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As public spending pressures grow, Rachel Reeves faces a battle to cut borrowing and keep markets onside
The year is 2034, and much has happened since we first entered our time machine. But one thing that hasn’t changed is the ever onwards and upwards march of public indebtedness.
A decade previously in the autumn of 2024, Britain’s national debt had passed 100pc of national income, a milestone that would have been regarded as barely conceivable a generation before, but had by then become such a familiar story among mature, advanced economies that it scarcely raised an eyebrow.
Our time traveller would nevertheless have been dismayed to learn that it then carried on rising, and from the vantage point of 2034, now stands at 125pc of GDP and still growing.
At the Treasury, they are tearing their hair out in despair.
Another of those “external shocks” that perennially batter the world economy has come sweeping in and, to their horror, government ministers find themselves bereft of the fiscal buffers to cushion the blow.
Worse, international investors have abruptly lost confidence in the country’s ability to service its debts and a buyers’ strike has taken hold in the UK gilts – government bonds – market.
The pound is in freefall and interest rates are rocketing, further increasing the Government’s borrowing costs and undermining its ability to tap bond markets for funds.
In desperation, Bank of England independence is suspended and its officials are instructed to print money to pay for the Government’s spending needs.
Inflation takes off and the pound falls further still; descent into economic, social and political chaos quickly follows.
This is a description of times to come, and it may not work out that way. Yet the trajectory is clear, and our imagined fiscal crisis may strike even sooner if nothing is done to change it. Already there is some small evidence of strain in the gilts market, should you look for it.
Yields are arguably higher than they should be given the likely fall in the Bank of England’s official policy rate. Credit risk is beginning to become a concern.
No one knows where the point of no return lies; the fact that public indebtedness has already risen as far as it has without the skies falling in has generated a certain complacency among policymakers.
How much debt is too much debt? How much will the markets tolerate? Quite a lot, it would seem, before things finally crack.
Yet as Michael Saunders, a former member of the Bank of England’s Monetary Policy Committee and now senior economic adviser to Oxford Economics, observes, no government would want to test where the breaking point might lie. The consequences are too dire to contemplate.
It is, however, worth noting that the last time the UK faced an all-out buyers’ strike in debt markets was in 1976, when the Labour government of the day was forced to go cap in hand to the International Monetary Fund for a bailout.
The circumstances and the structure of debt markets back then were very different; but so too was the national debt at less than half where it is today relative to national income. Catastrophic loss of market confidence, it seems, can strike at any moment. Think the Liz Truss mini-Budget debacle.
As Rachel Reeves, the Chancellor, prepares for her first Budget later this month, it is this overarching threat that must remain front and back of all she does.
In attempting to make Labour fit for government, Reeves donned the hair shirt and committed herself to roughly the same fiscal rules as her Tory predecessors, including that of getting debt falling as a percentage of national income by the fifth year of the forecast.
Yet at the same time she wants to spend a lot more on public works, which she regards as essential for long-term economic growth. Meanwhile, the pressures on government spending – from defence to the green transition to an ageing population – just keep on growing.
Already she’s caved into inflation-busting pay demands from public sector unions, adding nearly £10bn to the Government’s wage costs.
And she’s also promised to stick with a number of costly spending commitments, such as the triple lock on the state pension, a pledge that according to modelling by the Office for Budget Responsibility (OBR) will over time add a further 8pc of GDP to the national debt relative to less generous forms of indexation.
There will be no return to the austerity of public spending cuts, the Chancellor insists, but to avoid Tory claims of a “tax bombshell”, she ruled out increases in income tax, VAT, National Insurance and corporation tax.
Together, these four taxes account for three-quarters of all government income, leaving Reeves scrambling around in the foothills of the tax system for alternative revenue-raising measures.
You might think that this long list of apparently contradictory promises, aims and commitments makes an impossible circle to square. And you would probably be right.
Britain’s debt predicament is hardly unique: it is shared by virtually all mature, advanced economies of any size. Using IMF data, gross national debt in the US is 123pc of GDP, in France it’s 112pc, in Canada it stands at 104pc, in Italy at 139pc, and in Japan, a jaw-dropping 255pc.
In the UK, the national debt currently stands at £2.77 trillion in cash terms. On its current path, it seems only a matter of time before that total tips over £3 trillion.
Both nationally and globally, the rising tide of indebtedness is the economic story of our times, with no sign of a letup in sight. Recent analysis by the Institute of International Finance (IIF) finds that globally, total debt – including that owed by governments, households and companies – rose by a further $2.1 trillion (£1.57 trillion) in the first half of this year to a scarcely conceivable $312 trillion, or more than three times global GDP.
Yet it is the mounting size of government debts which gives the greatest cause for concern.
