In last week’s Budget, there was much talk about the need for us to be fair to future generations and run a responsible fiscal policy, i.e. reduce the ratio of government debt to GDP. This has got me thinking about the fundamentals of public finances.
I often encounter people who speak about the eventual need for us to repay the national debt. Yet, although individual government debt securities are indeed always paid back (at least in this country), these repayments are usually financed by issuing other debt securities – so the overall debt is never actually paid back.
We do, however, from time to time reduce the significance of this debt in the economy by keeping such a tight hold of new borrowing (and, very occasionally, running a surplus) that the debt total rises at a slower rate than GDP, with the result that the ratio of debt to GDP falls.
Over the last several years, however, we have been doing the opposite. From a low point of 21.6pc in 1990/91, debt was driven up by the global financial crisis and the Covid pandemic, followed by the war in Ukraine. It is now running at about 98pc of GDP.
Does this matter? I am going to give a frustrating answer, typical of economists: yes and no. We have had much higher rates of government debt before. After the Napoleonic wars the debt ratio almost reached 250pc of GDP. And again during the First World War. The Second World War saw the ratio exceeding 250pc. Yet the economy did not collapse. Indeed, during the 1950s when the debt ratio averaged 147pc, the UK economy grew at an average annual rate of 3.1pc.
Similarly, other economies such as Japan have managed to run with large government debt ratios and the roof hasn’t fallen in.
So what is all the fuss about? Firstly, if you start off with such a huge debt ratio then it is very difficult to respond to a future crisis – a war or another pandemic, for instance – with strongly supportive fiscal policy. Adding still more debt then risks the debt ratio exploding as markets worry that they will never get their money back and the interest rates on which they will lend rise.
Such circ*mstances usually end in either default or extremely high inflation, or both.
Secondly, the debt needs to be serviced. How burdensome this can be was very evident in last week’s Budget. Interest payments on the government’s debt are now running at about 4.5pc of GDP. They account for over 10pc of government spending.
This is where the consequences of high debt hit home. You can overdo the point about future generations; after all, they will be holding more government debt. Admittedly, some of this debt will be held by foreign investors and interest payments on these foreign holdings are a net loss to the UK.
But for the rest of it, this debt is owed to ourselves. So what is the problem? The problem is that, other things being equal, the need to service these debts means that taxation is higher by some 4.5pc of GDP or government spending is lower by this amount, or some combination of the two.
Accordingly, because of the debt, we and future generations suffer the economic consequences of depressed incentives and economic distortions created by taxation and/or enjoy reduced benefits from state spending.
Our debt interest burden has quite a history. For most of this century, as a share of GDP it amounted to about 2pc. In 2020/21 it even got down to about 1.2pc. And all this despite the explosion of government borrowing because of the Covid pandemic, coming on top of the large increase in borrowing in the wake of the financial crisis. No wonder, then, that politicians and financial markets were not much concerned about debt interest.
There are no prizes for guessing what explains why debt interest was so low during these years. It was the unprecedentedly low interest rates of that period that allowed the consequences of the borrowing splurge to be hidden from view. Once interest rates started to rise then the consequences became clear. And debt was still surging.
Debt interest being such a large factor as it is now is far from being a new phenomenon. During the Napoleonic Wars, debt interest accounted for almost 60pc of government spending. From the end of the Second World War until the mid-1980s, on average debt interest accounted for about 10pc of all government spending. A combination of inflation, real economic growth, occasionally tight fiscal policy and (eventually) low real interest rates saw it fall back to just over 2pc in 2020/21 after which, as we have seen, it surged higher.
We are by no means out of the woods yet. According to current fiscal plans, although fiscal policy will be tightened over coming years, the debt ratio doesn’t peak until 2026/27. In due course, sooner or later, interest rates will come down and this should help to reduce the cost of new borrowing.
Even so, according to the Office for Budget Responsibility, after falling back a bit over the next few years, debt interest as a share of GDP starts to rise again.
The reason is that throughout this period we have continued to enjoy the benefits of the Government having financed some of its requirements with borrowing carrying very low rates of interest. As those gilts mature, they will need to be replaced with gilts carrying a higher rate of interest.
Accordingly, having fallen below 8pc, by 2028/29 the ratio of debt interest to overall government spending is set to rise back up to 8pc.
It is often said that we will have to bear the consequences of so much government largesse in the Covid years and beyond. This is where we see the consequences – not in the need to repay the debt but in the continuing costs of servicing it.
Roger Bootle is senior independent adviser to Capital Economics. roger.bootle@capitaleconomics.com
