As we have a new government and we also have a better idea about the effects of the financial crisis on the public finances, I thought it would be worthwhile to update my 2008 paper, A Bankruptcy Foretold. Recalculating the UK government’s debt in 2010 gives a figure of £4.8 trillion or 333% of GDP – six times the official figure of £772 billion.

This figure is so high because it includes the liabilities from pensions debt –  financial commitments that the government has made but hasn’t set aside any funds to pay. If we think about a pension as deferred pay, the amount that I have included in my calculations is only the amount that has already been earned. This is a real debt, not a figment of actuarial imagination, as the government is obliged to pay it sometime in the future – but the value is less certain then the official debt. “Less certain” does not equate to zero, however, and there are long established practices of how to estimate this figure which companies have to use in their accounts.

This pensions debt is made up of two parts – unfunded public sector pensions schemes (e.g. teachers, civil servants and NHS occupational pensions) and unfunded National Insurance Fund pensions (i.e. state pensions).

Two immediate questions arise – can we afford to pay this debt and what should we do about it? Let us consider the first question as if this were a mortgage. Historically mortgages have been granted at approximately 3 times income (although this has increased recently). If we guesstimate the government’s potential income at between a quarter and a half of GDP, that would make the debt between 6 and 13 times income – which would make it on the very edge of affordability.

Clearly this level of debt will make it much harder to reduce taxes. It also means that if there is a serious shock of any kind (e.g. another banking crisis) there is no realistic way that the debt can be paid back. The situation is exacerbated by the recent bank nationalisation, though I have only made a small allowance for bank liabilities. However, if there were a severe economic shock, many of the banks’ debts might go bad, meaning that the government would be on the hook for up to another £1.5 trillion.

So what can the government do? Firstly, it has to act to stop the situation deteriorating. I have been calling for a while for proper accounting treatment for the debt – this is a minimum – but I have also become convinced that the only way that the government will manage the costs properly is if the pensions start to be funded. The government does not have a spare £4.8 trillion to fund past liabilities, but what it could do is transfer money in respect of future earned pensions as they become due into separate funds overseen by trustees – as happens in the private sector. In theory there is nothing wrong with a pay-as-you-go (PAYGO) system, but the government has proved over a long period that it is not capable of running one responsibly.

The other thing that has to happen is the negotiation of a “haircut”. What public sector workers and taxpayers currently have is an IOU from a near-bankrupt creditor. Swapping this for a smaller, but funded pension, would be a good deal.  What if we don’t do this? The Greeks are kindly showing us what happens next.

Click here to read A Bankruptcy Foretold 2010.