How is the government going to reduce the debt it incurred in partially protecting the economy from the pandemic? There’s one answer that won’t do – that it could erode the debt by high inflation.
This won’t work partly because almost a quarter of debt is now index-linked and so will rise as inflation rises. It will also fail because if investors anticipate permanently higher inflation they will sell gilts thereby pushing up their yields and raising the cost of servicing the debt. It is only unexpected inflation that erodes debt, but this is difficult to achieve even if it were desirable (which it’s not).
Which is not to say that government debt cannot fall quickly. It can. After World War II, government debt was equivalent to 259 per cent of GDP (it’s now 99.2 per cent). But in the following 20 years it dropped to just 80.7 per cent. This wasn’t – for the most part – because it was eroded by inflation. That averaged only 4.3 per cent in this period: it was only in the 1970s that inflation cut the debt significantly.
Instead, two things did the trick. One was that the government ran consistent surpluses on its primary balance (that is, excluding interest payments) and on its current account. It borrowed only to invest in infrastructure. The other was that economic growth was strong and interest rates low: in the 20 years after 1946, real GDP grew by 3 per cent a year while bond yields averaged only 0.3 per cent after inflation. That meant that the debt-GDP ratio fell because GDP rose faster than the cost of the debt. Which vindicated what Maynard Keynes said in 1933: “Look after the unemployment, and the Budget will look after itself.”
Sadly, however, we are unlikely to repeat this trick. After the war there was huge pent-up demand, for civilian capital equipment, housing and consumer goods. This had two effects. One was to power strong economic growth not just in the UK but around the world, thus boosting exports as well as domestic demand. The other was to cause private sector investment to equal and sometimes exceed saving – both personal and corporate. As a simple accounting identity, the counterpart to this financial deficit was a public sector surplus: if the government is receiving more than it is spending, somebody else must be spending more than they are getting.
But while there is some pent-up demand now, there’s much less than there was after 1945: the pandemic did not destroy the housing stock or factories. In fact, there’s no strong reason to believe it has put an end to the long-term stagnation we experienced before it struck us.
So, maybe we can neither inflate nor grow the debt away. And nor can it be greatly reduced by fiscal austerity, as this depresses economic activity and thus tax revenues.
Which leaves us just living with it. Economically speaking, this is no problem: the same weak growth that keeps debt high also holds down the cost of servicing that debt. But this isn’t to say doing so is costless: it means we’ll continue to hear claims about “black holes” and debt “burdens.” The main cost of high government debt is the noise pollution it causes.