The government response to COVID-19 has involved vast, debt-financed increases in public expenditure. The spending has been on a far greater scale than during the financial crisis. With interest rates close to zero fiscal policy is firmly in the driving seat.
That leaves governments, rather than central banks, with the task of securing growth. Instead of raising taxes and reducing public spending as many did after the last recession, governments are now planning the next stage of fiscal easing. Policy is pivoting from countering recession to bolstering the recovery. High levels of public borrowing are likely to be here for some time to come.
Last Wednesday’s UK budget illustrated these trends. The response to COVID-19 has cost about £160bn since March, equivalent to 20% of existing public spending or 7% of GDP. New measures announced last week add about £30bn to this tally through measures to support jobs, the hospitality sector and the housing market. The government has also granted tax deferrals and loan guarantees worth £123bn, some of which will never be recovered.
The government’s deficit has shot up from a little over 2% of GDP last year to perhaps £350bn this year, equivalent to 18% of GDP. This would be the largest peacetime deficit in UK history (the UK ran deficits of around 25% of GDP during the second world war). Huge though the increases in spending are, the easing of fiscal policy in the UK is less than that being seen in some other advanced economies, including the US, Germany and Japan.
As a result of the surge in borrowing the ratio of UK government debt to GDP has risen from around 80% at the start of this year to above 100% for the first time since the early 1960s. France and the US are also likely to join the growing number of countries whose debt exceeds GDP. Prior to this crisis, only Greece, Italy, Japan and Portugal had levels of debt above 100% among advanced economies.
The extra £30bn of spending announced last week looks like the first tranche of a bigger programme of fiscal easing designed to bolster the recovery.
The chancellor of the exchequer, Rishi Sunak, is expected to announce additional spending in the autumn budget, and possibly before as well. Mr Sunak seems sanguine that the risks posed by higher levels of public debt can be managed. He has argued that in the medium term, the size of the economy is more important than the size of the debt. Last week Mr Sunak said his goal was to ensure public finances were sustainable “over the medium term”. This formulation suggests that any new fiscal rules may be limited to reducing public debt as a share of GDP by the end of this parliament (2024), a less onerous rule than that which led to public austerity in the early 2010s.
Low interest rates make today’s debt burden look eminently manageable. The UK government currently pays interest of 0.17% on new, ten-year debt, less than a quarter the rate at the start of the year when public sector debt was far lower. The interest rate or yield on government bonds has dropped as a result of the collapse in economic activity and vast central bank purchases of bonds through quantitative easing.
For now the bond market, backed by huge demand from the Bank of England, is giving the government the green light for more borrowing. For policymakers the focus is on securing the recovery, not on limiting the deficit. Barring an improbably speedy recovery substantial new spending measures and tax cuts are likely before the end of the year.
Yet cheap financing costs cannot be taken for granted. The euro area crisis demonstrates that the bond market changes its mind. The interest rate on Italian government bonds doubled in 2010–11 on concerns about government indebtedness. The result was a deep financial crisis which called into question Italy’s continued membership of the euro and triggered Italy’s second recession in two years.
There is also the question of how long the Bank of England will continue to buy UK government bonds. Quantitative easing has added around £450bn to the Bank’s balance sheet in the wake of the financial crisis, most of it in the form of UK government bonds. This total looks set to rise to £745bn fighting the current downturn. The Bank now owns over a quarter of the entire stock of UK government debt, making it a major force in shaping the demand for and price of UK bonds. The Bank’s governor, Andrew Bailey, made this clear last month when he said that the government would have struggled to raise debt in March had the Bank not intervened with £200bn of asset purchases to calm markets. Bank demand for UK gilts has helped facilitate a surge in government borrowing but arguably this is a by-product of a policy designed to bolster growth, not its main aim. As Mr Bailey has said, “At no point have we thought that our job was just to finance whatever debts the government issues”.
So in the longer term the UK government will also need to stabilise the public finances and build greater leeway to cope with future crises. In common with most advanced economies the UK also needs to strengthen its finances to fund health and pension commitments for ageing and shrinking workforces.
There are four main approaches to manage high levels of government debt. The first is to cut public expenditure, as happened following the 2008 financial crisis. The second is to raise taxes. The third is to grow the nominal size of the economy through some combination of higher growth or higher inflation. This was the way in which the UK reduced the ratio of debt to GDP in the decades following the second world war. But a return to faster growth rates does not seem on the cards and inflation is limited by central bank inflation targets. The fourth option is to live with higher levels of public debt, as Japan has for the last three decades, helped by central bank debt purchases and low interest rates.
Of the four options, cutting spending is politically and economically difficult. The ideal would be for faster growth to come to the rescue. Counting on such an unlikely outcome looks unwise. That leaves some combination of tax rises and living with higher debt as the most likely responses.
Spending cuts bore the brunt of the UK’s fiscal adjustment following the 2008 global financial crisis. The pressure to maintain government spending seems to be far greater today. COVID-19 has fuelled inequality by bearing down most on the incomes and job prospects of lower earners. Limiting the scale and impact of unemployment implies an increasing need for active labour market policies, such as training and help finding work, as well as higher levels of income support for the unemployed. Public opinion has moved on since 2009, when most voters favoured balancing the books by cutting public spending. Today YouGov polling shows 47% of respondents prefer tax rises and just 27% favour cuts to public spending.
Where might the burden of future tax rises fall? Concerns about inequality could move the focus of future tax rises away from income and sales taxes and towards those on wealth, capital, savings and profits. Last week the prime minister, Boris Johnson, reiterated his party’s manifesto pledge not to hike income tax, national insurance contributions or value-added tax.
If the priority is to reduce public debt the obvious candidates are the major taxes, with broad coverage. Income tax, national insurance contributions and value-added tax account for about 60% of tax revenue. Corporate taxes and business rates amount to just 10%. Raising the basic rate of income tax from 20% to 21% would raise £4.7bn while increasing the higher rate from 40% to 41% would raise just £1bn. Other options that would raise meaningful revenue include harmonising self-employed national insurance contributions with those for employees or eliminating higher rate pensions tax relief.
The government is acutely aware of the risk of premature fiscal tightening. In the near term the economy is likely to need more public spending and tax cuts. The chancellor acknowledged last week that the public finances will have, in time, to be put on a firmer footing. But for now fiscal policy could perhaps be described as being in Augustinian mode – “Lord make me chaste, but not yet”.