UK public debt stands at almost 100 per cent of GDP. History shows how to respond

 ------------------------

UK public debt stands at almost 100 per cent of GDP. History shows how to respond

The miraculous reductions of the past show what is—and is not—possible today

By

Barry Eichengreen

November 25, 2021

Chancellor Winston Churchill on his way to deliver a budget, 1927. PA Images / Alamy Stock Photo

Stein’s Law, named after the eminent American economic Herbert Stein, holds that “if something can’t go on forever, it will stop.” The law holds for the government accounts: at some point the tendency for the stock of public debt to grow faster than the economy will have to stop. There are limits on the share of tax revenues that can be devoted to debt service without crowding out socially valued and economically valuable projects. Modern monetary theorists dispute this, but other economists do not.

Chancellor Rishi Sunak’s October 2021 autumn budget is, as far as I can see, the first major statement by a government official since the pandemic which details plans for slowing the growth of public debt and stabilising the debt/GDP ratio. On its basis, the Office for Budget Responsibility sees public sector net debt as a share of UK GDP falling from 98.2 per cent to 97.8 per cent in the next two fiscal years. This is a modest adjustment compared to the aftermath of the Global Financial Crisis, when there were equivalent tax increases but also severe cuts in discretionary spending. Evidently, the lessons of premature austerity have been learned.

The OBR then sees the debt ratio falling to 88 per cent of GDP in 2026/2027, assuming the economy continues to expand. The argument for reducing the ratio is that this must be done in order to enhance the government’s capacity to meet the next emergency. This may be another financial crisis or novel coronavirus. It could be a geopolitical event or climate-related disaster. No one can say. But prudent governments budget for contingencies.

And not for the first time is the government weighing how it should do so. It is instructive when considering options for the UK today to look to history. Only then can we draw conclusions about the speed and extent of debt reduction that can realistically be achieved.

Two centuries ago, Britain emerged from the French and Napoleonic Wars with a debt-to-GDP ratio of 200 per cent, twice current levels. On the eve of World War I, that ratio had been reduced to less than 30 per cent. That contemporaries saw another conflict coming had concentrated minds. The extent of the franchise was still limited even after the Reform Acts of 1832, 1867 and 1884, making for strong creditor representation in the House of Commons. The long 19th century was a period of peace by earlier standards. Not having to engage in large amounts of military spending, the government was able to run primary budget surpluses (revenues minus spending net of interest payments), excepting only during the Boer War.

Obviously, this is not an experience that can be replicated. Today’s political environment creates intense pressure to devote revenues to objectives other than debt retirement. The government can aspire to fiscal restraint, but not with the same single-mindedness.

The UK then emerged from World War I with another massive debt, approaching 200 per cent of GDP in 1923. Agreeing on tax increases and spending reductions was more difficult in this era of universal franchise. The Treasury argued against deficits. The Colwyn Committee, set up in 1924 by then chancellor Winston Churchill, made a forceful case for debt reduction. Backed by these arguments, the government delivered primary surpluses from 1923 to 1929.

But it reduced the debt ratio only to a limited extent. Interest rates were high, reflecting doubts about the government’s commitment to debt consolidation. They were higher than the growth rate of the economy, causing the denominator of the debt/GDP ratio to lag behind the numerator. Alarmingly, this is an experience that can be replicated. Productivity growth in the UK has disappointed for a decade. Failing to solve this problem will make stabilising the debt ratio well-nigh impossible.

After World War II, in contrast, the stars were aligned for debt consolidation. Between 1945 and 1973, a debt burden of more than 250 per cent of GDP was reduced to less than 50 per cent. Helped along by a backlog of unexploited investment opportunities and a favorable external environment, growth was rapid even in what was now “the sick man of Europe.”

Moreover, interest rates were below growth rates, unlike before. Strict regulation compelled banks to invest in government bonds, pushing prices up and yields down. Capital controls bottled up savings, benefiting the market in gilts.

“Between 1945 and 1973, a debt burden of more than 250 per cent of GDP was reduced to less than 50 per cent”

Today’s environment is different. Capital controls are not coming back, Brexit or not. Their views informed by the Global Financial Crisis, regulators see force-feeding government bonds to the banks as creating a “diabolic loop” in which bank and government balance sheets destabilise one another. Some see the Bank of England as capping bond yields by purchasing an ever-increasing share of public debt. But, sooner or later, this will threaten inflation. At that point, in my view, an independent central bank and powerful creditors’ lobby will push back.

Critically, in the quarter century following World War II, government was able to run primary budget surpluses while at the same time expanding the welfare state. Although social spending rose from 5 per cent of GDP in 1938 to nearly 8.5 per cent in 1974, surpluses were maintained.  Some criticise the postwar expansion of programmes to alleviate poverty as insufficiently ambitious. But this is what happens when it is necessary to use one instrument (the budget) to pursue two targets (poverty alleviation and debt reduction). More positively, this experience points to the possibility that debt consolidation can be consistent with support for the National Health Service, with the need for public spending on tackling climate change, and with “levelling up” the north.

How were these imperatives reconciled after World War II? First, rapid economic growth made for buoyant revenues. There were no major economic dislocations like those of the 1920s and 1930s to throw revenue growth off course.

Second, there was a willingness and ability to levy taxes on the wealthy and on corporations. Willingness, given the arguments for social solidarity inherited from the war. Ability, since controls limited the scope for relocating to lower-tax jurisdictions. Those limits didn’t prevent the Rolling Stones from moving to France, but they did permit the maintenance of higher tax rates on corporate profits (which were taxed at the same rate as ordinary income until 1965).

It is beyond the capacity of the UK today to replicate the miraculous reductions in the debt ratio following the French Wars and World War II. A century of budget surpluses, like those of the Victorians, is beyond our political grasp. Statutory limits on interest rates like those after World War II are not on the cards. Inevitably, debt consolidation will be more difficult and halting.

But what the UK must do is figure out how to grow the economy, enhancing its debt-bearing capacity and augmenting government receipts. It can use taxes on corporations and the wealthy to increase revenues; the recent G20 agreement on a 15 per cent minimum corporate tax is a first step. It can devote those resources to prudently expanding social programmes while also running primary budget surpluses. This may not be the best imaginable debt-management strategy. But it is the best available strategy.

Barry Eichengreen

Barry Eichengreen is, with Asmaa El-Ganainy, Rui Esteves and Kris Mitchener, currently completing a new book on public debt. His last book was “The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era” (Oxford)

Prospect