Deficits still matter… just not right now

The British government, like many others around the world, is on course to rack up a record peacetime deficit in the current fiscal year as it tries to limit the severity of the steepest economic downturn since the Second World War.

The Office for Budget Responsibility (OBR), the country’s official budget watchdog, forecasts the fiscal policy response to the pandemic will result in a deficit of £355 billion, or 16.9 per cent of GDP, in the year to April 2021.¹

Figure 1: UK public sector net borrowing (per cent GDP)

In May 2020, total government debt rose beyond £2 trillion – more than £100,000 for every family – pushing the country’s debt-to-GDP ratio above 100 per cent for the first time since 1963. Worse still, with Chancellor of the Exchequer Rishi Sunak having been forced into taking a raft of further measures to support the economy this year in his March budget, the OBR forecasts debt will rise to £2.7 trillion by April 2022.

No return to austerity… for now

Figures such as these have led to a series of alarmist newspaper headlines. Whether or not this influenced Sunak’s thinking is unknown; however, his generous budget simultaneously unveiled a series of tax hikes that will begin kicking in from next year as he tries to get the deficit back under control.

The chancellor is to freeze thresholds on a variety of personal taxes, including income tax, for up to five years and from April 2023 the corporation tax rate will rise to 25 per cent from 19 per cent currently. According to the OBR, by the year to April 2026 the government’s tax take will be 35 per cent of GDP, its highest level since 1970.

Figure 2: Tax as share of nominal GDP (per cent)

Sunak, who has previously described balancing the books as a “sacred duty”, said it would be irresponsible to allow borrowing and debt to rise unchecked as he warned “it is going to be the work of many governments, over many decades, to pay it back”.²

There is no shortage of independent experts arguing taxes will have to rise at some point. Paul Johnson, director at the Institute for Fiscal Studies, a think tank, told a committee of lawmakers in February he would be “genuinely surprised if in five years' time, taxes were not higher”.³

However, few outside the Treasury believe now is the time to even be talking about tightening fiscal policy. “While Rishi Sunak is treading cautiously, any premature tightening of policy, should it prolong the downturn, risks being self-defeating. Moreover, it seems unnecessary,” says Stewart Robertson, senior economist for the UK and Europe at Aviva Investors.

Debt interest costs still falling

While in normal times the British government may have struggled to plug such a gaping hole in its coffers, this is not presently an issue. All the extra supply of government bonds has been mopped up by the Bank of England (BoE). Since the crisis struck in March 2020, it has bought £430 billion of gilts,⁴ comfortably absorbing the additional £350 billion of bonds the government has had to sell.⁵

Although public sector net debt now stands at its highest level in sixty years relative to GDP (see Figure 3), the cost to the government of servicing that debt has fallen (see Figure 4). Indeed, when excluding gilts bought by the central bank, debt interest costs at 1.7 per cent of GDP are at a record low.

Furthermore, the OBR forecasts they will fall appreciably further over the next few years as gilts offering higher coupons mature, to be replaced by bonds with lower ones.⁶

Edward Hutchings, gilt portfolio manager at Aviva Investors, questions why the government is even considering tightening policy at the present time. He believes politics is driving things more than economics as the chancellor looks to appeal to traditional conservative voters.

“Hopefully in six months’ time, the pandemic will be under control and the economic picture will be looking brighter. But I don’t get a sense the market is looking for action to get the deficit under control at this point,” he says.

Tighter fiscal policy could benefit gilts relative to international peers since it might suggest monetary policy will have to stay looser for longer than would otherwise have been the case.

Figure 3: UK public sector net debt (per cent GDP)

Figure 4: Debt interest payments (per cent GDP)

Hutchings says the UK government can draw further comfort from the maturity profile of the gilt market. According to the OBR, the average maturity of gilts in circulation is 15.4 years, although this falls to 10.5 years when allowing for the impact of the BoE’s purchases.⁷

“Such a long maturity profile, which compares favourably with other G7 nations, significantly reduces the danger rising interest rates will prevent the government refinancing its debt,” he says.

Figure 5: Average maturity of the debt stock by country (end-December 2019)

For the past four decades, ‘neoliberal’ economic theory has been in the ascendancy across much of the West. The desire for a smaller state, typically involving privatisation programmes, is a core principle. Drawing inspiration from classical economic theory, it contends that running large and persistent deficits is not sustainable over the long run. The functioning of markets will be impaired as higher interest rates begin to ‘crowd out’ private-sector investment, depressing economic growth.

Such thinking runs deep in Britain’s Conservative Party, which was at the forefront of the global shift to neoliberal economics when Margaret Thatcher came to power in 1979. It is also not hard to see why the Conservatives, having struggled to restore financial discipline for a decade in the wake of the financial crisis, might be wedded to the idea of bringing the deficit back under control at the earliest opportunity.

However, this line of thinking is at odds with a growing consensus among academic and business economists, many of whom question whether the austerity experiment of recent years made sense.

Economic orthodoxy turned upside down

Even bodies such as the International Monetary Fund (IMF) and Organisation for Economic Cooperation and Development (OECD), which for so long were among the loudest cheerleaders of neoliberal economic policies, appear to be having second thoughts about the wisdom of austerity.

