K | a-zofinequality

Kicking the can down the road

The UK government’s indebtedness has grown massively since 2008. After several decades of the national debt being held at a relatively stable level of about 30-40% of GDP, it more than doubled in the wake of the 2007-08 Financial Crisis and subsequent recession. Before that increase could be paid down Covid-19 hit, resulting in another massive increase in government borrowing. Public sector net debt (Chart 1) recently exceeded 100% of GDP for the first time since the aftermath of World War II, meaning that the government owes more than the UK’s annual national income. The nominal value of government debt has also surpassed £2 trillion for the first time ever.

Chart 1

Source: Office for National Statistics [1].

The public sector budget deficit (Chart 2) – the amount the government borrows to fund spending which is not covered by revenues – rose significantly in the aftermath of the financial crisis and was reduced over the following decade of austerity, though not entirely eliminated. While the complete fiscal impact of Covid-19 remains to be seen, early indications including a budget deficit in excess of 20% of GDP shows that it could make the financial crisis look like a small bump in the road by comparison. The Chancellor’s autumn spending review shows that total borrowing in 2020 is expected to total nearly £400 billion [2].

Chart 2

Source: Office for National Statistics [3].

The debt burden.

What is the impact of a large and growing national debt? The most obvious point is that, by definition, borrowing is just spending deferred to the future. Borrowing today will have to repaid by younger and future generations of taxpayers. This may be justifiable if the present value of spending is expected to exceed its future value, for example, for investment projects which are likely to pay for themselves over the long run or to tackle emergencies which, if left unchecked, could leave the economy depressed into the future or otherwise harm future generations. However, given the large stock of debt at present it is worth critically reviewing whether all this indebtedness really meets that standard. Furthermore, many economists argue that a large stock of debt has a negative impact on present economic conditions as well as imposing future costs.

Governments borrow by selling bonds, which are commonly referred to as “gilts” in the UK. The two key components of gilts are the “yield” and the “maturity”, which are basically the interest rate and duration of the bond, respectively. The yield is how much the government will pay the gilt’s owner every year, expressed as a percentage of the gilt’s total value, and the maturity is how long the yield will be paid – once the gilt reaches its maturity date it is repaid in full. For example, if the UK government were to sell a gilt with a yield of 1% and a maturity of 10 years for £1,000, that means the government would receive £1,000 now and in return would pay the gilt’s owner £10/year for 10 years; after 10 years the original £1,000 would also be repaid to the owner and the gilt would have expired, yielding no more payments [4].

While the burden of government debt is typically measured by looking at the debt-to-GDP ratio, i.e., how much does the government owe relative to the annual volume of economic activity in its country, a fuller picture of the government’s costs can be seen by looking at yields and maturities. UK government debt is longer-lived than that of most comparable countries with an average maturity of 16 years, though in reality maturities are spread out across a wide spectrum, from Treasury bills which last just a few months to 50+ year gilts [5]. Longer maturities mean that the full cost of repaying the debt does not have to be met for longer and a wide spread of gilt durations mean that in any particular year only a small portion of the total stock of debt has to be repaid. But the preponderance of long-term UK government debt also means that yields have to be paid for longer.

Fortunately, the expansion of the stock of UK government debt has, somewhat counter-intuitively, coincided with a steep decline in yields, down from a weighted average of more than 4% to less than 1% (Chart 3). After Covid-19 hit yields were depressed even further, with some gilts being sold for negative yields – meaning the gilt owner pays the government to hold their money – for the first time ever [6]. As a result of this shift the share of public revenue spent on servicing the debt has actually continued to fall through 2020 even as the amount of public debt has grown massively [7].

All this means that the UK government owes a large and growing stock of, comparatively speaking, long-lasting and cheap debt. On the one hand, this means that even the vast expansion of borrowing in response to the last two major economic crises should be relatively affordable. An IMF paper estimates that UK government debt might currently be sustainable up to a level of 140% of GDP [8]. On the other hand, this picture could change dramatically with little warning: if interest rates were to rise significantly while the government still needed to borrow more the cost of any added debt would be increased. A rise in the recorded rate of inflation could be particularly damaging as it would tend to drive up nominal interest rates and would also increase the yields of index-linked gilts which are adjusted in line with the Retail Prices Index [9]. In other words, the current low-interest, low-(consumer) inflation macroeconomic environment is particularly accommodating to high levels of public indebtedness; if that environment were to worsen while the debt and deficit remain large things would quickly appear much less rosy.

Chart 3

Source: Debt Management Office [10]

Furthermore, as mentioned above, in addition to imposing future costs of repayment a large outstanding national debt may act as a drag on the economy in the present. The relationship between debt levels and economic growth has been the subject of intense and frequently controversial academic study and debate. An influential study (Reinhart and Rogoff, 2009) which suggested that economic growth sharply fell if countries exceeded a debt-to-GDP ratio of about 90% was infamously found to have contained coding errors which, once resolved, undermined the headline finding. There is also a problem of endogeneity when studying such a relationship: the debt-to-GDP ratio and the GDP growth rate are obviously not independent of each other; sluggish economic growth can increase the debt-to-GDP ratio just as much as increased borrowing (and rapid growth will likewise reduce the ratio) so the direction of causality is not obvious. Nevertheless, a wide range of empirical studies have confirmed the finding that high levels of public indebtedness are at least correlated with lower rates of economic growth and several have found a cliff-edge where growth rates drop sharply somewhere in the region of 75-100% [11].

