IEA Blog

Earlier this year I published a report estimating British government debt at £4.8 trillion. However, over the summer the Office for National Statistics (ONS) published a paper which proves me wrong on two counts – firstly, I understated the true debt and secondly, rather than going bankrupt sometime in the future, the UK should probably already be calling in the receivers.

If the reader will stay with me, I would just like to briefly explain the differences between my figures and those of the ONS (they are quoted in the press with a debt figure of £4 trillion). The ONS found extra debts of £250 billion which I was not aware of (from PFI projects and nuclear decommissioning). In addition, both sides of the balance sheet are included, so if we are doing this it is OK to include the nationalised banks’ liabilities of up to £1.5 trillion as long as their assets are also included. Also, projections of “official” national debt are £900 billion whereas I used £770 billion.

The main difference between our figures is the allowance for state pensions: my figure for this is twice theirs because they have used a GAD estimate from 5 years ago, whereas I have estimated what the liabilities are now. That means that our gross national debt is about £6.5 trillion.

The ONS also calculate the country’s assets as approximately £3.5 trillion, if we include the banks’ balance sheets. We therefore have a hole of £3 trillion to be funded by future tax revenue. This is in addition to future government spending. To ensure the public finances are sustainable in the long term, the government will not only have to reduce the current budget deficit of 9% of GDP; it will also have to run a surplus to “pay off” the £3 trillion. And this assumes that the assets will also generate cash or could be sold off, both of which are pretty unlikely.

Looked at this way, the UK is effectively an enormous unfunded and effectively bankrupt pension scheme, with a large speculative holding in some banks and a sideline in running a small island state off the northern coast of France.

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Today, the Public Sector Pensions Commission - which was established in autumn 2009 by the IEA, the Institute of Directors and other groups - has released its report, Reforming Public Sector Pensions: Solutions to a growing challenge.

A key finding is that the true value of the main unfunded public sector pension schemes is over 40 per cent of salary. However, the combined employer and employee contribution rates are set at around 20 per cent of salary – the result of the government using artificially high discount rates in its calculations.

The report calls for greater transparency on the true costs of public sector pensions and sets out a series of reform options that would bring costs down. These include:

• increasing employee contribution rates
• switching from final salary to career average earnings
• reducing accrual rates
• raising pension ages
• reducing index-linking
• ending the contracted-out status of public sector pensions
• switching to funded defined contribution arrangements

 Click here to download the report.

The Emergency Budget included a proposal to raise the state pension age for males from 65 to 66 by 2016. This increases the retirement age significantly earlier than the original schedule. The previous Labour government had planned to increase the male pension age to 66 by 2024 and to 68 by 2048.

Existing legislation is gradually increasing the female retirement age from 60 so it matches the male pension age of 65 by the end of 2020. It is unclear whether the coalition will equalise the male and female pension ages at 66 in the future. 

The first widespread government pension provision was established in 1908 with the Old Age Pensions Act which set the collection age at 70. But this scheme was established at a time when the average manual labourer died by the age of 50 – so relatively little had to be paid out. Later on, though, with the passing of the Contributory Pensions Act of 1925 the collection age was lowered to 65, allowing more people to receive the benefit. This was the last significant change made to the retirement age; with the exception of the 1946 National Insurance Act which lowered the female pension age from 65 to 60. From 1946 to 2010 there were no changes in the pension age. 

Today, not only are people living longer than they were sixty years ago; pensioners now comprise 19% of the population, a larger proportion than the under 16s. This is a problem because sixty years ago when the average male was born, he was expected to live until 63 or so. However, advances in healthcare have allowed people to live – and claim state pensions – for around fifteen years longer.

Providing these prolonged benefits places an enormous strain on the public finances. For example, in 2010 the government will spend £4 billion to support public sector pensions. By 2015, this figure will increase to £10 billon. According to Nick Clegg, the present and rising cost of these pensions is simply “not affordable”. Since 2001 the cost of state pensions has increased by 38%.

