Unlike the period after the Global Financial Crisis, we doubt that the government will immediately turn to a prolonged period of austerity after the surge in the debt to GDP ratio during the coronavirus crisis. This suggests the economy won’t have to drive with the fiscal policy handbrake on.
- Unlike the period after the Global Financial Crisis (GFC), we doubt that the government will immediately turn to a prolonged period of austerity after the surge in the debt to GDP ratio during the coronavirus crisis. This suggests the economy won’t have to drive with the fiscal policy handbrake on.
- The UK’s public finances are in their worst position since the aftermath of the Second World War. The deficit is likely to surge to close to £330bn this year, more than five times that seen in 2019/20 and around 17% of GDP. And the government debt to GDP ratio looks set to rise from around 93% in 2019/20 to about 105% in the 2020/21 financial year. (See here.)
- A fair chunk of the increase in this year’s deficit (£133bn) reflects the discretionary fiscal stimulus which will not be repeated next year. Even so, the narrowing in the budget deficit that we expect over the next few years from 17% of GDP in 2020/21 to about 6% by 2022/23, as tax revenues rebound and the stimulus measures expire, would still be consistent with the debt to GDP level remaining above 100%. (See Charts 1 & 2.) In fact, the debt ratio may not start to fall back until 2024/25 and then only due to the expiration of the Bank of England’s emergency coronavirus measures, such as the Term Funding Scheme with incentives for Small and Medium Sized Enterprises (TFSME) which is included within government debt. (See here.)
- If anything, these fiscal projections may prove to be too low. They make no allowance for any major new discretionary measures in the summer or autumn as the government moves away from crisis mode and towards promoting the economic recovery. And they could be worse still if the economy is weaker that we expect. So there will be a significant step up in the government’s debt burden.
- As a result, there have already been suggestions, not least from the Treasury itself, that a period of austerity (tax rises and/or spending cuts) will soon follow to bring the debt ratio back down, just as there was in the decade after the GFC. But there are three reasons why we doubt austerity will be embraced as significantly this time.
- First, the attitude of the public to the recent big rise in government spending is very different now to that following the GFC. The public is unlikely to demand the recovery of money spent on healthcare and the NHS. If anything, this crisis is likely to lead to pressure on the government to spend more on health and welfare. Meanwhile, the memories of the previous painful bout of austerity mean there will be scant support for another prolonged squeeze on public spending.
- Second, the current government’s attitude is very different to that in the George Osborne/David Cameron austerity years. The pandemic has not dampened the government’s resolve to announce new spending to “level up” the regions. And as spending on investment typically boosts demand by more than tax cuts, the government could get a bigger bang for its buck. (See here.) By providing a boost to the economy, the government could argue that this will prompt a quicker improvement in the public finances.
Chart 1: Public Sector Net Borrowing (% of GDP)
Chart 2: Public Sector Net Debt (% of GDP)
Sources: BoE, OBR, Capital Economics
Sources: BoE, OBR, Capital Economics
- Third, there is a greater acceptance and confidence in the ability of the government to carry higher levels of debt. The justification for austerity over the past decade was that the near-term pain was worth it to avoid a sharp rise in government bond yields and higher borrowing costs that would inflict even more damage to the economy further ahead. But in recent years, the bond markets have been unconcerned about elevated levels of government debt. And neither the recent deterioration in the public finances nor Fitch’s downgrade of the UK’s credit rating from AA to AA- in March have led to a significant rise in borrowing costs. (See here.)
- This all suggests that the government may choose to live with much higher levels of debt than in the past. Of course, this will only be possible as long as interest rates remain below nominal GDP growth. If they don’t, then debt servicing costs would rise as a share of GDP and the debt would become unsustainable. With 10-year gilt yields at 0.3%, well below our estimate of potential GDP growth of around 1.7%, current conditions are conducive. And if spare capacity in the economy keeps inflation muted, as we expect, we doubt the Bank of England will think about raising interest rates for at least five years. (See here.)
- Even so, this doesn’t mean that the government is completely off the hook. Tolerating higher debt levels would leave the government far more exposed to a sudden rise in inflation and borrowing costs. And in order to prevent the debt ratio from rising further, we estimate that the primary deficit (i.e. the deficit excluding interest costs) would probably need to return to 1.5% to 2.0% of GDP, similar to that seen before the crisis in 2019/20. (See here.)
- Meanwhile, even if the financial markets are willing to tolerate a higher debt burden, there are other reasons for the government not to throw caution to the wind, not least the long-term pressures on the public finances from an ageing population. At some point, in order to cope with the increase in spending required by an ageing population, taxes are going to have to rise.
- Overall, in the coming years there is probably neither the political will nor an urgent need for the government to tighten its belt as much as it did after the GFC. Instead, the debt ratio may be worked down over a period of 20 or 30 years as was the case after the Second World War. That doesn’t mean that the government won’t have to eventually rein in any fresh borrowing and slowly tighten fiscal policy in order to get the books back in order. Neither does it rule out tax rises, perhaps on companies that have benefitted from the coronavirus (such as tech firms) – although any money raised may be used to pay for more health spending rather than reducing the deficit.
- However, with any lurch to tighter fiscal policy likely to be smaller than after 2008/09, the economic recovery is unlikely to be significantly undermined by the government’s fiscal decisions. With fiscal policy set to be much less of a drag on economic growth, this suggests that the next decade will be very different to the decade after the Global Financial Crisis.
Ruth Gregory, Senior UK Economist, +44 7747 466 451, firstname.lastname@example.org