Thanks to the pandemic, national debt has soared and now makes up more than 100% of GDP. The interest on that debt has grown too, by more than £8bn. Taken together, servicing the national debt now costs more than the entire annual schools budget. All of this debt must be paid off someday, and so it seems all we’re doing by spending beyond our means today is pushing the burden on to our children – those same children we’re hurting by underfunding their schools and taxing their employment.
Variations on this theme abound, and it’s often used by politicians – the Chancellor included – to signal the need for fiscal discipline, either in the form of higher taxes or lower public spending. But although the argument has a superficial appeal, it is fundamentally misleading and at odds with all the modern literature of how debt works.
At its most basic debt is the accumulation of deficits over time. By this, I mean when governments spend more than they receive in taxes, they issue bonds that are bought by private investors to make up the difference. These bonds, or gilts, will appreciate in value by a given amount and eventually will be bought back by the government when they have matured. Given the stated value of the gilt will ordinarily be greater when bought back than when it was issued, it is often assumed that governments will not benefit from this process.
However, because the economy (generally speaking) grows over time, that’s not normally the case. Historically, what tends to happens is inflation reduces the real value of the gilt relative to its value when issued. This means governments often pay back less money than they receive when the bond matures.
The process will only work when growth increases at a greater rate than interest rates. If interest rates grow faster than the economy, then the real value of the debt would increase. This is the trend that alarms some people, but the potential for something to happen is not the same as the risk of it actually happening. As the economist Larry Summers famously pointed out, it has now become a near-permanent norm that growth occurs faster than interest rates. Indeed, the only time it’s ever happened in post-war Britain was when the Thatcher government hiked rates to end a period of extremely high inflation.
Dissenters will point out that debt as a proportion of GDP has nearly quadrupled since the early 1990s – and they are not wrong. However, this statistic is largely irrelevant for understanding the actual burden the debt puts on the economy. This is because debt is a snapshot of past deficit, whereas GDP shows production over a period of time. As economic statistic whiz Joey Politano has quipped, it is the equivalent of comparing the amount of petrol in a car to the speed it is travelling.
We are better off comparing statistics in motion, like GDP, with other statistics in motion – what economists call ‘flows’. Looking at the current cost of financing the debt as a percentage of GDP is a better way of looking at how big a fiscal problem debt is. According to the ONS debt interest payments are currently equal to 1.9% of GDP. Compare that to 2010, when the corresponding figure was 2.9%, while in 2000 it was 2.4%, in 1990 it was 2.9% and in 1980 it was 3.4%. So, while we ought to be wary of frittering away public money, the reality is that servicing the national debt is costing us less than ever before.
That’s also why we should be wary of introducing austerity measures – tax rises or spending cuts, essentially – that risk breaking the golden rule about growth outstripping interest rates. As mentioned earlier, the real cost of debt will fall where growth is greater than the rise in interest rates. However, supply-side pressures on inflation, not least the war in Ukraine, are currently pushing up interest rates. If growth does not keep pace, the cost of servicing our debt cost will start to rise, risking more painful tax rises and/or spending cuts.
That’s why the Government should keep any growth-sapping tax rises to a minimum and focus fully on measures to get the economy growing. For just as slower growth in GDP means more expensive debt, so higher growth makes that debt cheaper.
It’s worth reiterating that for all the grim economic news about at the moment, we are not in a debt crisis, or in any imminent danger of entering one. The worst thing we could do is engineer such a crisis by applying the wrong macroeconomic policies. At this Spring Statement and beyond, Rishi Sunak must give short shrift to the deficit hawks and focus relentlessly on growth – that’s by far the best way to both mitigate the cost of living crisis and emerge from Covid a better country.
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