The growth in expenditure on pensions is a direct consequence of the widening gap between retirement age and life expectancy. In the context of Britain’s worst ever peacetime fiscal crisis, it is imperative that the government raises the retirement age more rapidly to reflect longer life spans.

Two things struck me about the OBR report published yesterday. I shall blog about the other later…

The first was its treatment of public sector pensions. This is an area where the IEA has published a lot of work – including a paper published on the same day as the OBR report. The approach of IEA authors to calculating public sector pension liabilities is now widely accepted amongst those who do not have a vested interest in not changing current practice. The OBR should join that group of independent observers and not align itself with the special interests. Not only did the OBR use existing government figures for public sector pension liaibilities when the best estimates are about £400bn higher than the government’s estimates, it also suggested that the most appropriate estimate of the annual cost of public sector pensions going forward is what is known as the “current service cost”. It used the government figure here of about £28bn. This is incorrect for two reasons. Firstly, the government’s current service cost uses an inappropriate discount rate which leads it to be understated by about £7bn. Secondly, this figure also ignores the fact that previously granted liabilities are discounted. As each year passes they get nearer and thus the discounting effect gets less and the liabilities grow. This might add another £30bn to the annual cost.

Calculating the outstanding liability wrongly leads to an understatement in the total accrued liability equal to more than 50% of the outstanding government debt to which the government admits. If public sector pension liabilities are included in the national debt then it would rise to about 2.5 times the level the government has declared. The second omission leads to an understatement of government borrowing of about 25% of existing borrowing levels (though it is possible that there are some offsetting factors here caused by the incoherent way the public sector pension liabilities are included in official figures – as well as important under-statements of costs, there are some over-statements too).

The OBR says that it will continue to assess this, drawing on the work of GAD and the ONS. Help! Perhaps it should draw on the work of Bernie Madoff too – indeed there is a marked similiarity between these government schemes and Bernie Madoff’s fraudulent ponzi scheme.

This is not entirely the OBR’s fault. In the first report it was merely asked to discuss these issues. It has done that. But it is supposed to go further in future years in analysing these issues. The single additional sentence “we will also draw on the work of the many independent groups in coming to an independent assessment of off-balance sheet liabilities” would have been comforting. The OBR simply drawing on the work of the Government Actuary and the Office for National Statistics to calculate public sector pension liabilities is not good enough. It will not be able to provide an independent assessment of the government finances if that is all it does. There is no excuse any more. All the relevant information is in the public domain and reasonable people independent of government do not dispute it.

As we have a new government and we also have a better idea about the effects of the financial crisis on the public finances, I thought it would be worthwhile to update my 2008 paper, A Bankruptcy Foretold. Recalculating the UK government’s debt in 2010 gives a figure of £4.8 trillion or 333% of GDP – six times the official figure of £772 billion.

This figure is so high because it includes the liabilities from pensions debt –  financial commitments that the government has made but hasn’t set aside any funds to pay. If we think about a pension as deferred pay, the amount that I have included in my calculations is only the amount that has already been earned. This is a real debt, not a figment of actuarial imagination, as the government is obliged to pay it sometime in the future – but the value is less certain then the official debt. “Less certain” does not equate to zero, however, and there are long established practices of how to estimate this figure which companies have to use in their accounts.

This pensions debt is made up of two parts – unfunded public sector pensions schemes (e.g. teachers, civil servants and NHS occupational pensions) and unfunded National Insurance Fund pensions (i.e. state pensions).

Two immediate questions arise – can we afford to pay this debt and what should we do about it? Let us consider the first question as if this were a mortgage. Historically mortgages have been granted at approximately 3 times income (although this has increased recently). If we guesstimate the government’s potential income at between a quarter and a half of GDP, that would make the debt between 6 and 13 times income – which would make it on the very edge of affordability.

