Does the national debt matter?

Britain's national debt has gone above £1trillion for the first time in history, according to campaigners at the UK National Debt Clock website. That's a big number. And it's more than double what it was five years ago. But what does it actually mean? And should you be worried about it?

How the UK got into debt

If government spending outstrips tax revenues, it has to borrow the rest. It does this by issuing gilts, which are just IOUs from the UK.

Investors — from banks and pension funds to foreign governments — buy the gilts. In doing so, they agree to lend the UK a specific amount of money over a specific period of time, at a specific interest rate.

The national debt — that £1trillion figure — is all these added together. It's how much we owe in total.

So when the government says it plans to cut the deficit from around £150billion last year to £35billion by 2014/15, all it means is that it's going to reduce the amount that it overspends by each year. The national debt won't fall — in fact, it will keep rising.

In real terms

Numbers like £1trillion are meaningless to most people — simply too big to imagine. So let me put it this way.

It currently costs £44billion a year to simply pay the interest on the current debt and that figure — even after all the cuts — is going to just get bigger.

Already we spend more on the debt than we do on defence (£40billion), housing and the environment (£27billion) and transport (£22billion).

If we had no debt (and as recently as 2001/2 the government was running at a surplus), we could simply scrap council tax and still be £19billion better off every year as a nation. That's a saving three times as big as the £6billion in cuts that George Osborne initially announced.

But is it too big?

There are two things you really need to look at when deciding if we're in too much debt. Firstly, how big is the national debt compared to the size of the economy? This is the debt-to-GDP ratio. In Britain's case, our annual GDP is around £1.4trillion. So our debt-to-GDP ratio is about 70%.

Secondly, you need to look at the trend. Is the national debt rising or falling? And how rapidly? In our case, we borrowed around 11% of our GDP last year.

To give you a bit of perspective, when Gordon Brown was chancellor, he didn't want the debt-to-GDP ratio to go above 40% while the European Union gets twitchy when a country's deficit goes above 3% of GDP.

So we're well above what both our old chancellor and the EU think is 'healthy'. But many countries are currently operating perfectly well with more debt than that. Japan's debt is around 200% of its GDP, for example.

Do we need more debt then?

Some pundits (often left-leaning) argue that the government should spend as much money as it takes to dig ourselves out of the economic hole we're in. This is the 'more stimulus' argument.

From this perspective, the government borrows or prints more money, but uses it to boost economic growth. As long as the economy grows faster than your debt levels, then you don't have a problem (because the debt-to-GDP ratio will actually fall).

For them, 'austerity' is a mistake. If you raise taxes, you take money out of people's pockets. And if you cut spending, unemployment will rise, companies won't invest and the economy may slip back into recession. In other words, you make the situation worse.

On the other side of the debate, often taken by conservative (small 'c') pundits, the argument goes that if the government borrows too much, it will crowd out spending and investment by the private sector. If the government is competing with the private sector for capital, then it will cost companies more to raise money.

Government can often be wasteful —  if so, borrowing by the government to spend will make an economy less productive. Also people and companies realise that they'll have to pay for current government overspending in the form of future taxes. As a result they save more and spend less. In turn, you hamper growth and simply dig yourself deeper into the hole.

Who's right?

Ultimately, there's no obvious point at which debt becomes unsustainable. But debt is not consequence free.

There's nothing superstitious or unsophisticated about being concerned about the national debt. Countries do go bust. It's happened in the past and it will happen again. And the more risky a country looks, the more it has to pay for its debts.

Countries differ from individuals and households in some key ways: countries can carry on passing their debts to future generations and they can also print money to repay their debts. But lender confidence matters.

Just as we all have friends to whom we'd never consider lending money, regardless of their financial position, so a country's reputation matters.

Britain has an AAA-rating (the best you can get) at the moment and that means borrowing is cheap. But a country where debt is seen as unsustainable (as happened to Greece) can pay three times as much for its borrowing.

At current debt levels that would mean we'd be spending more servicing debt than on the NHS, with income tax levels having to be almost doubled just to cover the interest on the money we'd already spent.

Worse, we might simply not be able to borrow money at any price, meaning things like the police, the army, schools and hospitals simply couldn't pay staff and state pensions could go unpaid. This is an extreme example (and a lot of other spending would be deferred ahead of these things), but investors have already shunned debt auctions of other European countries.

Where the money goes

It also depends on what a country is spending the money on. Borrowing to invest in a new road network is one thing — it's a one-off spend that should improve the country's productivity and therefore its growth. It's an investment that should pay for itself.

But if a country is borrowing merely to service its existing commitments — such as on pensions or healthcare spending — then that's a problem. This is a 'structural' deficit. Basically, it means a country is spending above its means and something has to give.

This is the real problem that Britain faces.

Even before the financial crisis, we were spending too much on things we can't afford in the long run. That's why the cuts are necessary. And it makes sense to try to tackle the issue now, because cutting the debt will also leave us less vulnerable to future shocks in the financial markets.

Make no mistake, if we were part of the eurozone, we'd probably be somewhere near the 'PIGS' hit-list (Portugal, Ireland, Greece and Spain) that's caused so much woe on the continent.

However, the way the cuts are dealt with does matter. If the government fails to tackle waste (back-office admin and costs), but ends up slicing away at the useful parts of the public sector, it won't be as effective. And the more taxes are hiked, the greater the risk of slowing the economy.

In other words, it's not a naked choice between 'austerity' and 'stimulus' or if we have too much debt — it's about using the resources we have more efficiently.

John Stepek is the editor of MoneyWeek.com