Sunday, January 22, 2012
Britain is not following the Japanese script
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Britain has a budget deficit that compares unfavourably with most of the economies downgraded by the ratings agency Standard & Poor’s a few days ago.

Britain’s overall debt, still rising mainly as a result of that budget deficit, vies only with Japan as the largest among leading economies, according to new figures from McKinsey, the management consultancy.

Yet Britain one of the few countries to retain a AAA sovereign debt rating with Standard & Poor’s - others in the club are Australia, Canada, Denmark, Finland, Germany, Hong Kong, Liechtenstein, Luxembourg, the Netherlands, Norway and Singapore, Sweden and Switzerland - and pays ultra-low interest rates on that debt.

It is quite an achievement, endorsing George Osborne’s claim to have made Britain a safe haven in the storm, though Treasury officials remain alive to the danger that one Friday evening it will be Britain’s AAA rating that gets downgraded.

There is, however, no evidence of that, or warning to that effect. And, given the verdict of the markets is more important than ratings agencies, low gilt yields, currently around 2% for the benchmark 10-year bond, are testimony to market confidence.

Or are they? Jonathan Portes, director of the National Institute of Economic and Social Research (Niesr), begs to differ. Portes, a former cabinet office economist who has taken Niesr back to its Keynesian roots, has a blog Not the Treasury View.

“Our current historically very low level of interest rates is - just as in Japan - a sign of economic failure, not success,” he writes. “The government has got the rhetoric and the economic logic completely wrong on this.”

I find this puzzling. Though this week’s gross domestic product figures for the final quarter of 2011 will underline the struggle Britain is in to get the recovery beyond stall speed, there are other economies with worse growth prospects and much higher bond yields, mainly in the eurozone.

The Japanese comparison also looks odd in other respects. The key to Japan’s lost decades (counting the 20 years since the early 1990s as a failure) was deflation; falling prices. Though inflation in Britain is falling, at 4.2% it remains high. So keen are markets to hold gilts they accept a negative real interest rate for doing so.

The fact the Bank of England is purchasing gilts under its quantitative easing programme is important but does not change the broad picture. It is easy to envisage a situation in which the Bank was buying gilts hand over fist while everybody else was dumping them.

Nobody expects years of deflation in Britain. Niesr is among the inflation optimists but its most recent forecast sees inflation over the next five years tucked just below the 2% target, not negative.

As an aside, and though it has a new forecast out shortly, it does not expect Japanese-style stagnation either. While downbeat for this year, it expects growth to average 2.5% over the 2013-16 period.

So we should knock the Japan comparison on the head. Somehow, though its critics will not have it, the government has fiscal credibility. If anything it is enhanced by the fact public borrowing is dropping even in a slow-growth environment. The fall under Alistair Darling’s plans, remember, was in the context of implausibly upbeat Treasury growth forecasts.

We should celebrate the fact that borrowing costs are so low. Not only will this lay the groundwork for a stronger recovery in future years but it will also mean a smaller proportion of spending will go on paying interest on the debt, with a higher proportion on public services.

Even the critics would surely applaud that. Debt interest used to be described by Gordon Brown as a “cost of failure”. Cutting that cost is to be welcomed.

While I am at it let me deal with another Japanese comparison, as drawn by McKinsey. As noted above, it estimates Britain’s total debt, 507% of gross domestic product, is close to Japan, with 512%.

Ireland is in a class of her own, with 663%, but others are lower. America has debt of 279% of GDP, Germany 278%, Italy 314%, Spain 363% and Portugal 356%.

McKinsey’s contention is that Britain has not begun to come down from these high levels of debt, to “deleverage” and needs to do so. The process of deleveraging, running down debt, is one that could undermine growth in coming years.

There is some truth in McKinsey’s view but not as much as you might think. There is a huge difference between Britain and Japan in government debt. Britain’s is 81% of GDP, Japan’s a huge 226%.

Corporate debt, 99% of GDP in Japan, 109% in Britain, is similar. Corporate debt in Britain is similar to South Korea’s 107% of GDP but lower than France, 111%.

What about Britain’s famously indebted consumers? I am not sure the household sector carries too much debt. Yes, at 98% of GDP it sounds high, and is well above Italy. 45%, France, 48% and Germany, 60%.

But debt is a stock while GDP is a flow and to compare them, while convenient, is apples and pears. Most household debt in Britain is in the form of mortgages. Countries with high levels of owner-occupation tend to have high levels of household debt.

US household debt is 87% of GDP, Canada 91% and Australia 105%. Britain’s household debt should ideally not rise much in coming years - and certainly not as much as it did in the pre-crisis decade. But nobody should expect or want a fall.

Where Britain does have a disproportionate amount of debt, 219% of GDP, is in the financial sector. This is nearly double Japan, more than five times America and roughly three times most other countries.

A significant proportion of that, however, reflects London’s role as a global financial centre and the preponderance of foreign banks in Britain. Take that out, as is appropriate, and total debt comes down to closer to 400% of GDP than 500%.

That is still too high. Not many people are aware that by far the biggest increase in debt in the pre-crisis period was not that acquired by households, companies or government but by the financial sector. The financial sector ballooned too much and, painful though it is in terms of credit availability, it is right it is now deleveraging.

What would be wrong, however, is to add to government debt. Even under the coalition’s deficit-cutting programme, debt will rise inexorably. Adding to that increase would guarantee Britain’s place at the top of the international debt league. It would also be the surest way of turning Britain, in terms of economic stagnation, into Japan. Clearly, it should be avoided.