This fear is already stalking economic policy. In the budget, the Office for Budget Responsibility (OBR) forecast that the ratio of debt to GDP would exceed 100 per cent in fiscal year 2022-23 and be above or close to this figure for the next three fiscal years too. To allow the OBR to say that debt would fall as a share of future national income, the chancellor announced that some measures, such as investment allowances, would last only three years.
With western countries including the UK now seeing the end of cheap money, economic vulnerabilities are high. This has already exposed financial cracks, as we saw last autumn with liability-driven investments and more recently with some banks. Since the 2008 global financial crisis, the UK has been hooked on cheap money, with low interest rates and quantitative easing (QE). It was right that that policy was eased after that crisis.
But it has been a mistake to keep monetary policy loose since then. That fed rampant asset price inflation, including high property prices, led financial markets to not price properly for risk and contributed to a misallocation of capital. The latter allowed zombie firms to survive and impeded structural transformation and the reallocation across sectors that is often associated with productivity growth.
When the pandemic hit, the Bank of England got it badly wrong by easing. It thought the supply-side shock was the same as the demand shock following the financial crisis, when it should have been obvious that it wasn’t. Its policy fed inflation. Meanwhile, QE has significantly increased the sensitivity of the government’s debt stock to changes in policy rates. It also saw the Bank become the biggest holder of gilts. Now, with QE being reversed, gilt issuance is soaring.
Over the last year, pressurised by the markets and inflation, the Bank has correctly tightened policy. But it needs to avoid overkill, as the impact of previous rate rises is still feeding through, and also be mindful of the extent to which credit and lending conditions may tighten. It is unclear where inflation will settle, but modest inflation alongside a normalisation of interest rates would allow a better allocation of capital — and higher productivity might follow.
Will growth allow the debt ratio to fall? In other countries, the US and Italy among them, debt to GDP ratios have started to fall over the last year.
We have been here before, such as after the Second World War, when debt to GDP was around 260 per cent. That ratio then fell steadily because of solid growth and financial repression. We need to see a repeat now, to avoid the debt trap becoming an economic reality. After the war, repression included rates staying as low as necessary to keep the pound stable. Now it might be a case of keeping them as low as fighting inflation will allow, but far higher than was the case over the last 15 years. Growing the economy will also be harder now, with trend growth around only 1.5 per cent.
Forecasters assume inflation will return to its 2 per cent target, but there is every likelihood it may settle above it. Over the next five years, a good benchmark might be to assume inflation around 3 per cent and growth around its 1.5 per cent trend. That would imply nominal growth of 4.5 per cent and this would permit the ratio of debt to GDP to fall significantly, provided interest rates were not too high.
But if the wider economic picture doesn’t allow the debt to GDP ratio to fall, then the focus of the markets will be on the need to keep the public finances in shape. The trend seems to be for ever-higher spending and taxes, particularly the further ahead one projects. Yet the UK already has the highest ratio of tax to income since the war and the highest ratio of public spending since the 1950s. Unless you raise economic growth, you have to either continue raising taxes or be serious about reforming what the state does and how it does it.
The ending of cheap money has focused attention on balance sheets across the banking sector and the wider economy. In an environment of high debt, the balance sheet of the public sector will face wider scrutiny too. Importantly, this month sees public finances reported in a new way. The Treasury says this will include “an additional balance sheet aggregate, public sector net worth (PSNW)”. This will be more comprehensive than the budget deficit and include the public sector’s financial and non-financial assets, such as the road network or buildings owned by the government, minus its liabilities.
The PSNW might suggest a fuller picture of long-term fiscal sustainability. It may incentivise a future government to allocate more to capital investment, but can this happen without broader spending control? The OBR forecasts the PSNW will fall from 81.6 per cent of GDP in 2022-23 to 73.1 per cent in 2027-28. As it impacts policy, financial markets will take notice of PSNW. The need to retain the confidence of financial markets is critical, particularly as uncertainty is high.
I do not think we will fall into a debt trap. Debt to GDP could even fall significantly as the relationship between the growth of nominal GDP and level of interest rates is critical. Yet the precariousness of public finances reinforces the need to keep inflation in check, so that interest rates do not rise too far. The fact that the UK has become a low-growth economy is the biggest challenge.
This article was published in The Times on 4 April, 2023.
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