The Government Deficit

The Government Deficit


     We often hear politicians talk about “the deficit”. What is it? Why do they seem so keen to blame it on other people and to talk about reducing it? Does it actually matter? I want to explain it very simply to begin with, so here is a story (bear with me, it does have a point.):

Our story is set in Toytown, home to Noddy and Big Ears. Once upon a time, Noddy was put in charge of all of Toytown’s money. Every year he was given fifty gold coins and he could decide how he spent it. This worried Big Ears, could Noddy be sensible? He gave him a lecture about behaving responsibly, not having wild parties with the Barbie dolls when he needed the money to run the Toytown school and to pay the Toymaker to repair the broken toys and to make new ones. They all needed some new doll houses and some faster toy cars. Noddy nodded his head wildly in agreement, he was terribly excited.
All the gold was put into the money pot at the beginning of the year and every time Noddy needed to pay the Toymaker, or to build a new road, he took some out. For a while, all went smoothly. Then one day, Noddy had an idea. The summer was very hot and he wanted to build a swimming pool. All the toys could swim and enjoy the pool, it would be a place for toys to meet and chat and, best of all, he could invite all the Barbie dolls. But a swimming pool would use up all the money from the money pot and there would be nothing left to pay the Toymaker. He went to see Big Ears.
Big Ears listened to Noddy’s plan and thought about it. He agreed that all of Toytown would enjoy a swimming pool, it was not a bad idea. But they must continue to pay the Toymaker each year. He told Noddy that he could borrow the money to build the swimming pool. So, Noddy went to the Toytown bank. He explained that he wanted to build a swimming pool and needed the bank to give him some money. He would pay back the loan, giving the bank eight golden coins every year. The golden coins would come from the money pot. It would mean that for the next twenty years they would not be able to pay the Toymaker so much money, but all the toys would enjoy the pool, so they would not mind too much.
Noddy built the swimming pool and everyone was happy. For the next twenty years the toys had fewer new houses and fast cars but they did not mind. Everyone enjoyed swimming and watching the Barbie dolls. They all lived happily ever after.

This shows how borrowing arises. It is when a government has a deficit one year by spending more than it receives. If it spends the money on something everyone needs in the long term, no one minds that it means a bit less money for other things for a few years.
Now, our government does not have a pot of golden coins. It receives money through tax (boo, hiss, we all hate taxes.) That income goes up and down depending on the economy. When the economy is going well, there is more money and therefore more tax, so the government has more income. When there is a dip in the economy, people earn less money and pay less tax and so the government receives less income. Now, although their income goes up and down, we do not want everything they spend money on to reflect that. We do not want them to open a new school one year, when the economy is going well, then close it the following year when there is a dip, then reopen it the next year when things improve again. We like stability. This is another reason why governments might borrow money. The economy might be bad for a while but they know it is likely to improve, so they borrow money to keep things going.
We therefore work on the principle that government borrowing is allowed. A government can borrow money to spend now and they pay it back later. The problem is that governments are made up of people and people are not always wise. Politicians like to be popular. They therefore like to promise people lots of nice stuff. Nice stuff makes people happy. Happy people vote for politicians. If the government does not have the money to pay for nice stuff, they promise it anyway, figuring that the future generation can pay back the debt in about twenty years (when they are too old to be in government, so who cares?) This is how borrowing grows. And grows. And grows.
Where does the borrowed money come from? It is borrowed from institutions (banks) and individuals (for example National Savings Bonds) and from selling Government Bonds.
This is all a bit boring, so let’s have another story. This one is a true story.

