Are Western governments heading for bankruptcy?

If you are a company, you have to include pensions liabilities as a debt in your accounts. However, governments, while professing to follow private sector practices in their accounts, turn a blind eye towards their own pensions commitments. This is convenient because these commitments are often unfunded, massive and could ultimately bankrupt us.

In a paper published by the IEA today, A Bankruptcy Foretold: The UK’s Implicit Pensions Debt, I calculate the UK’s total debt to be £4.1 trillion or 276% of GDP, as opposed to the official figure of around 40% of GDP. This makes our “real” debt position worse than Zimbabwe’s. Many other West European and North American governments are probably in a similar or worse position.

This figure is so large that I suspect it will be greeted with disbelief and not taken seriously. However, I want to stress that this really is our debt position, and I have deliberately been over-cautious in the calculation – the true level might actually be higher.

The debt figure is made up of “official” debt, public sector pension liabilities and accrued National Insurance Fund liabilities. In the paper I present a rigorous argument as to why this is a real debt, which it will be very difficult for governments to get out of paying. Indeed, the debt level is likely to increase as the demographic situation worsens.

So, what does this mean for the country’s future outlook if our debt level is indeed so high?

The debt the government carries represents the level of transfer to future generations – the debt will have to be paid off out of the government’s future tax revenue. The population has effectively promised itself a pension without setting aside a capital fund in the hope that, in the future, there will be enough taxpayers. But we are at serious risk as the demographics deteriorate further as there will be fewer tax payers to pay for an increasingly large burden.

If the government acknowledges its true debt level, it will have to behave like a highly indebted person – with extreme prudence and the introduction of austerity measures. It will be forced to cut spending, increase taxes, possibly print money to pay off its debts, and almost certainly look to break its pension promises.

While none of these options are at all appetising, the situation will keep on getting worse the longer the government delays paying off or reducing its debt. The options available will decline with time and those that are left will be increasingly painful.

Nick, coming from the co-author of ‘Sir Humphrey’s Legacy’ I am surprised at this. I fully agree that unfunded public sector promises have an NPV of about £1 trillion, this figure is now broadly accepted as correct by the newspapers. But including State Pensions is spurious; as we no, “there ain’t no fund”. If you include these, it is only fair to include the NPV of the future tax revenues that will be used to pay it as well.

Mark, thanks for your comment, but I entirely disagree. I have included in my figure only state pensions already earned, i.e. the government has already made a promise to pay them. I argue in detail in the paper why this is so. The government is therefore on the hook for these just like any other debt. True, they can be paid from future tax revenue, but so can all other forms of debt. If I included future pensions accruals I should include future tax revenues, but I have not done this.

I think we’re effectively bankrupt assuming 1 trillion of unfunded public sector pension liabilities. So 4 trillion is really neither here nor there.If only Brown had had the courage to act as the problem became evident. I blame him entirely.

A key assumption in the estimate of total British government liabilities at £4,076 billion [= 276% of GDP] at 30 September 2008 is the use of a real interest rate of 0.85%, the yield on index-linked gilts over 15 years assuming 5% inflation. The calculation is highly sensitive to changes in this rate, which can fluctuate quite sharply. I would be interested to know what the liability would amount to if one used an interest rate of 2.0%.

Indeed, the government could reduce state pensions by increasing the retirement age, means testing etc. so you could argue that you should use a risk-adjusted discount rate for those. However, public sector pensions are as absolutely guaranteed as they come and really cannot be reduced. So, I think you can argue that the 45% of official debt is a rock solid figure and the 85% or so of public sector pension debt is too. But there could be more argument about the extent of the state pension element.

Nick, great paper! One minor point: You say entitlements that people have accrued or earned should be considered debt, but if the government is expected to spend more on the NHS next year, that is future expenditure, not debt. But it is merely a technical question whether you organise welfare services on a contributory basis or not. In a Bismarckian social insurance system, health care IS an entitlement that people accrue. (I have seen estimates where these costs are considered implicit debt.)

Part of me agrees that accrued State pensions are an actual liabiity (I am not doubting your maths, as DRM says this is subject to interest rates) or that the UK is theoretically bankrupt. To prove this – ask pensioners “What would happen to your pension if all working age people in the UK moved abroad?”. But that’s not a realistic scenario, there are plenty of others who’d happily move in to the UK to pick up the slack, so the other part of me thinks it is only fair to include future taxes. Hmm.

In reply to DRM: Whatever interest rate you use you’ll get a very large number (with 2% rates it may be, say, 30% less). I don’t think the actual number is that important – the important fact is that our overall debt is over 200% GDP not 40%.

Reply to Mark: I think you are confusing debt with how you pay for the debt. Say I owe my friend £20 but I earn £100,000 per annum. What is my debt? – the answer is £20. My income is not relevant to the question. You are asking the question can I pay my debt? and in this scenario of course I can. The paper answers the question what is the government’s debt, the future income is not relevant. Whether the government can pay its debt is more complex – the subject of another paper!

Nick,Great paper.The newspapers are saying that recent projected rises of “official” debt (i.e. from “37%” to 57% of gdp) are pushing up credit default swap rates on UK debt, so that UK is less credit-worthy that Mcdonalds.If the real story is that debt is going to rise from 276% GDP to 296% gdp, why was UK EVER held to be more credit-worthy that zimbabwe, let alone McDonalds?

