How Quickly Should Government Debt Be Reduced?

The Chancellor is right to argue that debt will have to be reduced. There is no definitive answer to the question of the optimal level of debt, but debt in the UK has doubled since the onset of the financial crisis and, as a result, it would be harder to respond to a future severe downturn in economic activity through an easing of fiscal policy. Debt needs to be reduced to create room for it to be increased again if needed.
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Yesterday the Chancellor gave a lecture to the Royal Economic Society setting out three goals for British economic policy over the next two decades. The second goal was to sustain fiscal credibility by running budget surpluses in 'good times' so as to reduce the nominal value of government debt.

The Chancellor is right to argue that debt will have to be reduced. There is no definitive answer to the question of the optimal level of debt, but debt in the UK has doubled since the onset of the financial crisis and, as a result, it would be harder to respond to a future severe downturn in economic activity through an easing of fiscal policy. Debt needs to be reduced to create room for it to be increased again if needed.

Furthermore, the latest projections from the Office for Budget Responsibility (OBR) show debt interest payments increasing to 3.0 per cent of GDP in 2018/19. Although debt interest has been higher in the past, the more money that is spent servicing debt, the less there is available for spending on other items.

The long-run fiscal objective of the UK government should be to reduce the ratio of government debt to GDP, as soon as the economy is strong enough to allow it. Labour and the Liberal Democrats agree with the Chancellor on that point. The question is: how quickly should government debt be reduced and is it necessary to reduce the nominal value of debt, not just the value relative to GDP?

Theoretical arguments, summarised here by Simon Wren-Lewis and Jonathan Portes, suggest the adjustment should be slow because there are costs associated with sudden changes in taxes or public spending. But too slow an adjustment would risk leaving debt at a relatively high level next time fiscal policy needs to be relaxed to support growth.

The 2014 Autumn Statement projections see the debt ratio peaking at 81.1 per cent in 2015/16 before falling to 72.8 per cent in 2019/20. If the fiscal stance in 2019/20 is maintained in subsequent years, the debt ratio would fall back to its pre-crisis level (below 40 per cent) around 2030. This is probably what the Chancellor has in mind. It places a lot of weight on preparing the UK for another economic crisis that requires a fiscal response.

But attempting to reduce debt so rapidly assumes that the rest of the economy will be able to adjust. In particular, as I set out in this paper on fiscal rules, if the only way the economy can continue to grow when the government is cutting its debt rapidly is by households taking on lots more debt, as the OBR projections suggest will happen, then we are simply trading one economic risk for another.

Ideally, the effects of the government reducing its debt would be offset by the UK improving its trade performance, but this will require a massive turnaround in the performance of the UK's exports. The Chancellor set a target of doubling UK exports between 2010 and 2020 but, when the first estimates for 2014 are published next month they are likely to show that the level of exports was lower than in 2010.

It would not be sensible to link the pace of deficit reduction directly to the trade balance, but the experience of the last four years makes it a fair bet that turning around the UK's export performance is going to be a long haul. There is a case, therefore, for a slower pace of debt reduction that suggested by the Chancellor.

What is a good idea, though, is making the pace of debt reduction sensitive to the economic cycle. This is something that I have argued for repeatedly over the last few years, though it should apply to deficit reduction over the next five years just as much as it applies to debt reduction thereafter. The Chancellor argues that, once the deficit has been eliminated, the government should run a surplus in 'good times' and only be in deficit in 'bad times'. I would argue that, by the same logic, the next government should reduce its deficit faster in 'good times' and more slowly (or not at all) in 'bad times'.

Thus, if the drop in the oil price gives a significant and lasting boost to the economy, it should be safe to stick to the relatively rapid deficit reduction plan set out for the next couple of years in the Autumn Statement. But, if the economy looks like hitting a bad patch, then deficit reduction should be slowed. The Chancellor is right to build flexibility into debt reduction after 2020; he needs to incorporate the same flexibility into his plan to eliminate the deficit by that date.