The real danger to the public finances

Chris Dillow

Chris Dillow
The real danger to the public finances

This recession has raised government debt. The Office for Budget Responsibility (OBR) forecast last week that this will exceed 100 per cent of GDP until at least 2025.

For now, this is not a problem. If interest rates remain at their current level, the government will be able to reduce the debt-GDP level merely by running any primary deficit (that is, excluding interest payments) of under4 per cent of GDP. As it was running a surplus before the pandemic, this tells us there’s no need for austerity.

But, but, but. Rates might not stay low. “The highly favourable financing conditions the government currently enjoys might not persist,” the OBR warned last week.

Personally, though, I don’t think this is a problem.

High debt alone will not force up interest rates. We know this from Japan. Its government debt is over 200 per cent of GDP, but nominal 10-year bond yields are close to zero. We also know it from our own history. After WWII government debt was also over 200 per cent of GDP, but gilt yields remained low for years. They only rose as inflation rose from the late 1960s onwards – by which time the debt-GDP ratio had fallen a lot.

So what might raise borrowing costs?

History tells us that one possibility is inflation. This, though would be an effective way of reducing the debt:GDP ratio, as inflation both raises nominal GDP and devalues the debt. Also, one way in which inflation would rise would be if aggregate demand grows strongly. But in this world, tax revenues would flow in, thus improving the public finances.

We can put this another way. The world in which demand is growing strongly is one in which the private sector is borrowing – and private borrowing is the counterpart of a public sector surplus.

Higher borrowing costs caused by inflation, then, are not a threat to the public finances.

Borrowing costs might instead rise if the global savings glut (or investment dearth) were to disappear. But if the world is saving less and investing more, demand is growing. As some of this would come the UK’s way, tax revenues would rise, again reducing government borrowing.

Yet another possible way in which borrowing costs would rise would be if investors’ demand for safe assets falls. But this will only happen if investors’ appetite for risk rises. And why would it do so? Because the economy is growing well. Again, this would raise tax revenues and private sector borrowing, thereby reducing government borrowing.

So yes, there are lots of reasons why gilt yields might rise in coming years. Sure, the gilt market is currently attaching little weight to these risks, but we must not read much into this as the longer-term future is largely unknowable. But one thing is plausible. A world of rising gilt yields is quite likely to be a world of economic growth and thus rising tax revenues. Higher government borrowing costs are not therefore a threat to the public finances, because they’ll be the counterpart of a shrinking deficit anyway.

Instead, the likelier way in which government debt will stay high would be if economic growth remains weak. But in such an environment, demand for gilts will be high and debt thus easily financed. The old Keynesian truth therefore holds good: look after the economy and the public finances will look after themselves.

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