Blog How I learned to stop worrying and love responsible borrowing 7 things you should know about government finances By Jeevun Sandher 23 January 2023 1. Responsible governments, like responsible businesses, borrow to keep things on track during hard times Governments and businesses should borrow to maintain their productive capacity during a downturn. Imagine a successful business: if sales temporarily fall, they don’t sack all the staff to get borrowing down. They borrow to get through hard times so they can continue to make sales when
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How I learned to stop worrying and love responsible borrowing
7 things you should know about government finances
23 January 2023
1. Responsible governments, like responsible businesses, borrow to keep things on track during hard times
Governments and businesses should borrow to maintain their productive capacity during a downturn. Imagine a successful business: if sales temporarily fall, they don’t sack all the staff to get borrowing down. They borrow to get through hard times so they can continue to make sales when business picks up. Similarly, governments should borrow to ensure the country can be productive once the downturn passes. A business that focused only on having low debt levels wouldn’t be a very successful one. The same is true for governments.
2. The UK’s debt is more than manageable
First, the UK’s debt to GDP ratio currently stands at 100% of GDP, while a comparable country like Japan has a debt to GDP ratio of over 260%. The United Kingdom government, unlike you and I, will also not die in the foreseeable future. That means the government does not have to pay its debts down to zero as we do in our lifetimes.
Second, the debt burden for the government isn’t total debt. The debt burden for any business is the total amount of debt it has, or the amount it spends on debt interest, in relation to its income. Similarly, for a government, its debt burden is the total debt, or the amount it spends on debt interest, in relation to its GDP. If a business has £1 million of debt but £1 billion in turnover, it isn’t really a problem. Similarly, for the UK, saying its debt is over £2.3 trillion pounds doesn’t mean much without the context of how large the UK economy is (£2.3 trillion since you asked).
That is why the debt burden measured as debt/GDP can fall even as borrowing rises. The UK’s debt burden fell in the post-war period while the deficit was positive (Figure 1). That’s because income (or GDP) grew faster than debt. Responsible governments understand that.
Figure 1: Our debt burden (debt/GDP) fell even as debt rose because the economy (GDP) grew
Debt interest rates also matter. As can be seen below, a long period of relatively low interest rates meant that the debt interest fell in the post-financial crisis period even as the total amount rose. Pointing to “big scary debt number” isn’t a very sensible way for anyone to think about government debt.
Figure 2: Debt interest payments bear little relationship to the total stock of debt
3. The Truss government caused chaos with their political incompetence not their borrowing
The interest rate on government borrowing rose during the Truss premiership because of an “incompetency premium” attached to their government rather than worries about the UK going bankrupt. Political risk in high-income nations like the UK is usually close to zero but the Truss government added an incompetency premium.
We can see this when we look at how bond yields evolved in the UK in the period between Johnson leaving office, Truss’ premiership, and Sunak’s elevation. We use the UK-German bond spread (i.e. the difference between Treasury and German bonds) as a measure of the incompetency premium. The spread did not rise when she entered office and had already committed to a £100bn energy package, an £18bn corporation tax cut and the £13bn National Insurance cut. At this point, there was no sudden increase in bond rates. A large increase in expected borrowing did not lead to spiking bond yields
Figure 3: The UK “incompetency premium” spiked because of political announcements rather than economic ones
The mini-budget led to a rapid rise in bond rates despite very few extra tax cuts being announced. The major newly announced items were bringing forward the income tax cut (£5bn), the additional rate tax cut (£2 billion), the dividend tax cut (£1bn) and the stamp duty cut (£1.5bn). That equated to an extra £8.5bn of tax cuts in 2023/24 and £10.8 billion in 2026/27 from previous plans. Respectively, around 90% of tax cuts and expenditure in 2023/24 and 80% in 2026/27 had been pre-announced. The extra £11bn of tax cuts in 2026/27 worth 0.5% of GDP were economically foolish but it’s implausible to think they led to a rapidly rising default risk and so surging interest rates.
The UK-German spread, the incompetency premium, rose because no-one could not trust the Truss government to act competently. The sacking of the Treasury’s most senior civil servant and refusal to even look at an economic forecast demonstrated incompetence. The unexpected pro-rich tax cuts (where the top 5% gained over £8,500 while average families only got £400) during a once-in-a-lifetime cost-of-living crisis without a democratic mandate led to a skyrocketing incompetency premium. As Paul Krugman has pointed out, it’s not a great sign when a major bank is describing the British government as a doomsday cult.