Projections in the IIF’s latest Global Debt Monitor suggest that government debt alone will rise from its current level of $92 trillion to $145 trillion by 2030, and then to more than $440 trillion by the middle of the century, such are the pressures for spending on the energy transition.
Long-term projections for the UK by the OBR look equally scary.
Based on policy settings in March 2024, public spending is projected to rise from 45pc to over 60pc of GDP over the next 50 years, but revenues would remain stuck at around 40pc. This would result in a rapid rise from the late 2030s onwards in the debt-to-GDP ratio to 274pc of GDP, and even more when the prospect of economic shocks are factored in.
This is only a projection, not a forecast, and in practice couldn’t happen. The markets would call a halt long before these dizzying heights could be reached. But it gives an idea of the scale of the challenge faced by policymakers.
“If we are to tackle the serious risks we face, muddling through is not an option,” says Lord Bridges, chairman of the House of Lords Economic Affairs Committee. “To put debt back on a gradual, downward path, tough decisions must be taken in this Parliament. And we need a revised debt rule that has teeth and holds ministers to account.”
All things are relative, and in some regards the situation in the United States is even worse. There seems to be no appetite at all among the two presidential candidates for the sort of fiscal consolidation needed to put federal debt back on a sustainable path.
On unchanged policies the fiscal deficit will remain at between 5pc and 6pc of GDP for at least the next 10 years, says the Congressional Budget Office, resulting in a debt-to-GDP ratio of 172pc of GDP in 30 years’ time.
Deficits of this size have been recorded only three times before since the Great Depression – during the Second World War, the global financial crisis and during the recent pandemic. Yet today we are meant to be in more “normal” times, when fiscal buffers are supposed to be rebuilt.
That the US seems to enjoy little difficulty in funding such a massive hole in the public finances owes much to what Valéry Giscard d’Estaing, a former French president, called America’s “exorbitant privilege”.
The dollar’s position as the world’s dominant reserve currency in combination with the innate strengths of the US economy makes the US particularly attractive to international capital, supporting significantly higher levels of public indebtedness than would be regarded as sustainable anywhere else.
Sadly, these are not attributes enjoyed by the UK and much of the rest of Europe. In a recent appraisal of the UK economy, the Organisation for Economic Co-operation and Development said that Britain needed urgent action if it were to stabilise its public debts.
Mounting pressure for additional spending on pensions and other costs related to an ageing population, the green transition, infrastructure, defence, skills and innovation has left the UK in a particularly vulnerable position, with already-high levels of debt and depressingly low rates of growth.
It’s true that relative to GDP, the UK has historically experienced much higher debt-to-GDP ratios than we see today. But on all three such occasions in the past it has been because of the extraordinary expenditures associated with major wars – first the Napoleonic Wars, then the First World War and finally the Second World War.
On all these occasions, moreover, relatively robust economic growth followed, quickly eroding the size of the debt down to manageable proportions.
At the end of the Second World War, government debt stood at an eye-popping 270pc of national income, yet by the early 1990s, a combination of strong growth and repeated bouts of elevated inflation had reduced its relative size to less than 30pc.
Even as late as the financial crisis in 2008, debt was still less than 40pc of GDP. That’s when the rot set in. Three major economic shocks in a row – the financial crisis itself, the pandemic, and the energy price spike – caused debt-to-GDP ratios to skyrocket.
None of it would have been possible without the support of zero interest rates, which fed the notion that almost any amount of debt was somehow affordable.
The analogy I like to use is with the house buyer who persuades his bank to give him a 100pc mortgage. As long as interest rates are low, this can easily be serviced from earnings. But when they rise, as they have done over the past two years, then he’s likely to be in serious trouble.
“We are reaping the whirlwind of years of quantitative easing,” says Bridges. “This lulled us into thinking rates would always be low and enabled the build-up of massive debt.
“It’s now payback time, but whereas in the past we had tailwinds to help us bring debt down, we now face multiple headwinds – demographics, decarbonisation and defence, all against the backdrop of deglobalisation.”
As economies slowed and atrophied, political leaders gladly reached for debt as an easy substitute for the real wage growth they struggled to deliver.
“The dubious idea that high debt hardly matters was born of the ultra-low interest rate era,” says Kenneth Rogoff, of Harvard University, co-author of a highly influential book on financial and fiscal crises, This Time is Different.
“Today’s high rates have poured a bucket of cold water on that view. Even when interest rates were ultra-low, high-debt countries such as Italy, Greece and Japan all experienced ultra-low growth, and even with modest growth more recently, have still fallen far behind.”
On the Left, it is still quite widely believed that Rogoff gets things the wrong way around – that it is government failure to borrow and spend more freely that is the real cause of low growth. Austerity breeds stagnation, they argue.
But Rogoff is unrepentant.
“Running deficits is generally good for short-term growth, inheriting high debt is not,” he says. “Consuming desserts is usually pleasurable, gaining weight afterwards less so. But of course in the case of infrastructure and education, good investments pay for themselves in the long run, and thus do not negatively impact long-run debt sustainability.
