Will the UK ever be able to balance the books?
The latest Autumn Statement revealed the UK government is still struggling to plug a gaping hole in its finances. With growth likely to be more challenging in the next few years, its task looks unlikely to get easier any time soon, writes Stewart Robertson.
The UK government on Wednesday admitted public sector debt, as a ratio of total economic output, is expected to hit its highest level in over 50 years by 2017/18. Chancellor of the Exchequer Philip Hammond blamed uncertainty surrounding the impact of the decision to leave the EU for much of the deterioration in the state of the country’s finances since March. Nevertheless, his statement also served to underline the scale of the challenge facing Britain, like many other countries in the West. In doing so it raises a more fundamental question: will the country ever be able to balance the books?
The Office for Budget Responsibility (OBR) – the UK’s official independent fiscal watchdog – estimates slower economic growth over the next five fiscal years to March 2021 will result in cumulative public sector net borrowing of £216.3 billion. That is £122.2 billion more than it had expected just eight months ago. Furthermore, this projection is based on the assumption that the UK economy will continue to expand at a fairly healthy rate over that period, albeit by less than the OBR had anticipated in March.
It said £58.7 billion of the cumulative rise in net borrowing over the next five years could be attributed to the decision to leave the European Union. Economic growth is now expected to be lower due to declining business investment and weaker consumer spending caused by a squeeze on real incomes from higher inflation. These effects will be only partially offset by the improvement in net trade that flows from a fall in sterling. Furthermore, it conceded its forecasts were shrouded in an unusually high degree of uncertainty, not least because it was unknown what sort of trading relationship the UK will be able to negotiate with the EU after leaving the bloc.
Perhaps just as concerning, the OBR noted that, regardless of the EU vote, tax receipts would have been lower and spending higher than it had expected in March. It said that suggested the public finances were in a “structurally weaker position” than previously believed.
Hammond responded by providing himself with roughly £56 billion more borrowing capacity in 2020-21 than his predecessor George Osborne. But worryingly, public sector net debt is now forecast to peak in 2017/18 at an eye-watering 90.2 per cent of GDP. It is true that the annual deficit (public sector net borrowing) is well below the peak of 10.1 per cent of GDP reached in 2009-10, with the OBR forecasting a deficit of 3.5 per cent of GDP in 20016/17. But six years into a Conservative administration that has implemented a raft of austerity measures and seven and a half years into an economic recovery, it seems the goal of eradicating the deficit is as elusive as ever.
Coping with debt levels of this magnitude would be less of a problem if economic output were expanding rapidly. After all, the UK’s debt to GDP ratio peaked at 259 per cent in 1946/47, just after the end of the Second World War. Within a decade the ratio had halved. But that was in an altogether different era. Although economic growth in the UK has actually outstripped rates achieved in the rest of the G7 since the start of 2010, it remains anaemic by historical standards.
Furthermore, what little growth there has been in recent years has largely been the result of rising employment, and people working longer hours; not by increases in productivity. Having averaged around two per cent per annum in the post-war period, in recent years productivity growth has stalled. It wasn’t until the second quarter of this year that the level of productivity returned to where it had been prior to the financial crisis of 2008. Hammond conceded that with productivity having for some time lagged well behind that of other leading Western economies, the UK’s record was “shocking”.
Although the chancellor announced a raft of measures designed to boost productivity, they are unlikely to offset the impact of a sharp drop in business investment as a result of the ‘Brexit’ vote. And while the sharp depreciation of the pound will help support economic activity, without a pick-up in productivity it is difficult to see economic growth accelerating rapidly. Indeed, as the OBR itself says, likely curbs on migrant labour will only exacerbate the situation.
At the same time, Britain, like most other countries in the West, is facing an ever worsening demographic backdrop. An increasingly ageing population means higher spending on healthcare and pensions is putting ever more strain on the public finances.
According to the OBR, the number of pensioners is expected to jump 9.1 per cent in the five years to 2025 compared with the previous five years. That will push up spending on state pensions alone by 0.3 per cent of GDP.
As the chart below shows, the situation is expected to deteriorate further in the following decade. The Office for National Statistics predicts a marked increase in the number of pensioners by 2039 as the baby boomers of the 1960s enter retirement. By that time, rising longevity means more than one in twelve of the population is projected to be aged 80 or over.
Figure 1: Age structure of UK population, mid-2014 and mid-2039
Source: Office for National Statistics. Ages above 105 are not included on the population pyramid.
While the UK is a long way from the situation that has befallen Greece in recent years, the danger is that a vicious circle emerges, with sluggish growth leading to higher debt which in turn suppresses growth.
In their seminal 2010 paper, Growth in a Time of Debt, US economists Carmen Reinhart and Kenneth Rogoff argued GDP growth slows materially once government debt exceeds 90 per cent of GDP. Drawing on 200 years of public debt data, they said that beyond this threshold, market perceptions of risk can jump.
Their findings have been the source of heated debate. Analysis by the International Monetary Fund (IMF) in 2010 found “some evidence” of a 90 per cent threshold, while a 2011 study by the Bank for International Settlements identified a threshold of 85 per cent. But another IMF report published in 2012 found “no particular threshold that consistently precedes sub-par growth performance”.  And as Reinhart and Rogoff have themselves acknowledged, the question of causation has not been proven. Slower GDP growth could be the cause of a rising debt load, not the result of it.
Nonetheless, what is not in doubt is that the easiest way for a government to get debt back under control is via stronger economic growth. The problem facing the UK is that the Bank of England has virtually exhausted its options. The Chancellor could try to fire up the economy himself via an aggressive easing of fiscal policy, although this option appears to have been ruled out, at least for now. That is understandable as even if it were employed, success is far from guaranteed. But if the recovery begins to stall, Hammond may feel he has little option other than to loosen the purse strings, regardless of what it might mean for his efforts to balance the books.
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