Without growth, higher inflation looms as the UK finances itself by printing more money
27 January 2025
Daily Telegraph 27/01/25
Sir Keir Starmer and Rachel Reeves’s attempt to grow Britain’s economy won’t correct its course Credit: Hollie Adams/Reuters
Last week another update on monthly public borrowing prompted more gnashing of teeth about whether the Chancellor will breach her fiscal rules. But these short-term concerns risk masking a deeper issue of major significance. Is Britain’s fiscal position sustainable?
The ratio of UK government debt to GDP is about 100pc. Admittedly, Japan’s ratio is much higher. But it also has high domestic savings and huge international net assets. America’s ratio is also higher than ours. But America is ... well, America. It issues the world’s currency. Italy, Greece and France also have higher debt ratios than ours. Do I really have to spell out why this isn’t a recommendation?
Nor is having a high debt ratio unusual in our history. The ratio was over 200pc of GDP at the end of the Napoleonic wars and it exceeded 250pc in 1946. It subsequently fell to a low of 22.8pc in 1990.
Nevertheless, we have a major debt problem now. Three events have recently driven debt markedly higher: the global financial crisis; the pandemic and subsequent lockdowns; the war in Ukraine and the associated energy shock. All of these damaged the economy and led to higher government spending.
Fundamental economic trends have also turned adverse. Economic growth has slowed markedly, while real interest rates are now significantly positive. Meanwhile, government spending on pensions, health and welfare has been growing faster than GDP. Initially, the fiscal effects were offset by the simultaneous fall in defence spending after the end of the Cold War. But defence spending must now rise substantially.
Why worry? First, with a low debt ratio you have the scope to let it rise in response to shocks such as wars or pandemics. With the debt ratio at about 100pc, we have just about used up that scope.
Second, the cost of servicing government debt accounts for about 8pc of public spending, reducing the amount of money available for other things.
Third, the relationship between debt and interest rates can become explosive. If the interest rate on the debt exceeds the economic growth rate then the debt interest bill will rise faster than GDP, thereby increasing the debt ratio.
At low levels of the debt ratio, the process may be slow and it can be halted by running a small primary budget surplus, i.e. excluding interest payments. The higher the debt ratio, the larger the surplus needed to stabilise the debt ratio. As the markets react to this situation, interest rates may rise, thereby speeding up the increase in the debt ratio.
This is known as the “debt trap”. For developing economies, the end result is often default. For countries like the UK that can borrow in a currency which they themselves issue, the result is usually the backdoor, partial equivalent as the Government finances itself by issuing more of its own money, resulting in higher inflation.
The UK is approaching this dangerous situation. We are running a primary budget deficit of about 1.5pc of GDP. The real yield on long index-linked gilts is just below 2pc, while the implicit real yield on long conventional gilts looks to be between 2pc and 3pc. Yet the Office for Budget Responsibility estimates our potential annual GDP growth over the next five years at only 1.7pc.
So what is to be done? The most attractive solution is to secure faster economic growth. But supporting this option is rather like endorsing motherhood and apple pie. As our Prime Minister and Chancellor should have discovered by now, you can make speeches supporting higher growth until you are blue (or red) in the face, but this does nothing to bring about that result.
Another option is to adopt “financial repression”, whereby the interest rates on government debt are artificially suppressed, for instance, by obliging financial institutions such as pension funds to hold a certain amount of government debt. But in today’s world, when so much debt is held by foreigners, it is doubtful that financial repression would work very well. And such repression grossly distorts financial markets.
You could try to unleash a burst of inflation which would devalue the real value of that part of the debt which is not index-linked. But this would give you no more than a short-term release, especially short since quantitative easing sharply reduced the average maturity of public debt. The markets would immediately impose higher bond yields and you would be left with the damage caused by higher inflation.
This leaves the last option, namely to reduce government borrowing. Of course, we could try to do this by increasing taxation. But this isn’t bound to work. With wealthy and talented people fleeing the country in droves, and the remaining businesses and individuals in a state of depression about the financial outlook, this is not advisable.
The elephant in the room is government spending, which this year will exceed 45pc of GDP. Admittedly, this ratio is not high by European standards but increasingly our competition is outside Europe, where government spending and tax rates are generally much lower.
By all means let us try to boost economic growth by adopting business-friendly policies, but higher growth cannot be conjured up in a jiffy. Meanwhile, the overall economic situation calls out for fiscal tightening.
As well as the fiscal deficit, we are running a substantial current account deficit, causing our international net asset position to deteriorate. Our domestic investment rate is low and our low personal savings are partly gobbled up by the dis-saving of the public sector.
The current plans envisage the debt ratio falling, but only slowly. This is dangerous. Recent governments have not been straight with the British people.
We need to save more, invest more and export more. A stringent fiscal policy enacted to improve the public finances would also help to push the economy in this healthier direction. Things cannot go on as they are.
Roger Bootle is senior independent adviser to Capital Economics and a senior fellow at Policy Exchange. roger.bootle@capitaleconomics.com
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