Dicing with debt

by Mike Denham, former chairman

Since the turn of the millennium public sector debt as a percentage of GDP has tripled. It is now around 100 per cent of GDP and on official forecasts, set to go on increasing. The Office for Budget Responsibility projects that on unchanged policies it will be around 300 per cent by the early 2070s.

The government's annual debt interest payments have already rocketed to well over £100 billion, which is about what we spend on defence and law and order combined. And on unchanged fiscal policies, we will be borrowing ever larger amounts just to pay debt interest – a classic doomsday spiral that the OBR says will accelerate as we head towards mid-century and beyond.

Except, of course, we will never reach that point. The bond and currency markets will call time long before then. Just as in the 1970s, at some point market confidence will evaporate, and there will be a debt funding crisis – borrowing costs will spike, sterling will crash, and inflation will ramp up.

And we've already had a couple of warning shots. In 2022 adverse market reaction to the mini-budget was so damaging it required a policy U-turn and a change of administration to settle things. The market wobbles earlier this month weren't quite so dramatic - despite borrowing costs exceeding those after the mini-budget - but they still required emergency media statements from Treasury ministers pledging early and serious action to address the public spending problem.

Both episodes tell us we are already very close to the debt tipping point. And when we finally do tip over, whichever government is in power will be forced into an emergency programme of spending cuts and tax increases – just like those implemented by James Callaghan’s Labour government in 1976, only even bigger.

Because in important respects our current debt situation is now worse. As a percentage of GDP, official debt is now twice as big, and interest costs a quarter higher. Moreover, on top of its market debts, the government has huge unfunded public sector pension liabilities, now standing at around a further 100 per cent of GDP. Add in PFI debt, nuclear decommissioning costs, and unfunded state pension liabilities, and the real national debt now stands at over four times GDP (see here for the latest TPA estimate).

It is a wholly unsustainable position, and something has to give. The important question is what?

History tells us there are four ways of dealing with an unsustainable national debt:

  1. Repayment

    Nineteenth-century British governments regularly repaid large amounts of debt – that is, they ran budget surpluses. And more recently we've had three repayment interludes: when Harold Wilson's government was forced to tighten fiscal policy following the 1967 devaluation; when Nigel Lawson was Chancellor in the late 1980s; and when Gordon Brown was temporarily cohabiting with Prudence in the late 1990s. But all three were soon reversed.

  2. Default

    Many countries have defaulted – Argentina has defaulted nine times – but HM Government proudly boasts that it "has never failed to make principal and interest payments on gilts as they fall due". What it fails to mention is a string of partial defaults through what's known as debt conversion. The most recent was in 1932, when the National Government converted £2.1 billion of War Loan paying 5 per cent, into a new loan paying just 3.5 per cent, making all its holders significantly poorer at a stroke.

  3. Inflation tax

    Before the 1980s, all of HM Government's debt was denominated in fixed money terms, and even today, three-quarters of it still is. What that means is that governments have been able to work off their debts by running the printing press and engineering inflation – effectively a gigantic stealth tax on debt holders. Of course, it doesn't work with the inflation-protected index-linked gilts introduced in 1981. And crucially, it doesn't work if the markets get their retaliation in first by hiking bond yields to compensate for anticipated future inflation.

  4. Growth

    GDP growth is the holy grail of indebted governments. Growth lifts tax revenue, cuts social spending, raises GDP, and floats the government free. And it does so without making its creditors poorer: it's by far the best solution for everyone. The trouble is that highly indebted governments find it difficult to stimulate and promote growth. They have limited scope for tax cuts and find themselves boxed in by the very debts they're trying to work off.

The current government's hope seems to be that they can solve, or at least contain, the debt problem through growth. Unfortunately, there’s a decidedly mixed picture when it comes to the real-world measures needed to achieve that, as exemplified by Rachel Reeves’ disastrous tax-borrow-and-spend budget.

On the positive side, it is encouraging that the government is proposing to reform the planning system to simplify and speed it up. Similarly encouraging are the Chancellor’s recent announcements on Heathrow expansion, the proposed Oxford-Cambridge science “supercluster”, and much-needed infrastructure elsewhere.

It certainly constitutes a growth agenda, even if most of it would not bear fruit for many years. But words are one thing and action another. Wholesale throttling back on growth-destroying policies like net zero, enhanced employment rights, and business regulation, will be exceptionally difficult pills for Labour to swallow.

Moreover, such potential policy changes are not a substitute for an early re-think of fiscal policy. Spending is still spending, even when it’s spent on infrastructure, and even if the projects can somehow be brought in on budget. To get growth going again, the government urgently needs to demonstrate that it can grip the debt problem without ramping taxes ever higher.

As for outright default, we can probably rule that out because, unlike, say, Argentina’s US dollar debt, Britain’s debt is denominated in our currency. This means it’s open to the government to monetise the debt, as it’s already done on a huge scale through Quantitative Easing – another name for running the printing press.

Which makes a return of the inflation tax much more likely. We’ve already had one bout, with prices across the economy rising sharply following the invasion of Ukraine in 2022. There could easily be more to come over the next few years, particularly if a stuttering economy and continued shambolic policy-making further undermine international confidence in sterling.

However, there’s a catch. The catch is that the inflation tax only works if markets have failed to anticipate the increased inflation and failed to hike bond yields to compensate. Yet these days global bond investors are apt to hike yields quickly if there’s even a sniff of higher inflation. In 2022, gilt yields shot up from around one per cent to around four per cent in the space of just a few months.

For a government that is borrowing to finance its interest payments – as ours now is - a key issue is whether the rate of interest it’s paying on outstanding debt is greater or less than the growth rate of money GDP. If it is greater, then the additional borrowing to pay interest will be added to both the stock of debt and the debt-to-GDP ratio. And that ratio is important because it’s the growth of GDP that drives the growth of tax revenues to service the debt. If GDP growth falls short of debt growth, then the doomsday spiral gets a vicious twist.

Right now, money GDP is growing at an annual rate of around four per cent, broadly in line with the average interest rate on existing debt. But it’s important to note that the rate on new borrowing is now around one percentage point higher, and with planned gilt issuance running at £200 - £300 billion annually, the debt danger signal is flashing red.

So, with growth stalled and bond markets pushing yields well above inflation, the only way to get on top of the debt build-up is to stop borrowing, or better still, start repaying. And that means either spending cuts or tax increases.

Neither would be easy or popular, but as argued previously, spending cuts would be far more preferable to yet more tax increases. After surveying experiences around the world, an IMF paper spelt out the reasons why:

“The bottom line is that reducing the debt-to-GDP ratio depends a lot on how the budget deficit is corrected. If a surplus is increased by raising taxes, the downturn in growth may be so large that it raises rather than reduces the debt-to-GDP ratio. Deficit reduction policies based on spending cuts, however, typically have almost no effect on output, so they are a sure bet for a reduction in debt to GDP.”

Taxpayers must hope that our worryingly naive and inexperienced government is now aware of these realities and is sufficiently rattled by the dire reaction to its current fiscal policies to change course urgently. To do nothing risks a debt funding crisis, but to impose yet more tax increases could well make the eventual crisis even worse.

 

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