How do we avoid falling deeper into the debt trap?

It has been hard in recent days not to think about debt. Not mine, you understand, but that of the government, which I suppose is indirectly mine, too. You will have heard politicians say many times that they are taking tough decisions to avoid saddling future generations with unacceptable debt. We may even hear that from the chancellor next month.
I don’t what to depress anybody, but we may already be part of those “future generations”. Twenty years ago, when public sector net debt was about 30 per cent of gross domestic product (GDP), it would have seemed unlikely that we would have got so quickly to the roughly 100 per cent it is now.
Debt has been on my mind because two important reports have been published. On Thursday, the Office for Budget Responsibility (OBR) released its annual Fiscal Risks and Sustainability report. Originally due in July — as a reminder to the then-Tory government that, as the song says, “there may be trouble ahead” — it will now reinforce Labour’s tough rhetoric on the public finances.
A couple of days earlier, the House of Lords economic affairs committee published a report summed up well by its title, National Debt: It’s Time for Tough Decisions. The committee includes among its membership former Treasury permanent secretary Lord (Terry) Burns, former chancellor Lord (Norman) Lamont and the economist Lord (Richard) Layard.
It also includes former Labour MP Lord (Jeff) Rooker, from whom I was pleased to receive an email recently. He, along with Audrey Wise, once a fellow Labour MP, was responsible for one of our most important tax reforms, the Rooker-Wise amendment of 1977, which requires income thresholds to rise in line with inflation, unless primary legislation is passed to prevent it. That, of course, is what is happening now, and is due to last until 2028, with the long freeze on allowances and thresholds.
I’ll return to the Lords report in a moment. The OBR’s is scary enough to warrant an 18 rating. Its central projection is that debt will rise to 274 per cent of GDP over the next 50 years, on the back of public spending rising to the equivalent of 60 per cent of GDP, while government revenues get stuck at 40 per cent.
The three main factors pushing debt higher are familiar ones: “an ageing population, with a falling birth rate and the ‘baby boom’ cohorts moving through retirement, putting downward pressure on revenues and upward pressure on spending”; “climate change, including the fiscal costs of completing the transition to net zero while also coping with damage from rising temperatures and more severe weather”; and “rising geopolitical tensions”, which will mean higher levels of defence spending relative to GDP.
Debt, the OBR says, is on an unsustainable path. Merely to return it to pre-pandemic levels and keep it there would require significant spending cuts and tax increases each decade.
There is another way out — one I go on about quite a lot — which is to raise productivity. If it could be lifted to 2.5 per cent a year, roughly its growth rate in the 1990s, this would work miracles with the public finances. Stronger growth in productivity would mean stronger growth overall, allowing the UK to expand its way out of a deep fiscal bind. Instead of rising to 274 per cent of GDP, debt on this scenario could fall to a healthy 65 per cent.
There are two health warnings to be attached to this. One is that restoring productivity growth to past rates (and better than the average before the financial crisis) is a massive challenge after the stagnation of the past decade and a half. The other, as the OBR points out, is that politicians have always been keen to spend the proceeds of growth, or use them to cut taxes, when they have emerged in the past.
There is another problem with the OBR’s projections, which is that the real difficulties only emerge later. Thus, debt is projected to be only 105 per cent of GDP in the early 2040s, not much above current levels, with the big increase coming from then onwards. That is far enough away to allow politicians keen to stay in power to kick the can down the road.
This is where the Lords report comes in. People sometimes ask me why we should worry about government debt rising from one massive number to even bigger numbers. The quick answer is that we are already seeing the consequences of that higher debt in what it costs to service it. The debt interest bill is projected by the OBR to average exactly £100 billion a year over the period 2022-23 to 2028-29, dwarfing the spending of most government departments.
As the Lords report puts it: “A debt level risks becoming unsustainable if there is an insufficient buffer to absorb future economic shocks; or if a government’s approach to fiscal policy creates a long-term trajectory of increasing debt service costs.”
There is another point — one made by some of the witnesses to the Lords committee’s inquiry. For the public finances, there is something that you might call “the equation of doom”: if the interest rate paid by the government on its debt (r), adjusted for inflation, is greater than the economy’s growth rate (g)— if “r” exceeds “g” — you have a problem.
That has not been an issue in recent years. Although growth has been weak, the interest rates, or yields, on government debt (gilts) have been even lower, helped by large-scale purchases of them by the Bank of England.
As the Lords report summarises: “If r exceeds g, the debt-to-GDP ratio is likely to rise in the absence of a government primary surplus (that is, the government raises more in revenues than it spends on anything but debt interest).”
Achieving a primary surplus looks as challenging as generating a productivity boom, so the risk is of what Paul Johnson of the Institute for Fiscal Studies described as a “debt-interest-fuelled doom loop”, which, as he put it, wishful thinking will not prevent.
A debt trap, in which efforts to slow the rise in debt through tax increases and spending cuts reduce the economy’s growth rate further, is perfectly possible. Fixing the public finances without hobbling the economy — and hobbling it would mean not fixing them at all — is the central challenge.
We need to hear much more about how the government plans to grow the economy. Otherwise, we will fall into that debt trap.
Wherever you look, interest rates are falling. On Thursday, the European Central Bank cuts its deposit rate from 3.75 to 3.5 per cent, as widely expected. Earlier this month, the Bank of Canada reduced its key policy rate to 4.25 per cent, its third cut in row. The only question about America’s Federal Reserve has been whether it will reduce rates by a quarter or a half this week. Markets expect a quarter.
It has been expected that the Bank of England, having reduced interest rates last month, will be a wallflower when it announces its decision this Thursday, with no change in rates. That is still the expectation, with the next cut coming on November 7, soon after the October 30 budget.
While a cut from the Bank is unlikely this week, two successive months of unchanged GDP, suggesting the economy has lost some momentum, alongside a further deceleration in pay growth, have at least made the meeting of its monetary policy committee (MPC) slightly more interesting than it might have been.
The next UK inflation figures are out on Wednesday, for August, and should again be slightly above the 2 per cent official target. Higher energy prices will push up the rate in October, though there is an interesting offset to that. Petrol prices, now averaging less than 140p a litre, are at least 10 per cent lower than they were a year ago.
Interest rates will not be the only thing on the MPC’s mind this week; it also has to decide on the pace of so-called quantitative tightening (QT) — the reverse of quantitative easing (QE). So far, the Bank’s balance sheet has shrunk from a peak of £895 billion to about £690 billion.
It should go down by at least another £100 billion over the next 12 months. At least that is the general expectation, but the Oxford Economics consultancy, which employs former MPC member Michael Saunders as an adviser, thinks the Bank could go for an additional £10 billion-£20 billion. This is because there will be a natural rundown of the balance sheet as £87 billion of UK government bonds held by the Bank will be maturing and a higher figure would maintain a higher level of “active” gilt sales. Yes, I know it is complicated.
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