David Davies MP: A layman's guide to the difference between debt and deficit - and why the Government is right to be cutting it (the deficit)

David Davies is Conservative MP for Monmouth and chairman of the Welsh Affairs select committee.

"Why is the Government trying to cut the national debt so quickly?” That’s a question I have been asked numerous times over the last few weeks in one way or another along with calls for certain things - such as the BBC, civil service redundancy payments etc. - to be exempt from cuts.

Full marks to anyone who has noticed this is the wrong question. The Government has no plans whatsoever to cut the national debt.  In fact they are looking at cutting the deficit over a period of four years.

Anybody could be forgiven for being confused about debt and deficit because even Gordon Brown, seemed unable to make the distinction. Two minutes into his infamous exchange with a voter from Rochdale who he later called a “bigot” he tells her in response to a question about debt: “We got (sic) a deficit reduction plan, cut the debt by half over four years.” (It’s all on YouTube, two minutes into the clip)

If a serving Prime Minister and former Chancellor can mix up debt and deficit what hope is there for the rest of us?

Yet the distinction goes to the heart of the Conservative-Liberal Democrat economic policy, which I fully support.  As a non-economist, here is my humble attempt to explain the nation’s economic situation and the Coalition’s solution into a few paragraphs of simple English.

The Debt
The Public Sector Net debt or national debt is the total amount of money which the British Government has borrowed and must pay back. It officially stands at £952 billion and has been rising at an accelerated rate since the end of 2007. Many commentators think that the true figure is much higher because the official figures take no account of liabilities for PFI projects, the liabilities of Northern Rock or public sector pensions. At the moment the official national debt is about 65% of the nation’s GDP.  On top of this the private sector has a debt of around £3 trillion.

The Deficit
The deficit is the difference between what the government receives each year in revenue and what it spends. The government currently receives around £520 billion each year and is spending £680 billion each year so the deficit is around £160billion. Each year the deficit adds to the national debt. Since 2000 – long before the banking crisis - we have been living beyond our means.

Debt Interest
Like any other borrower, Britain has to pay interest on its debt.  The interest costs the country around £40 billion every year. In the twelve months to September of last year, Central Government Interest Costs, the amount of money that was used to service this debt, was £41.4 billion.  This is more than we spend on defence. The higher the debt, the higher the interest payment will be, and even with all the cuts that are planned, our debt will continue to rise for at least another four years.

The Triple A Rating
At present Britain has an “AAA” debt rating. This means that the people lending money to the UK government view us as being undoubted in our ability to pay it back and are therefore willing to lend to us at low interest rates. If Britain loses this AAA rating the amount of interest we pay could, conceivably, escalate leading to even bigger cuts and higher interest rates which would drastically affect businesses and homeowners with mortgages.  The agencies who assess our credit ratings were threatening to lower it last year, but the deficit reduction plan has removed this possibility for the time being.

A ”double dip” recession
Some economists have argued there is a risk that the “cuts” in spending should be delayed in case they cause the economy to go back into recession. Most would agree that this is a risk. However, other economists point out that a steep rise in interest rates caused by a lack of credible action to tackle the deficit would also risk causing a double dip recession. Whatever the Government does there is a risk of a double dip recession – the question is: which adds up to the greater risk? The government has concluded that while spending cuts run the risk of causing a recession, no spending cuts run a much greater risk, perhaps even a certainty of an economic crisis at some point within the next few years. That is why the cuts are necessary.

Who’s fault is all this?
The previous government very successfully put the entire blame for the debt crisis on the banks. However a quick look at websites like the UK debt bombshell website show that since 2000 the government has been spending at least £30 billion a year more than it has been getting in tax. As Gordon Brown endlessly reminded us, these were years of strong economic growth yet we still could not spend what we earned. The “Debt” had already reached £650 billion before the financial crisis struck in 2008. This is disgraceful given that in 1997 the Labour government took over an extremely healthy economy. The national debt then was tiny compared to what it was now, expressed as a percentage of GDP it stood at 43%. This was at the lowest level since World War II. The current level is 64.6%.

The Solution
The Coalition government has a policy of reducing the deficit, not the debt, to zero by May 2015, i.e. balancing the books. The £160 billion which we are currently adding annually to our debt will slowly reduce until earnings match spending. At this point the debt will have reached about £1.4 trillion but will no longer be getting any larger.

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That is if all goes well. So to go back to the original question, we will not even be in a position to think about cutting a penny of the national debt for at least four years. This course of action is actually proving to be both pragmatic and effective.  In the UK we have developed a strong feeling of confidence in our ability to pay for and manage our finances prudently amongst both global and domestic investors. If we did not pursue this strong sense of sound economic ability and care, we would create economic chaos for the country, as seen in Greece or even Ireland, and leave us all far worse off than is currently going to be the case.

The figures concerned are so large they are actually quite hard to visualise. Therefore I have tried to give them some perspective. An individual (Britain) earns a salary of £50,000pa (or £520bn). Unfortunately he is spending around £53,000 (£550bn), but business looks good and for six years neither he nor his bank are worried. One day a hurricane which started in America blows into Britain and the roof of the house falls in (the banking crisis). He blames the builders (the banks), but has to admit that during the good years he put no money aside to deal with the unexpected and didn’t undertake regular inspections of his building.

Large sums are spent putting it right. By now his earnings are £52,000 but his spending has gone up to £68,000. The bank thinks he is a bad risk and threatens to lower his credit rating and charge vast amounts of interest on his debt or possibly stop lending to him altogether.

Our friend weighs up two options. One is to carry on spending and hope that the banks will keep lending and that either something will turn up in a few decades or alternatively that he will be able to pass the debt on to his children.

The other, which he adopts, is to take action immediately to get his spending down to the level of his income within four years. The bank is pleased that he is now adopting a responsible attitude (in reality they would have declared him bankrupt!) and offer to let him carry on paying low rates of interest.

Of course, this is a simplistic analogy but one which goes some way to explaining the predicament. A failure to tackle debt now will leave an even bigger mess in a few years, leaving a millstone of debt around the necks of our children and grandchildren.

I will fight any decisions on cuts which I think are grossly unfair to my constituents in Monmouthshire, but rather than ask the Government to keep borrowing money I will look for ways of allowing money spent in one area to be matched with savings elsewhere.

The Coalition government is  not going to take the easy option of risking long-term financial pain to win short term popularity. Instead we will face short-term financial pain to secure a long term economic future.