Our story begins years and years ago, when Egypt was run by Pharaohs. One night, when most of the world was asleep, Pharaoh stood next to the river Nile. He watched the black water lapping against the bank and listened to the frogs chirrup peacefully. Suddenly, the water began to swirl. Pharaoh watched carefully, was a crocodile about to emerge? He watched the water part as a nose appeared. It was a pink nose.
     Feeling confused, Pharaoh leaned closer. The water was bubbling and swirling and the nose began to be joined by others. There were seven and they all began to emerge from the water. First there were nostrils, huffing and puffing droplets of water, then long furry faces with long lashed eyes. Then strong necks and heavy shoulders, then backs and tails and legs. They were cows! With much splashing and mooing, the cows fought their way to the bank. When their hooves were safely on dry land, calm descended and they began to graze, nosing amongst the reeds for food. Pharaoh watched in amazement. The cows were fat, with great pink udders bursting with milk. Their damp coats shone in the moonlight, their stocky legs bearing the weight of wide flanks as they wandered along the river bank.
      Then the water began to swirl once more, to bubble and boil. Seven more noses appeared, followed by snouts and eyes and bodies. Pharaoh watched as seven new cows heaved themselves onto land. But these cows were not lush and fat and brimming with health. They climbed weakly from the river, emitting only the thinnest of moo. They were skinny beasts, with shrunken udders and sharp bones protruding from their flesh.
     The thin cows approached the fat cows. At first, pharaoh thought that they too were going to eat the lush grass that grew beside the river. But, in horror, he watched as they opened their mouths, showing great pointed teeth and they bit into the flesh of the fat cows. The night filled with screams and wails as the thin cows crunched through bone and flesh, lapping blood and chewing muscle. Pharaoh dropped, sickened to his knees. The thin cows had completely consumed the fat cows, yet they looked just as gaunt as before.
     With a great heaving sigh, Pharaoh awoke. It had been a dream, disturbing and vivid. He got up from his bed, drank some wine and emptied his bladder. Then, feeling tiredness seeping back he sank back into the comfortable warmth of his bed. His mind began to wander.
     This time he dreamed not of cows, but of wheat. He stood in a cornfield, feeling the golden sun warm his back and he saw that one stalk had seven ears of corn. They were plump and good. Then seven thin ears grew next to them, straggly and full of blight. The thin ears swallowed up the fat ears.
     When Pharaoh awoke, he was very uneasy. His dreams had been vivid and he was unable to forget them. What could they mean? He was Pharaoh, a powerful man, so he began to tell everyone he knew about the dreams, asking what they might mean.
Eventually, one of his servants told him about a man who he had met years ago, when serving time in prison. The man was called Joseph and he could interpret dreams. Pharaoh had Joseph hauled from prison and told him his dreams.
     Joseph said that God would tell him the meaning. He told Pharaoh that both dreams had the same meaning. There would be seven good years, when the harvest would flourish and everyone would have plenty of food. This would be followed by seven bad years, when there would be a famine on the whole land. He said that God had sent the dreams, so that Pharaoh could appoint a wise man to organise the food. During the good years, they could put some of the extra food into storage, so that during the famine they had a supply of food to survive on. Pharaoh was very glad to know the meaning of his strange dreams, and being a wise leader, he appointed Joseph to be in charge of all the food.
     And that is the end of the story. (Actually, it isn’t – you can read more in Genesis 41!)

Let’s look at another true story. From 2002 to 2007, the British economy was doing well. Remember, this means more tax (income for the government.) So, were they wise like Pharaoh? Did they pay off some of their debt? Er, no. Actually, they increased the borrowing by having a deficit. They still spent more than they were earning.
Then, in 2008 there was a financial crisis. They had to borrow even more because they now were receiving less in tax plus they had to bail out some banks. Oh dear, sad story.

Now, what happens if this continues? “Does it matter?” I hear you ask, “What happens if a government goes bust?” Well, we can look at countries where exactly that has happened to find out the answer. Greece is one example. Other countries stepped in to help. They decided that some of the debt could be ignored and never paid back (so institutions and individuals who were owed money would never be paid back.) They also loaned them some money (from the International Monetary Fund.) They gave the loan in chunks, with lots of conditions, refusing to pay the next installment if Greece did not conform. They set tough conditions on how Greece was to be run.
Now, because Greece was part of the European community, it was saved from the worst consequences of going bust. If we look at Russia and Brazil, we can see how awful life could become. One of the first things to change is the exchange rate (how much your currency is worth compared to other countries currencies.) This makes all imported goods very expensive. Too expensive to buy. So, if you were Russian, you could only afford Russian cars, Russian petrol, even (horrors) Russian chocolate. Anything that is imported becomes way too expensive to buy. This would not be good for Britain….

At the moment, all politicians are discussing “deficit reduction”. It should be noted that what they mean is that at some point in the future, they will stop spending more than they earn. No one is suggesting that they should only spend what they earn now. The borrowing continues to grow……..


