I’m relatively relaxed about the fiscal costs of Covid: UK government borrowing will drop sharply as the economy recovers; the increase in the debt burden is manageable; and there’s no need to ‘pay for Covid’ with ‘austerity’ of any kind. (See my earlier blog explaining How I Learned to Stop Worrying and Love the Debt.) Nonetheless, this isn’t a green light to abandon fiscal responsibility altogether.
Let’s at least begin with the good news. Most importantly, government debt does not have to be ‘repaid’, only serviced. As long as the government can meet the interest payments, maturing debt can simply be rolled over.
Indeed, this is what usually happens. The last time the UK government ran a budget surplus was in 2000-01, since when public debt has increased by more than £1,700 billion – and most of that long before the pandemic.
Of course, there are limits to how much debt can be serviced in this way. But there is no particular threshold for the ratio of debt to GDP where sustainability becomes a problem.
The Office for Budget Responsibility’s latest central scenario (which actually now looks too pessimistic) assumes that debt will jump to 105% of GDP this year and then stabilise close to this level. But this ratio has been much higher in the past, particularly after the two World Wars, when it was then reduced by stronger economic growth and inflation.
Even today, UK government debt is still lower than in many other countries, including the US, France, Italy, and Japan.
In the meantime, the cost of financing this debt has actually fallen: the increase in the stock of debt has been more than offset by a fall in the average interest rate on this debt.
What’s more, the average remaining life of UK government borrowing in the gilt market is around 13 years. This means that even if bond yields do rise soon, it will be a long time before this is reflected in the overall cost of borrowing.
This is not just ‘kicking the can down the road’ for future generations. In ten to fifteen years the economy should be larger and the burden of a given stock of debt relative to income will be smaller.
Admittedly, a large proportion of government debt is now held by the Bank of England. This has helped to lower the cost of borrowing in the short term, but the precise way in which it has been done (swapping government bonds for floating rate central bank reserves) has increased the sensitivity to an increase in official interest rates.
But if interest rates do rise, we would also need to know why they are rising. Presumably, it would either be because the economy is recovering more quickly than expected, or because inflation picks up, or both. In either case, nominal GDP would also be higher and the boost that this would provide to the public finances is more than likely to offset any increase in debt interest payments.
In fact, I’d go further and suggest that the return of interest rates towards more normal levels would actually be a nice problem to have!
So far, so good. But this is not, alas, the whole story.
For a start, the long-term outlook is much more worrying. The OBR’s Fiscal Sustainability Report (published in July) includes scenarios where unchecked increases in public spending on health, social care and pensions could see debt balloon to more than 400% of GDP in 2070. That would be a very different ballgame.
In the meantime, even if the government doesn’t face the same financial constraints as a household, high public spending and borrowing still has other costs, including the poor allocation of resources and the risk of runaway inflation.
As even the more sensible proponents of Modern Monetary Theory (MMT) recognise, the state’s ability to print money does not mean it can also create real resources out of thin air. These constraints will start to bite again when the economy recovers.
Public sector spending has already averaged around 40% of UK GDP since WWII. In my view, this is already more than enough to fund good public services and a decent welfare safety net.
It must be possible to find substantial savings by pulling the state back from activities that can be done at least as well by the private sector – and still have room to increase public investment in the limited number of projects that cannot be left to the markets.
This is a very different way of thinking to that of many commentators, who take a certain path for public spending as a given and search instead for ways to raise the tax burden (usually to at least 40% of GDP) to meet it.
It is also important not to undermine the independence of the Bank of England. The central bank’s main job is to ‘maintain price stability’. Supporting government policy more generally is a secondary objective.
For now, there is no contradiction. The Bank’s Monetary Policy Committee (MPC) has judged that additional monetary stimulus is required to prevent inflation from becoming too low. Implementing this by using newly-created money to buy gilts has had the welcome side-effect of keeping government borrowing costs down.
But this could change. Facilitating a temporary increase in government borrowing to protect jobs and businesses during a 1-in-300-years recession is one thing. Subverting monetary policy to underwrite a permanent increase in the size and role of the state would be quite another.
Last, but not least, issuing unlimited amounts of debt is likely to drive up interest rates in ways that do threaten debt sustainability. If the government continued to rack up huge debts even in better times, the outcome could also be very different.
In summary, it is misleading to claim that the UK has already ‘maxed out its credit card’. But it would be even more misleading to suggest that the government has a ‘blank cheque’ to spend or borrow as much as it likes, whenever it likes.
Plain-speaking Economics 