How might government borrowing constrain present economic activity? It is obvious that a high debt burden from past borrowing will constrain a government’s fiscal room for manoeuvre, requiring them to raise taxes, cut spending, and/or borrow even more to make repayments and in doing so divert money away from more productive activities. Current borrowing can also have a such a diversionary effect as gilts compete with private borrowing for investment. This is termed the “crowding out” effect: if the government is borrowing more there is implicitly less money available to invest in private enterprises. This problem may be especially acute for credit-constrained firms, especially young and small businesses, while large well-established corporations are unlikely to be hit hard [12].

In the event that it does become infeasible to pay back the national debt this poses a substantial risk to monetary stability. Faced with the unattractive and politically self-destructive prospects of imposing severe austerity or giving up sovereignty to satisfy the demands of gilt holders, governments are likely to try and escape their debt troubles by either deliberating stoking inflation to reduce the real value of the debt, devaluing their currency in the process, or simply defaulting on their outstanding debts by imposing a “haircut” on gilt holders – a reduction in the amount they will repay – or renouncing their debts entirely, likely damaging their credibility and future capacity to borrow again. Previous examples of severe national debt crises include Weimar Germany’s struggles to make reparation payments after World War I which led to hyperinflation [13] and the Greek sovereign debt crisis of the 2010s which brought about political chaos and the imposition of crippling austerity measures, during which Greece’s GDP fell by a quarter and unemployment rose to nearly 30% [14].

Hidden liabilities.

The size and growth of the UK’s national debt is, at minimum, a cause for concern which should be treated with caution to ensure that it does not spiral out of control. However, official public sector debt figures may even be understating the issue. Many liabilities are not counted in that measurement and so future costs may be even greater than it appears. The Taxpayers’ Alliance has argued that the “real” national debt is several times greater than the official figure and already stood at £8.6 trillion in 2014-15 [15].

Official debt figures have already had to be revised upwards recently following a re-evaluation of how student loans are accounted for. Student loans differ from typical loans in that their repayment is contingent upon the borrower’s income and they are written off after a fixed period of time – 30 years after repayments are first due for recent borrowers [16] – meaning that typical accounting standards were inappropriate [17]. Correcting for this problem showed that the government was going to be repaid much less than previously believed, resulting in the recorded budget deficit being increased by more than £10 billion [18].

Private Finance Initiatives (PFIs) and other forms of public-private partnerships (PPP) are also often excluded from official debt figures, depending on whether the government or the private partner are thought to bear the greater project risk, despite the fact that all such schemes involve the government making regular payments for a specific period of time which will at least indirectly impact debt levels [19]. A PFI involves a private finance company being set up which borrows to fund a public project such as the building of a new school or hospital. This means the debt is privately financed – not sourced by issuing gilts – but the taxpayer is still on the hook to repay it for the length of the contract that the government agrees to. It is unclear, therefore, why all such projects should not be included in public sector debt figures.

PFIs may have been a sensible idea to the extent that nominally private companies could borrow at more favourable rates than the government, however, this is certainly no longer the case which has resulted in the use of these deals being scaled back substantially since 2008. They do not appear to have produced a good deal for the taxpayer in any case: even if no new PFI deals are entered into the costs of servicing the more than 700 which are already in place is expected to amount to nearly £200 billion by the 2040s; by comparison, the total capital value of the projects completed via these deals is just £60 billion [20]. This has unsurprisingly resulted in massive private profits being made at the taxpayer’s expense [21].

The government’s biggest liability which is not included in official debt figures at all is the cost of future social security expenditures, which is mostly made up of pension obligations. State pensions and most public sector employee pensions are unfunded and operated on a “pay-as-you-go” basis. This means that, unlike private pensions, there is no corresponding pension fund which is saved and invested to pay for pension expenditures. Instead, state and public sector pensions are simply paid directly out of the contributions made by current taxpayers and public sector workers; any shortfall is made up by redirecting revenue from other sources or borrowing. This makes pension entitlements a massive unfunded liability: a spending commitment that the government will have to raise funds to meet in the future.

Pension liabilities are a particular concern given the UK’s demographics and existing policies. The UK has an ageing population meaning that in the future there will be an increasing number of pensioners and, therefore, an increased burden on workers and taxpayers who have to fund greater pension expenditures [22]. Furthermore, state pensions are currently subject to the “triple lock” policy which guarantees that the state pension payments will rise in line with inflation, wages, or by 2.5% annually, whichever is highest [23]. In the context of a decade of low recorded inflation rates and sluggish wage growth this has, in practice, meant that state pension entitlements have steadily grown in excess of wages and consumer prices. While there is suspicion that the government will scrap the triple lock in the wake of Covid-19 in an attempt to consolidate public finances, so far it has instead strengthened the policy, removing a rule that would have frozen state pension payments if wages fall so that pensioners will still gain a 2.5% increase despite average wages falling [24].

