Public debt levels rose dramatically after the 2008 peak oil shock as governments recapitalized banks and defibrillated their sclerotic economies with large cash injections.
Many OECD countries now register public debt at around 100% of GDP. Although unpleasant, this is not new and economies have recovered from such debt positions before, most notable following the Second World War.
Three things are different, this time.
The first, and most obvious, is that there is no cheap oil this time to fuel recovery. The energy price discontinuity which triggered the present crisis, and the growth constraints that apply to its recovery, have the same underlying cause—the physical offtake limit of the petroleum system. The purpose of restoring capital liquidity and stimulating demand was to restore growth—but there is now no energy to fuel that growth.
Secondly and consequently, interest rates are therefore much higher than achievable growth rates. When the real interest rate on debt is higher than real output growth, then the debt/GDP ratio increases even if a government manages to match its primary expenditure with revenue. Further interest payments increase debt, which increase interest payments in a compound growth relationship.
Under such circumstances, government must borrow. The amount it can borrow is limited to the present discounted value of all future primary surpluses (and seigniorage revenue). The expectation that the supply of dirt cheap energy would continue to increase resulted in large estimates of future surplus, and correspondingly large debt. Much of the 20th Century growth can be viewed as a mortgage taken out on the prospect of repayments funded by future energy supplies. But the magnitude of future surpluses are now limited by energy availability, leaving us unable either to service the debts incurred or to undertake new debt.
So unlike previously, we cannot borrow our way out of this. Default can only be avoided now by increasing the primary surplus through a combination of reduced spending and increased taxation.
Which brings us to the third difference.
The population is ageing very rapidly. The Second World War created a baby boom which fell away in the 1980′s. So age related costs—pensions and health care—are escalating rapidly, while the number of people of working age to fund them is falling rapidly. In 2010 in the UK, we will increase public debt by a further £167 billion while spending £677 billion in our public sector. The majority of current and future pension payments are unfunded.
We can’t reduce spending, in fact it must rise to cover rising health and unfunded pension costs. Under such circumstances, the only option left to government is to raise taxes. But energy constraints limit taxable surpluses.
The UK and many other countries are therefore locked into runaway public debt escalation and national default, driven fundamentally by energy constraints. One estimate[1] projects UK debt/GDP rising from 100% in 2010 to between 300% and 500% by 2040, with similar projections for the US and many European countries. At some point between now and 2040, the UK will default on its debt. Since we won’t be the only country to do so, there will be no IMF bail out. Default will be permanent.
Say goodbye to a golden retirement on the golf course.
References
[1] Cecchetti, Mohanty and Zampolli, The future of public debt: prospects and implications, Bank for International Settlements Working Papers No.300, March 2010