The COVID-19 pandemic has left an indelible mark on the global economy, with the UK being no exception. The government’s response, a massive stimulus package, has raised questions about the sustainability of the UK’s debt and who will ultimately bear the burden. With the OBR forecasting that UK debt will converge to 310% of GDP by 2070, it’s worth looking into the dynamics of debt sustainability. With a thorough examination, we can determine the potential scenarios that could unfold whilst also making monetary and fiscal policy suggestions.
Because of the pandemic and cost of living crisis, the government will have to foot a hefty debt interest payment bill of £110 billion this year, equivalent to 10.4% of its revenue. This is the highest bill in any emerging economy in Europe – even Ukraine – which is grappling with the enormous cost of the war.
Across the year, the UK’s interest burden will be almost triple that of France, where the Government will spend only 3.5% of its income on debt interest. In Germany, the share will be just 1.4%.
On top of this, the Bank of England’s latest estimate of losses it will suffer over the next decade on government bonds has increased by around £50 billion to £270 billion in just three months. This dwarfs the £123.8 billion in QE profits sent to the Treasury between 2009 and 2022, suggesting a net cost to the taxpayer of £150 billion by 2033. Of course, this makes debt sustainability a very sensitive issue. If policymakers get their forecasts wrong, the taxpayer will be the one who foots the bill. As such, it is important to understand that my analysis rests on one big assumption – that real interest rates will continue falling faster than economic growth – which has so far been a consistent historical trend.
That being said, the UK is currently grappling with high-interest rates, a direct consequence of the Bank of England’s efforts to tame inflation, which stood at a staggering 7.9% in June 2023. The expectation of course is that these rates will begin to fall around 2025 – granted it’s a long time, but, once inflation is back to the 2% target and inflation expectations are anchored, our government can begin strategising.
By implication, a reduction in interest rates should make UK government debt cheaper, and reduce debt sustainability risk. However, the concept of debt sustainability is very complex. If the growth rate of an economy is higher than the interest rates, governments can continue to borrow without having to raise taxes. This is because the revenues from new issues are larger than the interest payments, and the higher the debt, the larger the difference between the two. This suggests that when real interest rates are lower than economic growth, governments can run primary deficits whilst keeping their debt ratios stable, implying infinite fiscal space.
Whilst I believe that the UK will eventually achieve higher growth rates than interest rates in the long run, I also think we must reach this condition as quickly as possible to reduce the bill for the taxpayer. Thus, the remaining question is if it is feasible for the UK to achieve higher growth rates than interest rates in the foreseeable future? The answer to this question is probably not. While there is a reasonable expectation that we will return to lower interest rates, this is unlikely to be the case in the medium term.
This is because high-interest rates are contributing to sluggish growth. So, as long as interest rates stay high, the UK’s growth potential will be dampened. Of course, reducing inflation is imperative, that being said, once interest rates can start returning to their natural rate (which is expected to be much lower than our current rate), they must do so to create more fiscal space.
Whilst monetary policy is an important player in this discussion, the government’s fiscal power should not be underestimated. As such, where monetary policy decides the position of our interest rate, fiscal policy must be concerned with the direction of our growth rate. This is the only way of ensuring debt sustainability for future generations.
But we must be careful. Paradoxically, efforts to raise growth by boosting aggregate demand through government deficits raise inflation and by implication interest rates. Therefore, the strategy the UK government must take is one of boosting productivity through supply-side measures to achieve long-run growth which outstrips long-run neutral interest rates.
With the right investments and developments in green technology, artificial intelligence, and productivity, the UK could unleash a growth boost that could make government borrowing sustainable, reducing the need to raise taxes. In other words, we may be able to sustain the debt incurred due to the COVID stimulus without having to pay for all of this borrowing – at least in the long run.