Whole of Government Accounts (WGA), which estimate the UK government’s entire financial position, show that as of 2018-19 public sector pensions alone accounted for a liability of £1.89 trillion or 42% of total liabilities, the largest single liability in the WGA. This is more than 90% of the present value of net public sector debt or GDP. The largest single public sector pensions scheme alone, the NHS pensions scheme, owes £620 billion in liabilities and zero assets [25]. The state pension is recorded under social security expenditure and future liabilities are not recorded even in the WGA, but the Office for National Statistics has previously estimated that, as of 2015, state pension entitlements amounted to £4 trillion or more than double GDP [26].

In total, the WGA show an estimated gross liability of £4.5 trillion and adding the state pension liability to that produces a figure in the region of the £8.6 trillion “real national debt” estimated offered by the Taxpayers’ Alliance above. Piling all these obligations up and calling them the “real debt” may be over-exaggerating matters, however. For one thing, WGA are meant to show the entire government balance sheet and also estimate that the government owns assets with a total value of approximately £2 trillion which means net liabilities are smaller than gross liabilities. Since 2016 official statisticians have published a broader measure of net public sector financial liabilities which is, in fact, slightly lower than net public sector debts (Chart 4).

Chart 4

Source: Office for National Statistics [27].

Additionally, the pay-as-you-go model used to pay for unfunded state and public sector pensions means that future liabilities should not really be considered independently of future revenues. For example, after accounting for receipts paid in by current workers, the net cost of public sector pensions is currently a comparatively modest £10 billion/year [28]. If this was included in debt figures it could mean an increase in the official deficit comparable in size to the re-evaluation of student loans but it is debatable whether that would be an appropriate accounting standard – not all liabilities ought to be considered debts.

The key point is that unfunded liabilities constrain future government spending decisions in a very similar way to debts. Just as present borrowing will have to be repaid in the future, the generation of entitlements in the present will have to be paid for eventually. The net value of public sector debts plus unfunded liabilities represents the amount of money that the government has already committed to paying out over the coming decades and it is undoubtedly a number in the trillions, several times present GDP, and this amounts to a substantial budget constraint upon future governments which is not wholly or clearly recognised by the headline national debt figure. Whether all of these obligations are defined as debts is arguably beside the point.

A sustainable approach to public debts and liabilities.

The UK government is committed to paying trillions of pounds over the coming decades in the form of debts and unfunded liabilities and will continue to generate more obligations in the future. This is clearly a great constraint upon what governments can do in the future as large chunks of their budgets will be pre-committed to specific ends. This is a fact that should be fully and transparently accounted for so that such spending obligations can be sustainably managed without imposing excessive burdens on younger and future generations.

A good place to start would be reviewing how these obligations are accounted for and publicly recognised. One thing that should be evident is that public finance accounts are somewhat byzantine and messy – things which probably should be accounted for in national debt figures are not and some things which perhaps should not be are. It is probably necessary to publish a range of statistics which illustrate the full picture of future spending obligations so that the public can be properly informed about what governments have done and are doing and so that governments can adopt effective policies to manage such obligations. Focusing intently on one part of a big picture, such as previous promises to eliminate the public sector budget deficit, risk failing to resolve broader issues and could even encourage governments to play games with figures, massaging what is and is not counted for the sake of meeting their targets.

Schemes like PFIs which commit public money to nominally private borrowing should be openly recognised as public debts. State and public sector pensions and other unfunded liabilities should at least be recognised as future spending obligations in order to inform the understanding of politicians and voters regarding how much fiscal space is available. Once all this is in the open governments may be able to make more transparent and credible promises and commitments, specifying and justifying what they intend to borrow for and letting voters judge their decisions rather than obfuscating what they are doing.

1https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes/publicsectorfinance/bulletins/publicsectorfinances/september2020

2https://www.ft.com/content/8250fec7-0581-477e-a525-bc2ab2dd5a11

3https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes/publicsectorfinance/datasets/publicsectorfinancesappendixatables110

4https://www.dmo.gov.uk/responsibilities/gilt-market/about-gilts/

5https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/785550/debt_management_report_2019-20_final_web.pdf (A.4-A.5)

6https://www.ft.com/content/3d576f71-6833-4a55-8b8c-f4abfb0ca172

7http://cdn.obr.uk/CCS1020397650-001_OBR-November2020-EFO-v2-Web-accessible.pdf

8https://www.imf.org/en/Publications/WP/Issues/2018/04/11/Interest-Growth-Differentials-and-Debt-Limits-in-Advanced-Economies-45794

9https://www.dmo.gov.uk/data/gilt-market/index-linked-gilts/

10https://www.dmo.gov.uk/data/gilt-market/average-gilt-issuance-yields/

11https://www.mercatus.org/publications/government-spending/debt-and-growth-decade-studies

12https://voxeu.org/article/public-debt-and-private-investment