“A sensible policymaker looks at the trade-offs between short-run gain and long-run cost.”
One economist who takes a more sanguine view of today’s debt overhang is Jagjit Chadha, director of the National Institute of Economic and Social Research (NIESR). In a recent paper, the NIESR said that UK public debt was neither at crisis point nor was the situation desperate.
“The real long-term risk arises from an excessive singular focus on debt-to-GDP ratio targets at the expense of public investment to raise productivity and long-run output,” Chadha insists.
“The whole idea of fiscal space is completely artificial and arbitrary. I’m not against sound money. Obviously debt has to be controlled. But there is now a large amount of research to suggest that infrastructure spending in a country which has for decades been starved of it will have a huge effect on output, ultimately leading to lower debt.”
Chadha’s view is plainly shared by Reeves. “Growth is the challenge, investment is the solution,” she proclaimed at the Labour Party’s recent annual conference.
But first she has to convince the markets, and in today’s world that’s a tough ask. Part of the cause of rising indebtedness is that it has been too easy for the government to borrow.
With interest rates now much higher, and the Bank of England determined to reverse the quantitative easing that once provided one of the biggest sources of demand for the Government’s debt issuance, it has become more difficult and much more expensive to raise money.
Worse, the other big source of domestic demand for gilts – Britain’s once-mighty defined-benefit pensions fund industry – is fast drying up.
By forcing pension funds to buy gilts for liability-matching purposes, UK governments ensured a large and steady source of demand for their debt, and an extremely low real rate of interest to match – what’s known in the jargon as “financial repression”.
In so doing, hundreds of billions of pounds of pension liabilities have in effect found their way on to the public balance sheet. The asset that now backs them is no more than a UK government IOU.
But that process is now largely over, leaving the gilts market much more dependent on foreign investors than it ever has been in the past. Unfortunately for Reeves, international capital has the whole world to choose from; it’s much more picky and fickle.
Maintaining fiscal credibility therefore becomes of the essence. In recent decades, governments around the world have sought to sustain at least the pretence of fiscal discipline with rules and institutions that are supposed to keep them on the straight and narrow.
Little good does it seem to have done either. In the decade prior to the pandemic, when there were no economic shocks to speak of, UK public debt still managed to rise by 14 percentage points of GDP. If governments cannot constrain themselves even during normal times, what hope for the bad?
As it is, criticism of the current rules is almost universal. Particularly scathing is the Institute for Government, which says they incentivise “bad policy decisions shaped by short-termism and fictional spending plans – and do little to promote fiscal sustainability”.
The challenge for Reeves is to change the rules in such a way that they accommodate her ambitions for spending on roads, rail, hospitals and other forms of public infrastructure, but do not upset the entire apple cart.
Her promise was to broadly stick by the rules as they currently stand, so any change might be regarded as a breach of the manifesto. Justification comes in the form of a supposed £22bn “black hole” in the public finances, which she somewhat unconvincingly claims to have only discovered after getting into office and examining the books.
Believe it if you will, for it conveniently provides cover both for changing fiscal rules she had previously claimed she could live with, and for further raising the tax burden.
Options for change range from the purely definitional – stripping out losses on the Bank of England’s programme of asset disposals, and treating some liabilities, such as GB Energy and the National Wealth Fund, as off balance sheet – to the rather more radical.
The more radical includes some consideration of public sector assets in calculating net debt, or what’s known as public sector net financial liabilities. Debt would be reduced by allowing some illiquid financial assets, such as the student loan book, to be netted off.
An even more creative approach would be to use public sector net worth as the yardstick, defining net debt as the difference between the Government’s liabilities and its assets.
The drawback here is that though this would open up plenty of fiscal headroom for capital spending, it would also show the UK in a particularly poor light relative to other major economies. After years of privatisation, liabilities far outweigh assets, more so than any other G7 economy.
In any case, depending on which of these approaches she chooses, Reeves could bag herself anywhere between £10bn and £50bn a year of extra headroom for spending on supposed growth-enhancing projects. Soundings in the City suggest she might get away with at least some kind of change; it is plainly not right that under the rules as they stand, it is always the capital budget that gets chopped first whenever there is a problem.
Even so, there’s no getting away from the old Treasury rule of thumb that every additional one percentage point of GDP (around £28bn) in public spending will get offset by interest rates 0.6pc to 1.2pc higher than otherwise.
For Reeves to do two of the things she promised not to – change the rules and increase taxes – in her first four months as Chancellor would be quite something. There is no position in government where trust is more important than that of Chancellor. Mendacity is not a characteristic markets admire.
In the end, there’s no getting away from it: debt is debt, however it is dressed up and whatever it is spent on. One way or another, it seems destined to carry on rising, until …