Hamish McRae: The debt crisis will change the way we live

Economic Studies

This is not just about the indebtedness of Greece; nor that of the other weak eurozone countries; nor about the future of the euro; nor, as we will learn today, that the liabilities of the British Government are far higher than the official figures suggest; nor even the real possibility that the US itself may default in the next three weeks if Congress cannot agree to an increase in its borrowing limit.

We are seeing all of this of course. But we are also catching a glimpse of something even bigger. This is the way in which the entire role of governments in Western democracies is starting to shift – has to shift – as they look across the chasm between what they are expected to do for their electorates and the resources they have available to do it. We are beginning to see how government 50 years from now will be quite different from anything in our lifetime.

Greece is the extreme example of a government that cannot pay its debts. The government has insufficient tax revenues, can only borrow for a few months, and that only because it has longer-term loans from other eurozone countries and the IMF to help it meet its outgoings. Portugal and Ireland are in a similar position. Now there is a danger that Spain, Italy and Belgium may find themselves in the same boat. The lead headline in Le Monde yesterday caught this well: "Crise de la dette: l'Europe toujours indécise, l'Italie à son tour menacée".

Menaced (or, threatened) in its turn indeed – it sounds better in French, doesn't it? Yesterday Italy was able to raise some one-year money (ie to be paid back in 12 months' time) at 3.7 per cent but that compares with a rate of a little over 2 per cent a month ago. And it is paying higher rates despite the new austerity measures put before parliament, designed to convince the markets that it has its finances under control. These will be voted on in the next couple of weeks. Think of it this way. Whereas the Italian government, even a few months ago, did not have to worry whether it could borrow enough to cover its deficit, that is now a real concern. It may be able to borrow at an acceptable rate, but cannot assume it. Some countries can still be confident of their borrowing capacity – Germany, China, for the moment the US and a few others – but not many.

We here are less vulnerable than we were before the last election, but we are not safe. Most people are not aware that we are still only raising eight pounds in tax for every 10 the Government is spending. We have to borrow the other two.

Later today, two documents are being published that will highlight the scale of the task ahead. One, from the Office for Budgetary Responsibility, is called the Fiscal Sustainability Report, and it will look at the long-term prospects for public spending and borrowing, taking into account our ageing population, environmental sustainability, public pension liabilities, interest we will have to pay on the national debt and so on. The other report comes from the Treasury and is called the Whole of Government Accounts. This exercise dates back to Gordon Brown's days as Chancellor and has been much delayed. It will look at the country as though it were a company: its debts, its assets, its obligations and so on.

These documents will not make pretty reading but they will at least be open and honest in the way they present the problem. The US has been less scrupulous in its own budgetary planning, producing a variety of quite unrealistic estimates for future borrowing. Its situation is in some ways even worse than ours. Did you know that the government is borrowing four dollars for every 10 it spends and only raising six in taxes? Huh?

For the time being, the US can get away with this, partly because the Chinese will lend money to the country and partly it can print dollars to fill the gap. But common sense tells us that this is utterly unsustainable. What common sense cannot say is the sequence of events by which it ends.

But end it will. That brings us to the great issue: what will government be like 20, 30 or 50 years from now? A century ago, when the foundations of the European welfare state were being laid, government was still typically 10-15 per cent of GDP. Governments did defence, a few public services and some welfare and pensions. That grew, helped (if that is the right word) by two world wars, and by the expansion of public services from the 1950s onwards, a process that is still moving forward in the US with the Obama health reforms. Now public spending varies between 35 per cent and 55 per cent in most developed countries.

The system worked well but did so under favourable circumstances: a growing workforce able to pay the taxes to support a relatively small retired population. Now, most European countries face a falling workforce and growing ranks of the elderly. In the extreme case of Italy there will in 30 years be only one worker for every pensioner. Something has to give.

We don't know what that will be but anyone interested might catch some clues from a new book by Professor Vito Tanzi, who was for 20 years director of fiscal affairs at the IMF. Called Government versus Markets, The Changing Economic Role of the State, it charts how that role grew over the last century and how that model is unsustainable. He believes the state's role will shrink over this century, with government taking perhaps 30-35 per cent of GDP, not the 10-15 per cent of a century ago. Even so, it would be a different sort of government from anything we are used to, a government that is gradually handing back responsibilities – you might say the burden – for health, pensions and so on, on to the rest of us. I think most of us intuitively know that – but adapting will not be easy, particularly if governments default on their own debts along the way.

h.mcrae@independent.co.uk