How deep a hole are we in? The Institute of Economic Affairs has just published a primer I’ve written on the state of the public finances, which digs into this question.
On the bright side, I argue that there is no need for any form of austerity, including tax rises, to fill a gap left by the pandemic. Nonetheless, fiscal responsibility is still important, and the long-term outlook is far more challenging.
Let’s start with the three positives. First, the increase in borrowing to pay for Covid does not itself have to be repaid; provided the government can continue to make the interest payments, debt can simply be rolled over. 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 with comfort, but the UK is still a long way from these limits. In its latest central forecast, published in last month’s Economic and Fiscal outlook, the Office for Budget Responsibility (OBR) predicted that public debt would rise to 105% of GDP this year. But this ratio has been much higher in the past, and is still lower now in the UK than in many other countries, including the US, France, Italy, and Japan.
Second, interest rates are likely to remain relatively low – by which I mean low relative to the growth rate of the economy – for the foreseeable future. Even if interest rates do rise soon, it is likely to be because the economy has rebounded and inflation has picked up, providing a boost to the public finances that would more than offset a bigger interest bill.
Third, the early rollout of the new Covid vaccine (along with economic data suggesting a smaller-than-expected hit from the second national lockdown) mean that the OBR’s ‘upside scenario’ actually looks the most likely.
In this case, economic activity would be back to pre-Covid level as soon as the end of 2021, the unemployment rate would peak only a little higher than it is now, and public debt would quickly fall back as a share of GDP. In short, there would be no significant long-term damage either to the economy or the public finances – and no fiscal hole to fill.
It never made sense anyway to be scaring people with talk of tax rises when the economy was only just getting back to its feet. Austerity of any form would only be likely to hold back the recovery. But now it is increasingly uncertain that tax rises would be needed at all.
Nonetheless, even if the impact of Covid is not as bad as feared, the longer-term risks are as big as ever. This is mainly about the demographic timebomb due to the ageing of the population.
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.
Indeed, public sector spending has already averaged around 40% of UK GDP since the second world war. 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 (rightly or wrongly) that additional monetary stimulus is required to prevent inflation from becoming too low. Implementing this by using newly-created money to buy gilts from private investors has had the welcome side-effect of keeping government borrowing costs down.
But this judgement 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, especially once the economy is operating close to full capacity again.
In summary, it is misleading to claim that the UK has already ‘maxed out its credit card’ or that taxes will have to rise soon to pay off Covid debts. 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.
This piece was first published by CapX