Liz Truss has pledged to put Covid debt on a ‘longer-term footing’ as part of her bid to become the next Prime Minister. The details are sketchy, but the proposal seems to be to extend the maturity of £311 billion of pandemic-related borrowing to lock in low interest rates, and to slow the pace of debt reduction in the meantime. Here is my initial take.
For a start, it is right to talk about ‘Covid debt’. Rishi Sunak has questioned whether there is even such a thing. It is true that the government has not issued any bonds with ‘Covid’ stamped on them, or with special terms. As far as the financial markets are concerned, ‘debt is debt’.
But this isn’t the ‘gotcha’ moment that some think. Hypothecating part of the debt to particular spending is not so different from (say) claiming that the additional revenues from the National Insurance increases will pay for the NHS. In reality, the extra money will just go into a single pot.
What’s more, it does make sense for the government to look differently at the additional borrowing due to the pandemic – including in terms of how and when it should be repaid – and to adjust policy accordingly.
The key point here is that the cost of the pandemic is a one-off (or at least, the response to what is hopefully a once-in-a-generation emergency). The figure of £311 billion is the OBR’s March estimate of the total cost of pandemic-related support’ of which 99% was run up in just two years.
If a family was hit by a large bill which is not expected to be repeated any time soon, such as repairing damage to a house or car, it would be reasonable to borrow to spread this cost rather than slash other spending to balance the budget.
Some might still ask whether it is fair to pass more of the fiscal costs of the pandemic on to future taxpayers. But they will also benefit from inheriting a stronger and healthier economy as a result of the Covid support, in the same way as later generations benefited from the victories in past wars.
This still leaves a number of questions about Truss’ plan. In particular, how would it actually be implemented? I’m interpreting this as meaning two things.
First, it means locking in historically low interest rates (negative in real terms) by lengthening the maturity of borrowing. The average maturity of UK government debt is already relatively long (about 15 years), but it could be longer.
This does not have to involve unilateral changes to the terms of existing bonds, which would amount to a technical default. Instead it could be achieved by buying back shorter-dated bonds at the prevailing market prices, financed by selling new longer-dated bonds.
There are a number of variations on this idea. The Adam Smith Institute has suggested replacing a chunk of existing debt with ‘consols’, or ‘perpetual’ bonds, which pay regular interest but do not have a fixed redemption date. They have often been used to finance wars.
This would have the advantage that the government never actually has to pay back the principal amount of the debt. Indeed, some consols issued to pay for the Napoleonic Wars were only finally paid off in 2015.
I’m not yet sold on the consols proposal myself, partly because there will be a price to pay for this flexibility in the form of higher interest rates. I also think that governments should face the discipline of having to pay back debt – or at least have to refinance it – within a fixed period. My preference would therefore be to issue more conventional longer-dated bonds instead.
But the consols proposal is much better than another suggestion – that the government should simply write off Covid debt altogether, and repay bondholders with money created by the Bank of England. This would be far more damaging for fiscal and monetary credibility, shred the independence of the central bank, and fuel more inflation.
Secondly, Liz Truss’ proposal would mean being more flexible about the pace at which the UK public debt-to-GDP ratio is reduced. The current ‘fiscal mandate’ requires public sector net debt (excluding the Bank of England) to be falling as a percentage of GDP by the third year of the rolling forecast period, which is currently 2024-25.
One option would therefore be to extend this deadline by a year or two. But this would probably not be necessary, because the underlying debt-to-GDP ratio is currently expected to be falling by 2023-24, a year earlier than required. This means that there is already some headroom against this target (about £28 billion on the latest OBR estimates, though calculations from the CEBR suggest the true figure might be twice as much as that) which could be used to finance higher investment and tax cuts without changing the existing rules. Debt would then still be falling in three years time.
To be clear, lengthening the maturity of debt, changing the fiscal rules, or simply making more use of the headroom in the existing rules, would probably mean more borrowing, at least initially. These changes would not ‘pay for tax cuts’ in the early years, or increase the ‘fiscal room’ against the current targets.
In particular, long-term interest rates are currently higher than short-term interest rates. For example, 30-year gilt yields (around 2.6%) are about 50 basis points above 10-year yields (2.1%). An additional 50 basis points of interest on £311 billion of debt might cost £1.5 billion a year (and this assumes that the government could undertake this switch without widening the spread further).
Nonetheless, this should still be worth doing. It is reasonable to assume that market interest rates will rise a lot further in the coming decades. This means that future taxpayers will benefit from paying the lower rates that have been locked in by extending the duration of borrowing.
It is also perfectly acceptable to reduce debt more slowly than the current plans. Most economists agree that UK fiscal policy has been tightened prematurely, that supporting growth should be the priority (even if some favour spending increases over tax cuts), and that the levels of UK debt are still manageable in the meantime. It is not therefore a straight choice between cutting taxes now and spending more on essential public services, as some like to claim.
In summary, there is a strong case for lengthening the maturity of debt, and for more flexibility on the timing of debt reduction. Indeed, this applies regardless of Covid. These changes alone would not necessarily create extra room for permanent tax cuts, and they probably would mean more borrowing in the short term. They therefore need to be part of a more ambitious economic plan, including supply-side improvements. But the principles here are sound, and the details can come later.