Nick, your analysis seems to make sense, however I believe you have some more work to do:If the current pensions liabilities are included your analysis implies that the ratio of debt to GDP increases by O(5), but by what order would Brown’s ’sustainable level’ increase? If one changes the accounting on one side, one must change it on the other too – so comparing the 200% (or 400%) to the 40% has little contextual meaning.

Nick, good paper and this brings to light some serious concerns over future pension provision in light of the fact that people are also not saving for their retirement.However it seems the government has found the answer, quantitive easing! By effectively devaluing the currency they are reducing the net impact of the future debt. Ultimately this must mean a lower standard of lving for pensioners however the majority of people will not even see it coming….With currencies in Western governments effective not tied to anything of intrinsic value (i.e. gold) what is to prevent them continuing to print money and let inflation erode the debt completely.

Nick, coming from the co-author of ‘Sir Humphrey’s Legacy’ I am surprised at this. I fully agree that unfunded public sector promises have an NPV of about £1 trillion, this figure is now broadly accepted as correct by the newspapers. But including State Pensions is spurious; as we no, “there ain’t no fund”. If you include these, it is only fair to include the NPV of the future tax revenues that will be used to pay it as well.

Mark, thanks for your comment, but I entirely disagree. I have included in my figure only state pensions already earned, i.e. the government has already made a promise to pay them. I argue in detail in the paper why this is so. The government is therefore on the hook for these just like any other debt. True, they can be paid from future tax revenue, but so can all other forms of debt. If I included future pensions accruals I should include future tax revenues, but I have not done this.

I think we’re effectively bankrupt assuming 1 trillion of unfunded public sector pension liabilities. So 4 trillion is really neither here nor there.If only Brown had had the courage to act as the problem became evident. I blame him entirely.

A key assumption in the estimate of total British government liabilities at £4,076 billion [= 276% of GDP] at 30 September 2008 is the use of a real interest rate of 0.85%, the yield on index-linked gilts over 15 years assuming 5% inflation. The calculation is highly sensitive to changes in this rate, which can fluctuate quite sharply. I would be interested to know what the liability would amount to if one used an interest rate of 2.0%.

Indeed, the government could reduce state pensions by increasing the retirement age, means testing etc. so you could argue that you should use a risk-adjusted discount rate for those. However, public sector pensions are as absolutely guaranteed as they come and really cannot be reduced. So, I think you can argue that the 45% of official debt is a rock solid figure and the 85% or so of public sector pension debt is too. But there could be more argument about the extent of the state pension element.

Nick, great paper! One minor point: You say entitlements that people have accrued or earned should be considered debt, but if the government is expected to spend more on the NHS next year, that is future expenditure, not debt. But it is merely a technical question whether you organise welfare services on a contributory basis or not. In a Bismarckian social insurance system, health care IS an entitlement that people accrue. (I have seen estimates where these costs are considered implicit debt.)

Part of me agrees that accrued State pensions are an actual liabiity (I am not doubting your maths, as DRM says this is subject to interest rates) or that the UK is theoretically bankrupt. To prove this – ask pensioners “What would happen to your pension if all working age people in the UK moved abroad?”. But that’s not a realistic scenario, there are plenty of others who’d happily move in to the UK to pick up the slack, so the other part of me thinks it is only fair to include future taxes. Hmm.

In reply to DRM: Whatever interest rate you use you’ll get a very large number (with 2% rates it may be, say, 30% less). I don’t think the actual number is that important – the important fact is that our overall debt is over 200% GDP not 40%.

Reply to Mark: I think you are confusing debt with how you pay for the debt. Say I owe my friend £20 but I earn £100,000 per annum. What is my debt? – the answer is £20. My income is not relevant to the question. You are asking the question can I pay my debt? and in this scenario of course I can. The paper answers the question what is the government’s debt, the future income is not relevant. Whether the government can pay its debt is more complex – the subject of another paper!

Nick,Great paper.The newspapers are saying that recent projected rises of “official” debt (i.e. from “37%” to 57% of gdp) are pushing up credit default swap rates on UK debt, so that UK is less credit-worthy that Mcdonalds.If the real story is that debt is going to rise from 276% GDP to 296% gdp, why was UK EVER held to be more credit-worthy that zimbabwe, let alone McDonalds?

Nick, your analysis seems to make sense, however I believe you have some more work to do:If the current pensions liabilities are included your analysis implies that the ratio of debt to GDP increases by O(5), but by what order would Brown’s ’sustainable level’ increase? If one changes the accounting on one side, one must change it on the other too – so comparing the 200% (or 400%) to the 40% has little contextual meaning.

Nick, good paper and this brings to light some serious concerns over future pension provision in light of the fact that people are also not saving for their retirement.However it seems the government has found the answer, quantitive easing! By effectively devaluing the currency they are reducing the net impact of the future debt. Ultimately this must mean a lower standard of lving for pensioners however the majority of people will not even see it coming….With currencies in Western governments effective not tied to anything of intrinsic value (i.e. gold) what is to prevent them continuing to print money and let inflation erode the debt completely.

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