The mess we are in

I wouldn't normally link to a Will Hutton piece but since I am going to lift two paragraphs and shred him to pieces, it seems only fair. Hutton wrote in last weekend's Observer that there was no need to slash the budget deficit, because the National Debt is below historic levels. Indeed, writes Hutton, Gordon Brown was to be feted for stepping into the breach with one of the greatest ever Keynesian acts in the face of fecklessness from the private sector. He reserved the following criticism for Conservative economic policies:

Meanwhile, David Cameron and George Osborne, who had been developing an interesting argument, if with little flesh, for a high-investment, moral, environmentally sustainable capitalism, have decided that the national debt peaking at some 80% of GDP constitutes a national emergency. Never mind that since 1750 the national debt has always been proportionally higher than this, except for two 40-year periods – one at the end of the 19th century and the other from the 1970s until now.

From 1750 to 1870, Britain won wars, assembled an astonishing navy, built an empire and launched the Industrial Revolution to become the envy of Europe, yet the national debt was consistently above 80% of GDP. Nobody cared. High national debt was a precondition for winning two world wars in the 20th century. Periods when the over-riding preoccupation has been lowering the national debt have coincided with industrial, economic and strategic decline. So it will again.

Now excuse me, but the period from 1750 to 1870 was very different from today. For a start, measured UK GDP would have been very low compared to today's figures simply because most workers would have been paid the wages of manual labour. On the other hand, UK government debt was used to finance the whole of the British Empire, securing both economic power and a plentiful supply of raw materials. Very little of the overseas activity created in foreign mines, plantations and factories secured by a British Administration would have shown up in UK GDP figures, but the infrastructure financed by the national debt created a worldwide trading advantage that continued into the second half of the twentieth century.

More importantly, unlike today's government expenditure amounting to 50% of GDP, in the period before the first world war, annual government gross expenditure amounted to no more than 10% of GDP. This meant governments had a lot of leeway to raise taxes to correct any overspend, but they were able to service interest on borrowings out of receipts from duties and tariffs in the empire.

There were later periods when the debt to GDP ratio was higher than today's figures, mostly following the first and the second world wars. At the end of each war GDP dropped as the bulk of the working population switched to the war effort and the war came to an end, while borrowing soared to pay for material as tax revenues were depleted. The ratio stayed stubbornly high after the first world war due to the 1920's and 30's depresssions, but government spending remained below 20% of GDP.

After the second world war the debt to GDP ratio reduced rapidly before stopping at a rate around 80% of GDP, but at the time the national debt included the borrowings of the nationalised oil, steel, electricity, coal, shipbuilding, gas and airline industries. During the war, government expenditure reached 60% of GDP, falling afterwards to just 30%.

So here we are today with 50% of GDP being spent by the government (or 51.4% if you don't think working family tax credits are "negative taxation") compared with the 30% in post war Britain. The national debt is equal to about 60% of GDP and a budget deficit in the £175-200 bn range (15% of GDP) and set to remain that way for 4 years, which will add another 60% of GDP. But as often pointed out, this ignores the impact of public sector pensions (growing at £3 bn a month), PFI and a large number of other guarantees and contingent liabilities which would push that figure up by another 100% of GDP.

So let's call that 220% of GDP. Now that is a big number, and while we have a diverse economy to support it, we don't have expanding overseas territories to finance, we aren't involved in the sort of wars that should sap the resources of the nation. Yet we have historically high borrowing levels and historically high government spending as a percentage of GDP. So how did we get here, except by fecklessness? Indeed the sort of fecklessness that puts record numbers of students through university and at the end leaves even the best and the brightest unemployed.

As Hutton says, a lot of the government spending is Keynesian, or to put it another way, spent for the sake of spending money in the hope that it will stimulate the private sector. The fact is that the stimulus hasn't worked. Once government spending is deducted from the GDP figures, we find that the private sector has declined in real terms every year since 2003. It may well be that a lot of this spending is not Keynesian, but political, creating government funded employment levels at over 70% in some parts of the country, comparable with communist-era Czechoslovakia.

Indeed, the decline of the private sector may even be accelerating. Very roughly, government spending (about 50% of the economy) is up about 5% year on year and GDP as a whole is down 5%, so the other half of the economy must be down about 15% (50%*5%-50%*15% = -5%).

We are way past the point where a Keynesian "stimulus" would have been effective. That should have happened when private sector capital investment fell away at the start of the decade or when private sector production started to drop in 2003, but the Chancellor at the time didn't think we needed to worry about the private sector because there was so much bingeing on cheap debt and high house prices.

The economic nincompoops at the Treasury mistook the chiming of cash registers for robust economic health. Those in power in government, who didn't understand commerce, thought business would look after itself, no matter what costs they imposed on it. They were right. Business did look after itself and moved offshore.

Meanwhile our stimulus isn't working. Other major economies have emerged from recession in the second quarter of this year, while the UK economy continued to shrink by -0.7%. The UK is now the only major economy for which the OECD is predicting no growth at all this calendar year, and unemployment has risen faster here than in Germany, France, Japan and 16 other OECD countries.

Which is why the budget cuts are necessary. We need infrastructure and spending, but we also need to be competitive. From the 1750's, financing a growing empire was key to economic prosperity, but today we live in an unremarkable medium sized post industrial economy, and if we want to attract investment into our economy we have to encourage the global investment community to put their money here and not on the other side of the world. It isn't possuible for a government to prop up the economy with workfare schemes paid for by borrowing. The UK economy will only grow when real economic value is created.

In the 1980's and 90's the country improved its fortunes by being an easy place to do business, with effective but unburdensome regulations and low overheads. That has all changed in the past 12 years and very few foreign firms have invested here under the Labour government. They aren't stupid and are not fooled by headline rates of tax, but look at overall costs of doing business including forecasts of future taxation because of government expenditure.

Perhaps we should look at it another way. The ultimate source of wealth to repay the national debt comes from private sector activity, not from government employment. The tax from the Prime Minister's salary is merely a refund of part of his salary. It doesn't per se produce any cash flow to repay borrowings in the way that taxes on the profits from sales of manufactured goods would. So let us look at the ratio of national debt to GDP less government expenditure (let's call it private sector GDP).

In the period 1750-1870, the ratio of national debt to private sector GDP was 80% of GDP/90% of GDP, or about 89%. After the second world war it was 210%/70%, or about 300%. If the national debt grows as predicted in the 2009 Budget, with all the off-balance sheet items added in the ratio will be 220%/50% or 440%.

That is the mess we are in.