Clearly this level of debt will make it much harder to reduce taxes. It also means that if there is a serious shock of any kind (e.g. another banking crisis) there is no realistic way that the debt can be paid back. The situation is exacerbated by the recent bank nationalisation, though I have only made a small allowance for bank liabilities. However, if there were a severe economic shock, many of the banks’ debts might go bad, meaning that the government would be on the hook for up to another £1.5 trillion.

So what can the government do? Firstly, it has to act to stop the situation deteriorating. I have been calling for a while for proper accounting treatment for the debt – this is a minimum – but I have also become convinced that the only way that the government will manage the costs properly is if the pensions start to be funded. The government does not have a spare £4.8 trillion to fund past liabilities, but what it could do is transfer money in respect of future earned pensions as they become due into separate funds overseen by trustees – as happens in the private sector. In theory there is nothing wrong with a pay-as-you-go (PAYGO) system, but the government has proved over a long period that it is not capable of running one responsibly.

The other thing that has to happen is the negotiation of a “haircut”. What public sector workers and taxpayers currently have is an IOU from a near-bankrupt creditor. Swapping this for a smaller, but funded pension, would be a good deal.  What if we don’t do this? The Greeks are kindly showing us what happens next.

Click here to read A Bankruptcy Foretold 2010.

Whilst it might be presumptuous of me to disagree with the sixty eminent economists who wrote to the Financial Times last week, I would like to refer them and the reader to my paper A Bankruptcy Foretold, published by the IEA at the end of 2008. I calculated that, if you include accrued pensions commitments, then the UK government’s debt was a shocking 270% of GDP – over three times higher than the official figure used as evidence by Lord Layard et al. Moreover, the effects of the banking crisis and fiscal stimulus mean the situation will have worsened considerably since my research was undertaken.

Now one gets a sense that for some reason pensions are viewed as not being a “real” debt, but they are a legal contract that the government has entered into and will have to be paid, just like any other government debt. Baby boomers are starting to retire now – so pensions are not a distant future promise, but have a similar term to other forms of debt. Corporate and public accounting standards recognise this, but the government chooses to ignore these standards. So in advocating continued fiscal stimulus, Lords Layard, Skidelsky and others are addressing a minor risk (that the UK will fall back into recession) whilst ignoring a major risk (that we will spiral towards some form of bankruptcy). The government should formulate a credible deficit reduction plan before it has no choice.

Just after Christmas a number of members of the IEA’s SMPC wrote to the Sunday Times about the dire need for a fiscal plan to deal with government borrowing. In this context, it is worth coming back to the issue of implicit debt mentioned by Nick Silver in A Bankruptcy Foretold. He argued that the UK’s real national debt was already 276% of GDP in November 2008 – and this was a conservative (i.e. low) estimate. What has happened recently in terms of projected government borrowing does not increase this larger figure significantly.

In this context, does it make that much difference that the government plans to increase official borrowing to 70% of GDP from 40%, thus adding about one tenth to the total national debt including implicit items?

The simple answer is “yes”. The implicit debt that Silver and others have written about is implicit because it is not funded voluntarily. Essentially, public sector workers are promised a pension by the government (that creates implicit government debt). The corresponding “asset” held by private individuals is a government pension promise. That asset is not tradable and a nurse cannot think, “I don’t like the look of these dodgy UK government pension promises, so I shall sell them and buy some Swiss bonds instead.” On the other hand, all the new debt that the government is piling up has to be funded voluntarily by investors who can choose to buy other assets.

The explicit debt could also be regarded by investors as being subordinate to the implicit debt. Will the government default on its pensions before it defaults on its bonds? Probably not. Thus UK sovereign bond investors should be concerned about the ballooning deficits which are in addition to existing, alarming and higher priority implicit pension debts.

