What to do with the debt

Why the debate over spending?

The financial crisis saw a huge transfer of private debt into the public sector (as bankrupt banks have been propped up and bailed out by taxpayers). As a result, sovereign debt has become a major issue.

Many countries around the world are running large deficits (ie, they spend more each year than they bring in), which are adding to rising national debts (the total amount owed).

Greece has already defaulted and forced bondholders to accept reduced payments (although this may not be the last of it). For others, such as Britain, the cost of borrowing government bond yields remains low, but overall debt leaves us vulnerable to changes in investors' mood.

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So politicians are trying to work out how best to cut our debt without destroying growth. A recent International Monetary Fund (IMF) report looks at what we can learn from similar crises over the past 100 years.

Has Britain been here before?

Yes. After World War I Britain had record debts worth 140% of GDP, far higher than our current official level of 66%. The country had come off the gold standard during the war, causing inflation, but the then prime minister, David Lloyd George, decided to return to the gold standard. This meant repaying the debt in real (inflation-adjusted) terms, rather than via a devalued currency.

Interest rates were raised to 7%, while high wartime tax levels were maintained and spending slashed. You could describe this option as austerity max', and it was a disaster. Unemployment rose as high as 16%, while the economy grew at an annual average rate of 0.5% between 1918 and 1938.

The high interest rates and low growth meant that even though the government turned a deficit into a surplus, interest charges saw our overall debt pile continue to grow, hitting 190% of GDP in 1933.

What about America?

By the end of World War II, America's debt had hit 120% of GDP. Many politicians feared a similar fate to Britain. But the US tried a different tactic. The Federal Reserve used a bond support programme (buying its own debt, basically) to keep yields low, while interest rates were also held down.

Higher inflation resulted, but while the government limited consumer credit, it didn't touch interest rates. A combination of inflation and artificially low bond prices helped erode the debt away. This financial repression' saw the debt fall to 75% of GDP by 1951, helped by strong growth and fiscal surpluses.

So is monetary policy the answer?

Not always. In 1997, Japan's public debt rose above 100% of GDP. Afflicted by deflation, Japan dropped interest rates to near-zero to try to boost growth. But the debt pile kept growing.

Low interest rates were ineffective because banks were still focused on shoring up balance sheets, rather than making new loans similar to Western banks today. Also, the government continued to run deficits, while external shocks like the 1998 Asian crisis and the 2000 dotcom bust didn't help. By 2008, Japan's debt hit 180%.

So cuts matter too?

Cutting spending is essential if a government wants to turn a deficit to a surplus. But it isn't easy. In 1920s Britain, Lloyd George invited successful businessman Sir Eric Geddes to outline spending cuts. 'The Geddes Axe' reduced spending but angered the public, culminating in the General Strike of 1926.

The trick is to get public support, says the IMF. For example, in Italy in the 1990s both public and politicians worried that rising debts would stop the country from joining the euro. This saw the election of "three technocratic governments" that pushed through "a substantial fiscal adjustment and... unpopular structural reforms".

The deficit fell from 7% in 1995 to 2.7% in 1997. As markets priced in Italy's new-found prudence, bond yields fell, making the overall debt pile easier to service.

Italy still has debt problems what happened?

Italy used many temporary measures, such as privatisations and a special tax "for Europe", to cut its deficit, and support for these faded as things improved. The only way to ensure governments spend within their means is to make long-term changes, rather than one-off cuts, as Canada's 1990s experience shows.

Having spent a decade unsuccessfully trying to sort out its finances, a new plan in 1995 focused on structural spending cuts rather than raising already high taxes. Canada reduced unemployment benefit, cut transfers to the provinces, and reformed pensions. As a result its debt fell by 35% over the next ten years.

What can we learn today?

Worryingly, Britain seems to suffer from the traits that mark most unsuccessful debt repayments. Banks are desperately trying to repair balance sheets, which means little of the Bank of England's monetary policy gets through to the rest of the economy. It is also keen on the wrong type of cuts, says Brian Reading of Lombard Street Research, and we are far from having a public consensus. "It made no attempt realistically to identify where taxpayers' money was to be saved."

We're short on luck too. The ongoing euro crisis and slowing Chinese economy are hardly providing an easy backdrop for economic growth. All in all, it's no surprise that, depending on how you measure it, borrowing is up between a fifth and quarter on last year, says David Smith in The Sunday Times.