Rishi Sunak is warning that a one percentage point increase in the interest rates paid on government debt could add £25bn to the annual debt interest bill. Does this stack up? And how worried should we be?
For a start, the £25bn figure is factually correct. There has been some confusion about this on Twitter, with Richard Murphy even accusing the government of a ‘straightforward lie’.
Murphy might have a better point if Sunak was only talking about ‘gilt yields’, or the ‘immediate impact’. But the £25bn refers to ‘all interest rates’ (front page of Saturday’s FT) and to the impact of ‘a one percentage point increase in the cost of borrowing’ on the annual bill ‘by the end of the parliament’ (front page of the Sunday Times).
What’s more, £25bn is clearly in the right ballpark. Very crudely, the OBR is forecasting that public net debt will top £2,500bn within a few years, and of course 1% of this would be about £25bn.
This figure is also justified in a more sophisticated way by the OBR’s ready reckoner (table 3.23 in the November 2020 Economic and Fiscal Outlook – supplementary fiscal tables: expenditure) which I’ve reproduced below. The numbers here take full account of the long maturity of borrowing in the gilt market, but also the fact that the Bank of England has reduced the effective maturity of government debt by swapping gilts for central bank reserves which pay the Bank’s short-term interest rate (currently just 0.1%).
Admittedly, to arrive at the £25bn figure in 2024-25 you have to assume that conventional gilt yields, the cost of borrowing via inflation index-linked gilts, and, most importantly, short-term official rates all rise by an additional one percentage point. But the Chancellor did say ‘(all) interest rates’, so this is not inconsistent.
Nonetheless, we can question the circumstances in which all these rates might rise. The £25bn figure is what it is and not wrong. But are the underlying assumptions credible?
Many MMTers (including Murphy) dismiss the possibility of any increase in short-term rates, presumably on the basis that the government could order the Bank of England to continue QE and funding asset purchases at just 0.1%, regardless of economic and financial conditions and whatever is happening to inflation. But it’s not obvious that this is any more plausible.
Even if it would be legal to trample over the Bank’s independence in this way, it would undermine credibility and market confidence. The result would probably be a run on sterling and an even bigger rise in gilt yields (including inflation index-linked gilts, of whose existence some people still appear blissfully unaware).
A more sensible argument is to that the impact of any increase in interest rates also depends (crucially) on why interest rates are rising.
It’s overwhelmingly likely to be because the economy has recovered more quickly than expected. This would then provide an offsetting boost to the public finances in the form of higher tax revenues and lower welfare spending (aka the ‘automatic stabilisers’).
To illustrate this, as a rough rule of thumb, a 1% increase in GDP reduces borrowing by 0.5% of GDP. The OBR is also forecasting that GDP will be over £2,500bn in 2024-25, so even if GDP is just 2% higher than expected by then (not unreasonable), underlying borrowing will be £25bn lower. This would offset the cost of a 1pp increase in interest rates on the debt, at least in that year.
Just as importantly, it would reduce the debt-to-GDP ratio too. This matters far more than the absolute size of the debt (in terms of billions, or even trillions, of pounds). (I recently wrote some more on the debt-GDP-ratio here.)
Put another way, rather than having to raise taxes or cut spending by £25bn, the government could borrow an additional £25bn to pay the interest, add this to the stock of debt, and the burden of debt (represented by the debt-to-GDP ratio) would still fall as the economy grows.
Rather than worrying about the risk that interest rates might go up, it makes more sense to think about where interest rates (r) are relative to the growth rate of the economy (g) – and to worry about g. As long as r < g, there’s plenty of fiscal space.
In short, the Chancellor should continue to focus on boosting economic growth in the Budget, rather than ‘consolidating the public finances’. (On that at least, I’m sure Richard Murphy and I would agree.) And this is despite the recent jump in gilt yields, which are still extremely low.