A submission by Dr Gerard Lyons to the House of Lords Economic Affairs Committee’s inquiry into, ‘How sustainable is our national debt’.
The UK’s debt position is a concern. The current level of public sector debt is high, and while it may improve in the next few years there is a serious danger that the UK will fall into a debt trap before the end of this decade. This occurs when two criteria are met. One, is the ratio of government debt to GDP exceeds 100%, meaning the stock of public debt exceeds the size of the economy. The second is that the rate of economic growth is lower than the rate of interest paid on the debt. In such a situation the ratio of debt keeps rising. The future relationship between growth and interest rates is a critical component of the outlook, as is action taken directly to improve the public finances.
There is no formal definition of sustainable public debt. In my view, the best guide is for public debt as a share of GDP to fall steadily, over time. Thus, the ratio of public debt to GDP is important and it also facilitates historic and international comparisons that can be useful for the policy debate. Our ratio of debt to GDP has been substantially higher, at around 250%, following the Napoleonic Wars and the Second World War. On both occasions it subsequently fell steadily. Thus, the ratio of debt to GDP must be considered in the context of the economic environment. A high debt to GDP ratio but an improving one in the right economic climate is not a problem. But if the ratio is high and rising it’s a concern. The message is that a high ratio of debt to GDP is a necessary, but not sufficient condition to be worried about debt sustainability. There is usually something else, too, such as economic problems, political turmoil or a banking or financial crisis that makes the environment more difficult for corrective action to be taken.
The debt to GDP ratio is not, however, the only important measure of sustainable public debt. The dashboard that needs to be monitored should focus on the debt dynamics and the structure of a country’s debt in terms of the maturity of debt, who buys the debt and the country’s ability to service that debt. Linked to this is that the country needs to be viewed as solvent by financial markets. Investors need to have confidence that a country is on the right track to keep its finances in shape. This involves a host of issues, including the need for policymakers to understand the financial markets and to manage expectations, keep them onside plus outlining an economic policy that is consistent and credible. It also necessitates the Bank of England establishing anti-inflationary credibility without a pyrrhic victory where the economy suffers.
There are six options. The main five are:
- Boost economic growth;
- Borrow;
- Curb public spending, including austerity;
- Tax;
- Reform;
- And the sixth, which is outside the domain of the government, is a loose monetary policy aimed at achieving financial repression through very low interest rates that penalise savers in order to ease the pain for borrowers, or that make it possible to inflate the debt away.
These six are not mutually inconsistent and may occur simultaneously. Of these, the two that should warrant most attention are growth and reform, both because of the present high level of debt and because of the longer-term trajectory outlined by the Office for Budget Responsibility (OBR). Reform could cover a host of areas. For example, it could be aimed at boosting public sector productivity or the efficiency of public spending, thus allowing spending to be kept under control and creating space for reduced borrowing or tax cuts if needed. Additionally, there could be a focus on welfare reform, as identified recently by Professor Miles of the OBR. One of six options is control of public spending. Curbs on future spending might be linked to public sector reform, too. I would not advocate austerity, and indeed I publicly opposed at the time the austerity of Osborne in the early 2010s, which had no long-term strategic thought behind it and was arbitrary, hitting hard non-ringfenced departments, and moreover it was unnecessary given the borrowing environment and the outcome made the economic situation worse.
The real challenge regarding debt sustainability is economic growth. Before the 2008 global financial crisis the UK’s trend rate of growth was around 2.25%, which meant that the economy doubled in size, in real terms, every 32 years. Now, trend growth is far lower. The Office for Budget Responsibility (OBR) factored 1.8% into their recent thinking, which may be too high. It might be closer to 1.25%. If the OBR was right, it would take the economy 40 years to double in size. At 1.25% it would be close to 58 years. Despite this slower growth, expectations on public spending do not appear to have adjusted accordingly.
This reinforces the importance of a sustainable, pro-growth strategy. Given the ageing population such a strategy should be ambitious, aimed at growth being closer to the 2.25% of the pre-financial crisis era. While GDP growth matters for debt dynamics, GDP per head is of prime importance when taking into account population growth including migration.
