The bleak state of the public finances

November 29, 2011 7:00 AM

Getting debt under control is proving harder than anyone envisaged

- David Cameron last week



At the time of the March Budget, the Office for Budget Responsibility forecast that borrowing would overshoot the Coalition's original 2010 forecasts by a cumulative £46 billion. The overshoot was entirely attributable to a spending overrun:



Since then growth prospects have deteriorated, largely reflecting the turmoil in the Euro area. So how much worse are things now?

According to the latest monthly public finance data (covering April to October) borrowing this year seems to be only slightly higher than the increased March forecast. However, tax revenues are coming in below expectations - Corporation Tax receipts have been especially weak. And some elements of spending - including debt interest and social security - are running higher than expected.



Against that, there is now evidence of retrenchment in other areas of government spending. Public sector employment fell by 4 per cent over the last year (to Q2), although average earnings are still increasing (up 2 per cent in the year to September).

The overall fiscal picture remains one of slippage. Borrowing is already forecast to be higher than originally planned, and the setback to European growth prospects means that the OBR's new forecasts will be worse again. On unchanged policies, eliminating the current deficit by mid-decade now looks unlikely.

Yet despite that, the bond markets have continued to support the government, with funding costs down to a 60 year low. It is an impressive pay-off for maintaining fiscal credibility.

However, the gilt market is on very thin ice. Inflation is now more than twice the yield on 10 year gilts – 5 per cent inflation vs. 2.3 per cent yield – implying that the market is taking a huge amount on trust.



The lesson of history is that such trust can be very fragile. The UK may be viewed as a haven of fiscal stability compared to the Euro area, but negative real yields are unlikely to be sustainable for long.

The forecasts built into the March 2011 budget allowed for higher average gilt yields than those currently in place – rising up to 5.1 per cent by 2015-16. So right now, the public finances should be turning out better. But as we've seen, they're not.

And given the inflation background, yields could easily go higher than allowed for in March. According to the OBR, for every one percentage point increase in yields above their baseline assumptions, debt interest payments would be £6 billion a year higher by 2015-16, with further cumulative increases beyond that.

And of course, the official debt is only one component of the real national debt. To get a complete picture we also need to take account of the government’s off-balance sheet debts. These include its unfunded pension liabilities and PFI contracts. Servicing of those liabilities means that the true cost of debt servicing (debt interest plus public sector pensions plus state pensions plus PFI) over the next few years will be around treble the official debt interest forecast:



This highlights an important longer term issue - the cost of our aging population. Because of the rising cost of pensions and healthcare for the elderly, we will need to continue our programme of fiscal consolidation far beyond 2015-16. According to recent calculations by the IMF, between 2010 and 2030, the UK needs to tighten fiscal policy by 13 per cent of GDP - the fifth biggest tightening of any advanced country. Against that, the current budget projections only allow for a tightening of around 8 per cent.

In these difficult circumstances, the Chancellor must use the Autumn Statement to underline his fiscal resolution. There is certainly a case for growth promoting tax cuts, but any such moves must be backed by a tougher stance on public spending.

In particular, we continue to believe that that the government should commit to a third fiscal rule, limiting the growth of public spending over the medium term. Such a rule could allow the Chancellor scope to cut some taxes in the short-term while reassuring the markets that the overall budget remains on a sustainable path.
Getting debt under control is proving harder than anyone envisaged

- David Cameron last week



At the time of the March Budget, the Office for Budget Responsibility forecast that borrowing would overshoot the Coalition's original 2010 forecasts by a cumulative £46 billion. The overshoot was entirely attributable to a spending overrun:



Since then growth prospects have deteriorated, largely reflecting the turmoil in the Euro area. So how much worse are things now?

According to the latest monthly public finance data (covering April to October) borrowing this year seems to be only slightly higher than the increased March forecast. However, tax revenues are coming in below expectations - Corporation Tax receipts have been especially weak. And some elements of spending - including debt interest and social security - are running higher than expected.



Against that, there is now evidence of retrenchment in other areas of government spending. Public sector employment fell by 4 per cent over the last year (to Q2), although average earnings are still increasing (up 2 per cent in the year to September).

The overall fiscal picture remains one of slippage. Borrowing is already forecast to be higher than originally planned, and the setback to European growth prospects means that the OBR's new forecasts will be worse again. On unchanged policies, eliminating the current deficit by mid-decade now looks unlikely.

Yet despite that, the bond markets have continued to support the government, with funding costs down to a 60 year low. It is an impressive pay-off for maintaining fiscal credibility.

However, the gilt market is on very thin ice. Inflation is now more than twice the yield on 10 year gilts – 5 per cent inflation vs. 2.3 per cent yield – implying that the market is taking a huge amount on trust.



The lesson of history is that such trust can be very fragile. The UK may be viewed as a haven of fiscal stability compared to the Euro area, but negative real yields are unlikely to be sustainable for long.

The forecasts built into the March 2011 budget allowed for higher average gilt yields than those currently in place – rising up to 5.1 per cent by 2015-16. So right now, the public finances should be turning out better. But as we've seen, they're not.

And given the inflation background, yields could easily go higher than allowed for in March. According to the OBR, for every one percentage point increase in yields above their baseline assumptions, debt interest payments would be £6 billion a year higher by 2015-16, with further cumulative increases beyond that.

And of course, the official debt is only one component of the real national debt. To get a complete picture we also need to take account of the government’s off-balance sheet debts. These include its unfunded pension liabilities and PFI contracts. Servicing of those liabilities means that the true cost of debt servicing (debt interest plus public sector pensions plus state pensions plus PFI) over the next few years will be around treble the official debt interest forecast:



This highlights an important longer term issue - the cost of our aging population. Because of the rising cost of pensions and healthcare for the elderly, we will need to continue our programme of fiscal consolidation far beyond 2015-16. According to recent calculations by the IMF, between 2010 and 2030, the UK needs to tighten fiscal policy by 13 per cent of GDP - the fifth biggest tightening of any advanced country. Against that, the current budget projections only allow for a tightening of around 8 per cent.

In these difficult circumstances, the Chancellor must use the Autumn Statement to underline his fiscal resolution. There is certainly a case for growth promoting tax cuts, but any such moves must be backed by a tougher stance on public spending.

In particular, we continue to believe that that the government should commit to a third fiscal rule, limiting the growth of public spending over the medium term. Such a rule could allow the Chancellor scope to cut some taxes in the short-term while reassuring the markets that the overall budget remains on a sustainable path.

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