equity) will often reduce their debt by restructuring their debt. There is no reason why we shouldn’t be doing the same.

Japan’s debt has just gone through the roof following the tsunami and related nuclear disaster a few months ago. Its debt is much worse than the UK’s levels of debt. However, the world’s international markets barely batted an eyelid. Why? Because most of Japan’s debt was until that point, predominately owed to the Japanese themselves i.e. the local taxpayer or to draw an analogy from the private sector, the equity providers. Domestic investors are seen as lower in priority than other investors as they have a lot more than a financial return vested in the success of their state’s economy. In other words, no one worried about Japan having lots of domestic debt because if Japan defaulted, those domestic investors would be extremely motivated to see Japan’s economy improve and so would be more likely to accept a default on their debt over that of foreign debt. In the eyes of the world’s markets, domestic creditors rank lower in priority than other creditors.

So what sort of domestic debt does the UK have? Well we can invest in gilts but that requires brokers etc and whilst a few of us might invest in gilts, it’s not exactly something that the general public does. The other way to invest in the UK government is through Premium Bonds where your return is quite literally a lottery. No one with any sense would invest in those. Apart from that, if you want to invest cash, you’ve got to go to the private market, not the UK government. As a nation, we invest our cash largely with the banks and building societies on both a short and a long term basis. Although we are on the whole a nation of borrowers rather than savers, there are still a lot of savers out there and since the crisis, their numbers are increasing.

If the UK government was able take the few thousand pounds that a young couple happened to be saving for a deposit on their first home and offer them a rate of interest better than that which is commercially available to such couple, then use these funds to refinance some of the national debt, the UK government would not have reduced the level of the country’s debt. However if the interest rate offered to the young couple is less than the coupon on a refinanced gilt (be it a prepaid gilt or simply one that is not issued as the debt is no longer required), the deficit would have been reduced by the difference in interest paid. The national debt would have been restructured to create a level of debt that – commercially speaking – ranked lower than the gilt holders.

Furthermore, as more and more debt is transferred to UK domestic lenders, the perception of risk in the UK defaulting on its gilts’ coupons would lower, and so potentially lower the rate of interest charged on the gilts still outstanding.

So why hasn’t this been done? It seems such a simple and obvious idea. Encourage people and SMEs to invest their savings in government debt for a better return than they can otherwise get and at the same time that investment will help reduce the country’s deficit. Very flag and family too. The domestic debt could be ring-fenced for certain projects to increase its appeal to the electorate.

Perhaps the numbers just don’t add up but even if we simply break even on this or if the actual deficit reduction would be negligible the political message of helping the “squeezed middle” and also of coming up with alternatives to slashing too far and too fast, would be highly beneficial to the Labour party. I’ve mentioned this idea to many of the great and the good who spend their time thinking about these things. None of them know why, other than to suggest that the numbers may or may not add up. If anyone reading this article has crunched the numbers and can tell me why it hasn’t been done, I’d love to know.

Mark Rowney is a finance lawyer.