But the arguments against government debt are not just about funding – which is why we should be concerned with implicit debt regardless of its impact on funding. Some argue that we will grow our way out of debt. We may. But it is not inevitable. This is especially so because our ability to repay debt depends not on growth in national income per head but on growth in total national income. Population may decline. The argument that we owe the national debt to ourselves also does not hold water (at least, not much water). People value the savings that government bonds represent in pension funds and so on. But effectively, these savings are wiped out by the equal and opposite liability of future tax obligations necessary to repay past borrowing. Do the members of private pension funds know this?

Personally, I think that government borrowing has a moral aspect and it always surprises me that the churchmen who jump on political bandwagons or leftists who bring up moral aspects of inequality (as they see it) do not ever bring this issue up. One generation living it up at the expense of another generation which has no choice in the matter is not acceptable. But I suppose, when you think about it, it is obvious why the left never bring this issue up. Look at the graph below. Government borrowing, implicit and explicit is expanding because the state is not able to finance its own largesse from the explicit taxes it raises on citizens. That is the real problem. Government debt, implicit and explicit, must be cut by cutting government spending.

The projections in last month’s Budget were terrifying. They suggest that net government borrowing is likely to reach unprecedented levels over the next three years:

● 2009-10: £168 bn = 12.4% GDP
● 2010-11: £173 bn = 11.9% GDP
● 2011-12: £149 bn = 9.1% GDP

But even these forecasts may be too optimistic. They are based on GDP growth of -3.75% in 2009, +1% in 2010, and +3.25% in 2011.

But if the recession is deeper and longer than expected – say growth of -4.5% in 2009, -1% in 2010 and zero in 2011 – the deficit is likely to be closer to £200 billion for each of the next three years, equivalent to about 15% of GDP. Even when the recession ends, though, the structural budget deficit is still at alarming levels.

This would mean almost one in three pounds spent by the government would be borrowed.

Clearly such high deficits are unsustainable and need to be addressed urgently if a funding crisis is to be avoided. Yet raising taxes above already historically high levels is likely to be counterproductive. It will yield little extra revenue in the medium term. A substantial cut in public spending will therefore be the only serious option available to the next government.

If the Conservatives win the next election, David Cameron will be forced to deal with this problem. And tackling the low-hanging fruit – cancelling ID cards, NHS computer schemes and Crossrail, for example – while worthwhile, will not be adequate when around £150 billion of annual spending reductions may be required.

It will be necessary to curtail the major areas of government spending: welfare, health and education. Indeed, emergency cuts, or at least freezes, in welfare benefits and public sector pay may be in order – the kind of measures seen recently in struggling central European countries. Indeed, we should start this year – welfare benefits, pensions and public sector pay should not rise by more than private sector pay rises. If public sector pay cannot be reined in this year it will never be reined in. If welfare benefits are not pegged to wage increases then employment incentives will be diminished.  

However, the crisis also presents opportunities for Cameron to launch positive longer-term reforms that reduce the scope of government. He could start by tackling public sector pensions (a liability of  over £1 trillion), move on to welfare reform and then health and education, promoting competition and efficiency through individual savings accounts and voucher-type schemes while getting rid of the costly bureaucrats.

How could this be done in practice? A voucher scheme could involve a voucher of a fixed money value being given for the first five years of the scheme. Its value in real terms – and certainly relative to national income – would then fall. This could be politically acceptable as it would happen at the same time as huge efficiency savings were achieved.

And let’s not forget regulation. Removing red tape – for example, the new gender pay audits – would reduce the government payroll while lowering costs for businesses. 

●  Philip Booth lectures on “Catholicism and Capitalism” at Westminster Cathedral Hall (video)

●  Gary Becker and Kevin Murphy argue that we must not let the ‘cure’ destroy capitalism

●  Kevin Dowd speaks about the financial collapse from a free-banking perspective (video)

●  Frederik Erixon and Razeen Sally discuss Keynes and protectionism

●  Oliver Hartwich criticises ill-conceived subsidies for the Australian car industry

●  Philip Booth says the sums don’t add up for local authority pension schemes