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The Mysteries of Insurance

PPI and the Mysteries of Insurance

     I was recently in a mobile phone shop. In front of me in the queue was a teenaged boy, about the same age as my sons. He had just chosen a very smart new phone and was in the process of paying. It was too hot in the shop and I was bored and wanting to leave, daydreaming and not really concentrating. Then I heard the salesman offer him insurance and I began to tune in. The salesman had a great patter, all about how annoying it would be if the boy lost his phone, how he was spending £200 on a new phone and if it was stolen on his way home, that was it, no phone, no £200. However, for a small amount each month, he would only need to pay the first £50 and then the shop would replace his phone, with a brand new one, for free. Was he prepared to risk having nothing, or would he like to take out insurance and be sure that his phone would be replaced?

     “No,” I shouted, “Don’t do it! The amount you will pay over two years plus the £50 excess is more than enough to buy a much better phone. And how likely is it to be stolen anyway? Quick, run away.”
Actually, I didn’t. Not out loud anyway. My children have spent many years teaching me what is socially acceptable and even I knew it would be inappropriate to shout at a complete stranger. However, in my head I was. Hence the purpose of this article.

      Do you understand insurance? Now, in the UK, ripping off teenagers is not illegal, as long as you explain everything to them first. Even if they are slightly dim, even if your patter is exceptionally impressive and biased, that is not against the law. We have a basic principle in our law that states “buyer beware“. That means, the responsibility for checking and understanding is with the buyer. Anyone can sell you anything and if they correctly explain (even very briefly or with a strong bias) what is involved, that is not against the law. It is up to the buyer to be wise.
When someone tries to sell you insurance, listen carefully. Use the calculator on your mobile if necessary or tell them you will think about it and come back tomorrow. Be sure that financially, it will actually benefit you. Do not trust them. Especially on mobile phones.
There is a rumour that mobile phone companies make more profit on selling insurance than they do on selling phones. Is it your money they are taking?

     In the last five years however, the government has subtly changed this for banks. For big banks, the principle seems to be “seller beware”. This means, the responsibility for being sure the correct product is being sold, that it really will benefit the customer, is now increasingly with the bank, not the person buying.
So, if you recently bought a product at a bank, like an ISA or insurance and you now feel that actually, it was not the best product for you, go back. If the bank does not refund your money, you can write to the ombudsman and they probably will. The government has not changed the law (which is still “buyer beware”) but it has forced banks to behave differently. This is due mostly to PPI.

     PPI has been huge. It has caused those annoying phone calls that always arrive when you are in a rush or in the bathroom. It is why we get those irritating texts when you think someone must love you after all but no, it is an irritating claims management company (read “shark”) hassling you. It has also had a huge impact in the last five years on the car industry because of all the reclaimed money increasing their new car sales! So what exactly is it?

     PPI was Payment Protection Insurance. It was always a rubbish product. If you had a loan, you could take out an insurance so that if you lost your job and couldn’t manage your monthly repayments, the insurance would pay them for you. But it only paid for a short time and the insurance itself was quite expensive. Banks did things like add it onto the end of the loan, so you paid them back for longer but you didn’t really notice. Banks were also bad because they sold it to everyone. Even little old ladies or unemployed people who did not have a job to lose were sold PPI (boo, hiss, we all hate the banks….) They did what the mobile phone shops do, they explained it quickly and with bias so people agreed to pay without really thinking about whether it was good for them.
The government decided that banks should pay out. They wanted this for three reasons:
Firstly, banks had been bad so they needed to put it right. A punishment really.
Secondly, people like being given money. It makes them feel happy. People vote for governments they like….. or perhaps I am just being cynical.
Thirdly, the government wanted to shift the responsibility for selling the right products to the banks, away from the buyer.

      So the regulator (this is the bank police) have made new rules. Some of these were even back dated, so banks could be blamed for not doing things before the regulations were even written.If one of those annoying claims persons (aka shark) persuades you to write to your bank and say you were wrongly sold PPI, the rules are so tough that it is easier for the banks to just pay out without doing proper checks. Even people who never bought PPI in the first place are making claims. Which actually, is stealing. The claims management companies know this and decided that they want a share too (imagine sharks circling.)

      Okay, so PPI was a bad product and banks behaved badly when they sold it to little old ladies. But what do you think about what has happened since? One of the greatest things about the UK is the fairness of our legal system. Compared to most of the rest of the world, our legal system is fair and we trust it. It makes the UK a good place to live and do business with. Is it okay for them to be unfair to banks and ignore other companies? Do we want our banks to go bust?