Despite arguing that countries should reduce debt after the financial crisis, the IMF recently said the actions of central banks mean most advanced economies can now live with much higher levels of public debt. It called on nations to “rethink” their public finance rules rather than rushing to reduce liabilities.⁸

Vitor Gaspar, head of the IMF’s fiscal policy unit, insists the main role of fiscal policy should be to help restore economic growth, cut unemployment and beat COVID-19. Laurence Boone, chief economist of the OECD, agrees. She argues governments should abandon short-term targets for public debt and instead focus on long-term sustainability, accepting that public debt will rise during crises and focus on getting deficits under control when things return to normal.⁹

Should Sunak go ahead with his planned tax hikes, the UK is likely to find itself something of an outlier. In Europe, discussions are underway that could lead to a loosening of the bloc’s fiscal rulebook. As for the US, President Joe Biden has secured Congressional approval for a $1.9 trillion stimulus package. This is on top of a record $3.1 trillion deficit in the fiscal year to October 2020, equivalent to 15 per cent of GDP.

As in the UK, that was the biggest share of its economy since 1945. The US deficit has also widened further in the first four months of the current fiscal year, compared with the same period a year earlier, pushing net debt to a record relative to GDP.

Debt looks as if it might rise significantly with Biden now turning his sights to a multi-trillion-dollar stimulus package. While in theory Republican lawmakers might refuse to raise the debt ceiling to try to block the bill’s passage, they seem unlikely to succeed with Democrats controlling both houses of Congress, albeit with a wafer-thin majority in the Senate.

Figure 6: Record US deficit (per cent GDP)

Conventional wisdom suggests deficits compromise the living standards of current and future generations by creating a burden of indebtedness that is difficult for taxpayers to bear. Left unchecked, the cost of debt servicing will eventually spiral out of control, leading to a government’s solvency being called into question.

While that may be true, some optimists would point to the UK’s experience in the post-war years as evidence that healthy economic growth can actually bring very high deficits back under control quite quickly. Having stood at 259 per cent in 1947, by 1991 the country’s debt-to-GDP ratio had fallen to 22 per cent.¹⁰

A multi-generational fight

However, the post-war years were characterised by high levels of productivity growth, which in turn fuelled strong rates of economic expansion. The mathematics of deficits means a country’s economic growth rate must exceed the cost of servicing its debt, or else austerity is needed to prevent debt rising ever higher. Robertson believes the poor productivity record of recent years suggests countries across the West are more likely facing a multi-generational fight to get deficits under control.

The task will be that much harder because most nations are faced with worsening demographics, and in many cases have huge unfunded pension liabilities and healthcare obligations. The fact politicians in many countries are increasingly ducking what they see as politically unpopular decisions adds to his concern.

Central banks’ success in keeping a lid on borrowing costs in the face of ever rising deficits in recent years has led some to argue textbook theory needs rewriting. They see little, if any, need for governments to get deficits under control so long as they can print their own currency.

Japan has been a useful test bed in recent decades. The country’s debt-to-GDP ratio, having reached 100 per cent for the first time in 1996, is forecast to have hit more than 260 per cent last year.¹¹ However, thanks to the actions of the Bank of Japan (BoJ), the government has had little difficulty funding its deficit. With the BoJ now owning around 46 per cent of outstanding Japanese government bonds, yields remain close to zero across the maturity spectrum. ¹²

Economists have long held the view that monetary financing of deficits is unwise. Since policymakers would find it difficult to turn off the taps, it would eventually lead to excessive inflation. Yet, despite repeated warnings, inflation has failed to materialise in Japan.

Whether the policy has succeeded in terms of its ultimate aim – reviving economic growth – is a matter of conjecture. Japan’s economic growth rate has been lacklustre for a quarter of a century. Between 1995 and 2019, real GDP per capita shrank more than seven per cent in US dollar terms. However, much of this apparent poor economic performance is explained by a shrinking workforce which, during the same period, fell 14 per cent.¹³

As Figure 6 shows, in terms of productivity growth the Japanese economy has performed comparatively well since 1996, lagging only the US among G7 nations.

Figure 7: GDP per hour worked, 1996-2019

Robertson says since it is impossible to know what would have happened if Japan had chosen a different route, it makes little sense drawing firm conclusions either way. That said, it is hard to conclude Japan has been an economic success story.

Deficits do still matter

For now, he thinks policymakers need to keep stimulus in place at least until the economic recovery has had time to take root. However, he takes issue with the notion that deficits no longer matter so long as central banks are prepared to fund them.

“There’s no magic money tree. Unless policymakers can deliver strong economic growth, and you have to wonder whether they can, eventually unpopular decisions will be needed to get deficits under control,” says Robertson.

By shifting the burden of debt onto future generations, policymakers’ actions may risk placing a tinderbox under societies that are already struggling to maintain their cohesion.

However, that is an issue for another day. With financial markets fixated on the power of central banks to keep bond yields low, investors seem likely to put any worries about the dire fiscal straits facing many nations to the back of their minds.