Like a company, the government can borrow in order to fund part of its spending. Over time this adds to its debt level. But the government’s liability is of course someone else’s asset. That is, the majority of UK government debt is owed to investors in the UK, such as insurance firms, pensions funds and banks. In other words, the UK state owes most of its debt to people in the UK. So, when it comes to repaying the debt in the future, it will be future UK citizens that will repay the debt to other UK citizens. Another big owner of UK public debt is the Bank of England (owning about a quarter of all UK public debt), which is of course a public organisation.
Governments often borrow over the long term. The average debt obligation of the UK’s government is to be repaid over a horizon longer than 15 years. But the debt need not necessarily be repaid then. Governments can refinance their debt, meaning they could, for instance, extend it by another 15 years while of course paying interest rates in the meantime.
As a result of the covid crisis, the UK’s public debt is set to top 100 per cent of GDP – that’s higher than any time since the 1960s. Once the crisis is over, the economy is expected to recover and debt levels should stabilise. But how high should debt levels rise in the interim to get the economy back on track?
Some say we should stop the rise as soon as possible, by implementing tough spending cuts such as premature stops to covid support schemes. But, in reality, we need not fear high debt as long as we find a way to boost the economy, while having a medium-term plan for sound public finances.
More acutely, there is a looming threat that – once the immediate crisis is over – the economy will be scarred and sclerotic. Stuck in the doldrums, businesses may hold back investing, households could consume more cautiously and many jobs might not quickly return.
Rishi Sunak will need to do whatever it takes to prevent this. A broad-based government stimulus is needed to drive up demand, reduce business uncertainty and put people back into work. This will require further borrowing. But increasing public debt to bring about a resilient post-covid economy is in fact the only way to ensure sustainable growth and, as a result, put public finances on firm footing.
At the moment new government debt is financed in roughly equal amounts by private investors and the Bank of England. The Bank plays an important role in that it helps keep interest rates on new debt low and by effectively creating new money that is helping to finance the deficit. In this low interest rate environment, even with more borrowing, only a small share of annual tax revenues would need to be spent on servicing the debt each year.
As long as borrowing costs remain low, a high level of government debt remains affordable. In fact, interest rates are currently so low that even a doubling of the UK’s debt would still mean the Treasury pay less to service the debt in the future than in the past, as a share of tax receipts.
But the government cannot rely on the central bank buying ever more of its debt forever. Ultimately, this would undermine the credibility of public finances. Therefore, a sensible strategy for sound public finances is needed.
A good approach to stabilise public finances is government investment. Boosting investment can have the twin benefits of driving the recovery, while also making it easier to repay debt in the future. Even the traditionally conservative IMF has recently argued just that.
Every pound of smart investment can bring in a multitude of that back in tax revenues in the future. This means the debt burden is more easily repaid, with a smaller share of taxes.
But with the economy likely smaller after the pandemic, smart tax increases will likely still have to play their part in stabilising public finances. There are a range of taxes that could be increased while also addressing huge injustices in the system. For instance, there is no economic reason why income from capital is taxed less than income from labour, which mainly benefits the well-off.
Finally, in financial terms, looking at government debt considers only one side of the government’s balance sheet. That is, it looks at how much the government owes, but it ignores how the government invests this money. A more holistic way of managing public finances would focus on the governments ‘net worth’, rather than debt. Under this view, if the state borrows and wastes the money it would worsen its financial position. But if the state borrows and invests it in productive projects and infrastructure, it boosts its financial position.
With the UK in dire need for investments in public transport, hospitals, schools and business clusters, many have argued that there are a plethora of areas in which investments could indeed be productive. So, a more holistic approach to public finances shows that debt need not always be a negative thing – in fact, it can be a crucial means for enabling investment in a more robust and more sustainable future economy.