     Should the same rules be applied everywhere? What this unfairness has done is make banks be “seller beware.” This safeguards people like us, who perhaps don’t really understand the financial products we are buying. Maybe the same principle should extend to mobile phone companies………


Every week a current financial issue is explained clearly at: under “mystery of money”

The Mystery of Pensions

The Mystery of Pensions


      Okay, so this week the UK Chancellor of the Exchequer, George Osbourne, announced in his new budget that when you retire, you now have more choices about taking out some money from your pension pot as a lump sum. There was then some discussion on chat shows and daytime TV (the sort of programmes that you deny to friends ever watching) about being able to buy that sports car or luxury boat you have always wanted with money from your pension pot. Hmmmm. This needs some further thought. Here follows a simple guide to pensions.

     First, we need to know that there are two different kinds of pension. The first kind is called “Defined Benefit”. This guarantees that when you retire you will receive a certain percentage of your final salary. For life. So, if you been a teacher your whole working life and retire earning say £30,000, you might receive £15,000 every year for the rest of your life plus a £45,000 lump sum at the beginning. It will be index linked (which means if inflation goes up, so will your pension.) When you die, your spouse will get half of that. If you are lucky enough to have one of these pensions (and most companies do not now offer these, so really only government workers have them) then you are very fortunate. My advice is do not leave your job!

     However, most of us mere mortals will have what is called a “Defined Contribution” pension. (Yes, I know, very similar name. That is because financial people like to muddle us normal people. It makes them look clever. Really, they should be called “final salary pension” and “cross your fingers or pray hard pension.” That would be more accurate.) In this instance, when you retire, all the money you have paid in (plus any interest etc) is used to buy an annuity. An annuity is a financial product – you give in a lump sum, they then pay out an amount every month for the rest of your life. Some are index linked (goes up if inflation goes up), some are not.

     So, if you worked your whole life earning the same as a teacher, paying diligently into a pension fund, I estimate that you will retire with a pension pot worth £245,000. This would buy you an annuity (index linked and half for spouse on death) of £6,400 per year, with no lump sum. Pause for a moment. You have paid about £200 every month into a pension fund. That is a lot of money. You will receive about £6,000 a year to live on. That is not a lot of money. It will not allow for many ice-creams. Or even much bread.

     Now, the amount of money in your pension pot, the amount you have to buy an annuity, might have gone up or down depending on how the pension company has invested it. You need to keep an eye on it from time to time. Do not just trust it will “be enough”.

      The new rules that were announced in the budget apply to defined contribution pensions. These are what this article will be discussing.

     My first point is that if, when you retire, you take out a quarter of your pension as a lump sum, then your pension (what you receive each year for the rest of your life) will be a quarter less. This is not difficult maths! So, before you buy that yacht/ferrari/cruise/conservatory, check that when you are eighty you will still have enough money for food and heating.

     Secondly, do not over estimate how much you will receive. Pension companies are run by people who like numbers. They may wear glasses and polo shirts but they are not necessarily bad nor do they wave magic wands at things. You might work for forty years and pay (what feels like a lot) into a pension pot. You may then be retired for thirty years or more. The amount you have paid in, when spread over those retirement years may be a lot less than you think. You need to check now, before you retire and think about the numbers (brace yourself. This is your income for a long time. Force yourself to check.)You might want some chocolate when you have retired. You might even want electricity or some new clothes.

     Thirdly, when you retire, choose your next pension company – the one who will pay the annuity – carefully. It might be the same company who you have been saving with but it doesn’t have to be. Look at how much you have saved and then ‘shop around’, ask how much different companies will offer you each year that you are retired.

     Finally, think about how pension companies work. As I said before, they are maths people. When they are deciding what annuities to offer they consider things like life expectancy, stock market predictions and interest rates. Interest rates are very important. At the moment, March 2015, interest rates are at an all time low. This means annuities (remember, thats the amount you actually receive to live on) are also at an all time low. However, everyone who knows about these things, expects them to go up again. So, (big point, get ready) people about to retire should consider delaying buying their annuity. Got it? If you can work a couple of extra years or leave your pension in it’s pot for a while and not start the annuity, you might be a lot better off. Your income might be significantly higher for your whole retirement if you can wait until interest rates go up a bit.

     Some of these issues are uncomfortable to think about and if you do not enjoy numbers then they are a bit of an effort. However, think about how much you would like to receive every month when you have retired and then check how much you are likely to receive. Do not wait until it’s too late. Everyone needs chocolate, it’s a basic human right…..

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