Although the natural riposte is that all governments want higher growth, the reality is that the outcome has been poor since 2008. A three-arrowed approach is needed: credible monetary and financial policies; a sustainable fiscal policy; and a supply-side agenda aimed at innovation, investment, infrastructure, and incentives. To facilitate growth there are many levers that can be pulled, but they are not always politically feasible. For example, implementing credible and ambitious planning reform to build more homes and business sites. A pro-growth strategy should prioritise policies aimed at boosting investment. The factors needed to improve the investment outlook are known and include more finance and lending for firms, sound macro policies, a lack of bureaucracy, the level, predictability and simplicity of tax, plus future expected demand. Investment in the energy transition is a necessary part of this. Institutional change could also be explored to support this, such as HM Treasury being split into growth and finance departments. The crux is that the private sector needs to be incentivised and empowered to play a bigger role.
In my view, the current account deficit merits serious attention in this debate about sustainability. This is not always appreciated. The UK has a twin deficit problem – a current account deficit and a budget deficit. In the late 1980s , I highlighted that the Lawson Boom would become a bust and that it was important to recognise that even though the government was running a budget surplus, the private sector’s liabilities were high and rising. The deteriorating balance of payments reflected this. If we fast forward to now, Japan, for instance, has a large ratio of debt to GDP, but its current account surplus echoes its high domestic savings and its ability to fund itself. The UK, in contrast, has low savings, a current account deficit and a need to fund itself not only at home from long-term domestic savers but also from overseas. As the OBR highlighted in their recent annual assessment of fiscal risks, the UK is increasingly reliant on foreign capital inflows to buy gilts: “Over the course of this century the share of UK government debt in foreign (non-official) hands has almost doubled from 13 to 25 percent, the second highest in the G7 and 2 percentage points below France.” At a time of elevated public sector deficits globally, the relative attraction of UK assets is important, as is retaining the confidence of international capital markets.
If the growth outlook is modest at best, and if we have to keep yields high to entice international investors to buy our debt then increasingly the focus has to turn to a policy choice that includes options such as curbing public spending, raising taxes or transformational reform of the areas that if left unaddressed would add to future expenditure pressures.
One of the committee’s questions is about the definition of the national debt. In my view, there are benefits attached to a focus on a public sector sheet, such as public sector net wealth (PSNW). It provides a comprehensive measure of the government’s finances. This might include off-balance sheet liabilities and large unfunded future pension liabilities. It could allow more focus on improving the quality as well as controlling the quantity of public sector expenditure and thus a greater focus on the role of the State. But a balance sheet approach does not change the fundamentals regarding the sustainability of the public finances. One argument against PSNW is that a government may find it hard to sell many of its assets if it wanted to. There is an important reason we look at public finances in terms of debt and liabilities and that is the Government needs to fund itself. By looking at PSNW the picture of the national debt appears to be transformed as three-quarters of the public sector’s liabilities would be offset by assets. At the end of the fiscal year 2022-23, in March 2023, the PSNW showed a deficit of £606 billion, only one-quarter the size of the national debt. But this does not change the need to keep the finances in shape and does not change the issues noted above about debt sustainability. The danger is that it gives the illusion of the finances being in better shape and thus be endorsed by those seeking large-scale public-sector investment. Such investment would be seen as creating an asset – so it should be justified and funded. But the reality is that if you create an asset you still have to finance the liability – and there is no getting away from that.