4. Interest rates on UK borrowing usually increase with economic growth and inflation. They have little to do with the risk of default
The interest rate on government bonds (i.e. borrowing) in high-income nations, like the UK, usually reflects the real return on investment plus expected inflation (plus political risk). They usually rise because there is more demand for investment and/or higher expected inflation.
The real return on investment is the rate that balances savings and investment. When the economy grows, and unemployment falls, the real return rises as the demand for investment grows (Figure 4). When the economy is shrinking and unemployment falls, the real interest rate falls as the demand for investment falls.
Figure 4: Government bond rates fall as unemployment rises because there is less demand for investment
During recessions, there are fewer productive investments available, purchases of safe government bonds rises and the interest rate on them falls. That is why interest rates fell dramatically after the Great Recession in 2008 while borrowing rose dramatically (Figure 5 below).
Figure 5: After the Great Recession, bond rates fell even as debt rose because there were few investment opportunities
Expected inflation affects bond yields as well. When inflation rises, the interest rate on government bonds increases. This is because investors demand a higher interest rate to cover price rises (Figure 6).
Figure 6: Government bond rates rise and fall
The key takeaway is this: government interest rates aren’t rising or falling due to worries about the UK being unable to pay its debt. The numbers just don’t add up for that kind of story.
5. Borrowing to invest is the best way to secure our children’s future
Firstly, (and we can’t stress this enough) what matters is the debt burden not debt alone. Responsible borrowing to invest in growth leaves our children with a lower debt burden not a higher one.
Secondly, if you really want to help future generations, then we need to create a prosperous and fair country for them to grow up in. Investments that boost sustainable growth help your children by ensuring they can get good jobs with higher wages, as well having good schools and hospitals they can rely upon. Our children’s lives right now also matter. There is no point in passing on low amounts of debt tomorrow if you’re not investing enough in their education today or you pass a burning planet on to them.
6. The UK government should act responsibly and borrow to invest in our future prosperity
As we’ve set out above, the UK should be borrowing to maintain its productive capacity (i.e. its people) during economic downturns. This helps to promote future prosperity. However, where there are tax rises that do not (significantly) reduce economic activity or disproportionally benefit the already very wealthy, they should be implemented. Where tax revenue is used to fund expenditure, it means that net benefit for the UK is higher (as the cost of funds falls to zero). For the UK, windfall taxes (that do not affect economic activity) and wealth taxes fall under this category. They could also raise £15bn and £60bn respectively.
The UK should also borrow for investments with a high economic or social return that will increase overall prosperity (and likely a lower debt to GDP burden as well). There are two high return investments the UK should prioritise. Firstly, net zero investments. The benefits of stopping catastrophic climate breakdown accrue for every human being yet to be born. They are incalculably large. Such investments can also raise productivity in the short run by lowering energy costs (through home insulation) and by spurring innovation. The second area is early years childcare. Early years childcare has high returns to investment. It is better to invest in your grandkids now, so they can be thrive and earn more in the future rather than keep worrying only about the debt.
7. The limit on how much we can borrow is hard to define, but we know we are very far from it.
We are very far from any limit on the UK’s borrowing capacity and the exact level on this can’t be defined by a single number. The limit to government borrowing is where the economic and social costs of borrowing outweigh the potential benefits. Where that limit is depends on the interaction between (amongst other things) the spare capacity in the domestic economy, balance of trade, institutional relationships (such as the Treasury and the central bank), financial stability and the relative performance in comparison to other countries. Crucially, what government borrows for also matters. Borrowing for investment that leads to a stronger economy simultaneously pushes up the limits to borrowing too. Borrowing for tax cuts, not so much.
Given that the limit is a matter of judgement or analysis rather than a simple, pre-defined number, we should not go for arbitrary fiscal rules because they’re easy to formulate. These fiscal rules are also constantly being broken and remade by Chancellors so as to render them (economically) meaningless. They have also led to a bias toward borrowing less than is responsible to hit the arbitrary target.
We should instead replace fiscal rules with a target range for borrowing set by an independent fiscal council, accountable to parliament. Missing costs of missing the target range would be symmetrical, or in other words, borrowing could be too high or too low, depending on the economic and institutional environment. Government could still choose to miss this target range if it wanted to, just as today they can choose to change their own fiscal rules whenever they like. But unlike today, because the target range would be independently set, government would need to explain their reasons to parliament and the public.