A charming little tale has come our way – one published in the Independent some time ago…
Debt is a dirty word that dominates economic debate in Toytown today. This is why.
A decade ago the only house in Toytown was owned by Big Ears. Noddy had long had designs on the property, but Toytown Building Society had always been a financially conservative institution which saw Noddy as a high risk character.
Suddenly, Toytown Bank decided to enter the property market, determined to increase market share. It invited Noddy into its shiny new office – indeed it almost forced him in with outlandishly attractive advertising – and offered him more money than he ever dreamed of to buy Big Ears’ house. Noddy duly made Big Ears an irresistible offer of #50,000 and Big Ears moved into digs.
He put the money in a deposit account at Toytown Bank, intending to live on the interest.
As a result of these transactions Noddy had a debt to the bank of #50,000, while Big Ears had a claim on the bank worth the same amount. Toytown Bank had an asset in its loan to Noddy, “backed” by the value of his house, and a liability in its deposit from Big Ears. The deposit from Big Ears counted as “money”, so the money supply expanded.
Everyone was happy – except the Treasurer of Toytown Council, who noticed that Noddy was spending more money than usual equipping his new house with kitchen equipment, mainly purchased overseas. Meanwhile, Mr Plod decided that he too should own a house, so he made an even more outlandish offer of #70,000 to Noddy. Noddy turned the offer down, but felt much richer.
OUT OF CONTROL
Indeed, when Toytown Bank heard of the offer, it concluded that it could lend #20,000 to Noddy to buy a new car, “backed” by the increased value of the house. Noddy bought the car from Big Ears, who deposited the money at the bank. The money supply increased further.
Eventually, everyone joined in. The demand for cars, furniture and kitchen equipment was out of control, and inflation surged. The Treasurer decided he must take action.
He could control spending by increasing taxation but – in a twist of fate that could, of course, only happen in Toytown – he had just won an election pledging to make a large tax cut, which he decided to implement. He was not worried about government borrowing, because the boom in spending was filling his coffers with revenue, and the budget of the town council was in surplus. Nor was he worried about the balance of payments which, in the new economics of Toytown, he said no longer mattered. (Again, we are lucky that no such thing could happen outside Toytown.)
By now inflation really was a problem, and the Treasurer decided that interest rates must rise. Eventually, Noddy found that he could no longer afford to pay the interest to the bank without drastically cutting his spending. Big Ears, meanwhile, was living comfortably on his increased interest receipts, but he was not inclined to spend all of the extra he was receiving.
Total spending in Toytown suddenly collapsed, since Noddy cut back his spending much more than Big Ears increased his. Although credits matched debts in the economy, activity fell.
Noddy remained in trouble. Soon the interest payments were impossible to discharge, so he decided to sell his house. He offered it to Mr Plod for #40,000, but Mr Plod was no longer interested. Noddy was on the verge of panic. The balance sheets in Toytown no longer looked very pretty. Noddy had a debt of #70,000, which he had little hope of repaying. Toytown Bank had a liability to Big Ears of #70,000, backed by “collateral” (Noddy’s house) which was now worth only #40,000.
It would lend no further money to Noddy, who anyway did not want to borrow. And Big Ears was beginning to feel a little uncomfortable about his deposit at Toytown Bank. Was it really secure? Should he withdraw the money just in case?
The Treasurer now decided to cut interest rates sharply, but this did little immediate good. Noddy, as we have seen, would not borrow money at any interest rate. Big Ears actually lost income as interest rates came down, so he cut back his spending a touch. The bank told Noddy that he must repay his debt in easy stages. Noddy began to find this a little easier as interest rates declined, but the bank knew he would be in trouble for several more years.
Meanwhile, the once-bitten-twice-shy bank refused to lend to anyone other than Toytown Council, which was thought to be secure. Mr Plod decided it might be time to pick up a bargain in the housing market, but the bank would not lend him the #40,000 he needed to make Noddy an offer.
That, children, is the story so far. But we understand that the Treasurer is now getting worried about his budget, since tax revenues have collapsed.
The Town Council is now in deficit, but because it paid off so much debt in the boom the level of outstanding Toytown debt is still low. The Treasurer realises that during the boom he managed to “privatise” a good deal of debt to Noddy, who is now labouring under its burden.
Some of the Treasurer’s advisers tell him that he should be worried about the annual deficit he is now running and that he must cut back council spending. They are particularly keen to save money by cutting Noddy’s wages – he happens to be a council employee. They make the point that if the council bails out Noddy and the bank they would be more likely to misbehave in future.
RESCUE PLAN
Other advisers say that the annual council deficit does not matter as long as the level of outstanding debt is still quite low. They say that it would be absurd to cut back council spending on Noddy’s wages, just when Noddy’s problems with debt servicing are at the heart of Toytown’s economic troubles.
Indeed, they go further. They say that the relative strength of the Government’s balance sheet should be used to rescue both Noddy and Toytown Bank from the consequences of their previous actions. Noddy should receive a tax cut to help him pay off his debt.
And the bank should be helped as follows. The difference between the value of its outstanding loan to Noddy ( #70,000) and the value of its collateral, the house ( #40,000) should be removed from the bank’s balance sheet. The council should issue a bond to the bank worth #30,000 in exchange for that amount of Noddy’s mortgage.
The bank’s balance sheet would thereby be repaired, so it would be more willing to lend to Mr Plod next time he dropped in. This would make Big Ears feel much better about the security of his deposit at the bank, so he would no longer think about withdrawing his money and he may feel slightly more willing to spend.
Finally, say the Treasurer’s advisers, the council could afford to give more generous debt repayment terms to Noddy than the bank, which might make Noddy more willing to spend.
The Treasurer has until 12 November, the date of his Autumn Statement, to decide what to do.
PS: There are no economic statistics in Toytown, so the graph is based on British statistics, which some say are quite similar.
Publication date: 1992
Author: Gavyn Davis, sometime adviser to one G. Brown.
Prescient or what?
(H/T JJ)