The Committee asked about the target for public sector net debt (excluding the Bank) as a percentage of GDP to be falling by the fifth year. This is not a meaningful target and should be ditched. For example, in the March 2023 Budget, to allow the OBR to be able to forecast that this fiscal rule had been met, the Chancellor announced that some measures such as investment allowances would last only three years. This had the adverse impact of that measure being seen as temporary, and thus it did not have the immediate full positive economic impact intended. It showed how the rules can undermine sensible policy. It had to wait until the subsequent fiscal event for this policy to be made permanent, with additional funding. The fiscal rules should change. The current set of fiscal rates date from October 2022 and are the ninth iteration. The initial set of fiscal rules were introduced in 1997 and remained unchanged until 2008. Then, like subsequent ones, they were discarded once they were not met and replaced with new ones. You wonder why anyone takes them seriously. There is a need to retain the confidence of financial markets, particularly at times when uncertainty is high or markets are not convinced about the credibility of monetary or fiscal policy. But this is not an argument for keeping meaningless rules. To move to no rules may trigger unintended consequences. Thus, the one rule that should be retained, in my view, is the aim to bring debt to GDP down over time and alleviate any market concerns about fiscal solvency. Perhaps if a public sector balance sheet is introduced then there could be a case for a net worth objective and for it to improve as a share of GDP over time. I think that rules must be seen alongside fiscal principles. The latter, though, may be qualitative and hard to quantify. In the past I have set out ten such fiscal principles, one of which was to take advantage of low borrowing rates to fund the deficit with debt of as long a maturity as possible. Such a principle would have made eminent sense in recent years but instead HM Treasury reluctance in 2012, and more recently in the pandemic, to embrace locking-into borrowing for very long-term maturities (thus avoiding future refinancing risk), at very low long-term yields, to finance necessary infrastructure provide two examples of its inability to prioritise growth.
The committee also asked what might sustainability of the national debt mean for fiscal policy? A focus on debt and debt sustainability should not be misinterpreted as an argument against using fiscal policy for economic management. In the good economic times, the public finances must be brought under control so that in difficult times fiscal policy can be used effectively. It is also important (whether it be monetary or fiscal policy) to avoid pro-cyclical policies. There is a vital need to recognise the importance of using fiscal policy – whether it be government spending or taxation – in a pro-active way when necessary. Fiscal stabilisers have proved an important and necessary part of the adjustment process to shocks and this is critical. Unfortunately, since the 2008 global financial crisis, the economic and policy consensus has opted to see monetary policy to be used as the shock absorber, with disastrous consequences. But to be able to use fiscal policy in such a way, it is necessary to run lower budget deficits or tighter fiscal stances in the good times. Incredibly, the UK has only run seven budget surpluses since 1969.
Groupthink is often cited as a cause for concern in policy. It is worth asking, therefore, where might the current consensus thinking be wrong in this area of debt sustainability?
Perhaps the first is to push back against pro-cyclical policies, as noted above. Here the consensus view is that if future economic growth is weak then more of the budget deficit is explained by structural, as opposed to cyclical factors and thus policy needs to be tightened further. Keynes would be turning in his grave. An example might be raising supply-side taxes when going into a recession. But regardless of the specific policy the issue is to avoid an unnecessary self-feeding downward spiral.
A second consensus view to challenge is that the future trend of public expenditure and of taxes is inevitably up and thus the tax take has to keep rising. To support this argument is that an ageing population necessitates increased spending on health and social care. Also, defence budgets will need to increase given geopolitical events. It goes without saying that public services need to be funded properly, the issue is whether the services can be provided differently. The opportunity here is to identify ways to ensure the same or better outcomes without higher spending, while at the same time recognising the constraints that ever-rising taxes may impose. One view might be constraints on public spending, as a percentage of GDP. Another may be to use private insurance in a more effective way for health and social spending. International best practice might suggest Japan’s Society 5.0 approach as a good example. Also, raising the retirement age, as well as saving earlier, can address issues linked to future pension liabilities. Linked to this debate is to recognise that in a globalised world economy that an ever-rising tax take may have consequences, and it becomes harder to tax areas that are mobile, whether it be multinational firms or skilled workers, and thus triggering a brain drain or wealth drain, or encouraging smaller growing firms to move elsewhere.
There is a need to change the UK’s terms of reference. European countries with high tax rates are often cited as reasons to justify the current consensus of rising spending and an upward drift of taxes. Moreover, this debate needs to be cognisant of the changing global environment, which points to a shift in the balance of economic power to the Indo Pacific, stretching from India in the west to the US in the east. Western Europe is set to be the slow growth region of the world economy, and in less than twenty-five years its share of global GDP will be less than 10% and smaller than India. The UK will likely be the largest economy in western Europe, with migration playing a contributory factor. Moreover, the annual average growth rates of real GDP from 2010 to 2022 were 1.1% for the euro area, 2.2% for the US and 2.7% for South Korea. The high tax, high public spend zone of Western Europe stands out globally as having the lowest growth rate. Our competitive landscape needs to be set by the Indo Pacific.