Sunday, July 12, 2020
Rishi to the rescue, but we'll have to live with the debt
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt.

Hindsight is a wonderful thing but I can honestly say, listeninging to Rishi Sunak’s plan-for-jobs statement last Wednesday, the words “deadweight cost” kept coming into my mind. This was except when he announced his “eat out to help out” 50% reduction in restaurant food bills on some days in August, when the word was “gimmicky”.

I am not going to criticise the saintly Sunak too much because he is more popular than any economic journalist is ever going to be, and because he is doing his best in very difficult circumstances. He is also refreshingly aware of the pros and cons of his policies and, unlike others, is not given to bluster.

The two obvious deadweight costs in his announcements were firstly, the £1,000 per worker job retention bonus, which could cost over £9bn, and which the permanent secretary to HMRC (Her Majesty’s Revenue & Customs) did not think was good use of public money. The second was the six-month cut in VAT for much of the hospitality sector from 20% to 5%.

The bonus will be paid to employers who furloughed staff only briefly and have had them back at work for some time. The VAT cut will benefit people who would have eaten out or visited attractions anyway. There may have been method in both, however. Refining the bonus would have taken too long and the VAT cut may be intended to funnel money to a troubled sector of the economy as much as persuading the reluctant to venture out.

The gimmicky “50% off” Treasury-backed restaurant promotion reminded me of those “buy one get one free” offers that are said to have contributed to the country’s obesity problem. The behavioural response to this will be interesting. When you halve the price of a burger, do people eat twice as many?

That is in the detail of what was another big announcement from this chancellor. City economists think the cost of last week’s package will be closer to £20bn than the “up to £30bn” costed by the Treasury. But this is on top of the £158.7bn of direct fiscal support already provided by the Treasury in response to Covid-19.

The appropriate way to think of the Covid-19 response, of course, is akin to that of fighting a war. You do what the chancellor has described as “whatever it takes”, lifting a line from the former European Central Bank president, and think about how to pay for it afterwards. In fact, the government is probably less constrained in its ability to borrow than its wartime predecessors, given the Bank of England’s large-scale quantitative easing (QE) purchases of UK government bonds, gilts. Its £300bn of additional QE this year is in the same territory as the likely budget deficit.

Debt has not always fallen after wars. In the 1920s and 1930s government debt averaged 170% of gross domestic product (GDP) after World War One, before pushing sharply higher during the Second World War. Its drop then from 250% of GDP or more reflected a combination of post-war austerity, demobilisation and financial repression; the government being able to fund its borrowing at sub-inflation rates. By the late 1970s debt was down to less than 40% of GDP.

Many people will say that, in response to this crisis, we should not worry too much about debt. The Resolution Foundation think tank expects public sector net debt to stay above 100% for the remainder of this parliament. That in itself is not worrying, though it is worth recalling that at one time, under Gordon Brown, the safe level of debt was thought to be 40% of GDP.

To put some numbers on this; official figures show that public sector net debt is currently £1,950bn, nearly £2 trillion, that government borrowing in the first two months of this fiscal year exceeded £100bn, and that the rise in debt over the latest 12 months, £173bn, is the biggest on record.

There are two things that make this situation unusual. One is the combination of high levels of debt and large-scale government borrowing. You may think this is always the case but it was not in the interwar years. Budget deficits were modest relative to GDP.

One lesson from the past decade is that, once borrowing is big enough, it takes time to get it down to “normal” levels. This year’s borrowing will certainly be big enough, between 15% and 18% of GDP, roughly between £300bn and £350bn.
When the Office for Budget Responsibility (OBR) looked at this three months ago, it concluded that a big budget deficit this year would be followed by a speedy return to normality next year, as temporary measures like the furlough scheme are wound down.

On Tuesday the OBR will publish an updated fiscal sustainability report, which will provide a more nuanced view in three scenarios. One will be optimistic, predicting a very rapid bounce, with no medium-term economic scarring. The others will show significant economic and fiscal hangovers.

The Institute for Fiscal Studies set out three such scenarios last month, ahead of the chancellor’s economic update. Its central scenario had the government still borrowing £130bn a year in 2024-25. That implies a bigger fiscal hangover than after the global financial crisis. In the five years after that, the government borrowed just over £650bn. This time, on the IFS’s projections, which may have to revised in the light of further action by the chancellor, the total will be around £860bn.

The second point is that there is no obvious way of reducing debt, even if the government wanted to do so. Two years ago, the OBR’s fiscal sustainability report showed that ageing populations and other factors would push government debt significantly higher over the next 40-50 years, if unchecked, to some 280% of GDP. The OECD has come to similar conclusions, and not just for Britain. This Covid-19 related debt surge means that these increases will start from a higher base.

It is not clear that Boris Johnson understands what austerity was but he has said that there will be no return to it. Tax increases on the scale needed to deal with the borrowing in prospect – many tens of billions - are not feasible, not least because of the damage they would do to the recovery, whether introduced next year or later. A wealth tax, now apparently not Labour party policy, would make barely a dent, which would mean raising one or all of the big taxes; income tax, VAT and national insurance, all of which the Tories are committed to not doing.

“Over the medium-term, we must, and we will, put our public finances back on a sustainable footing,” Sunak said in his statement. It is not clear whether he, or anybody else in the Treasury, yet knows how.

A strong recovery would, of course, help, and we should probably avoid the post-financial crisis obsession with how much of the budget deficit was “structural” and thus permanent, and how much cyclical. Beyond the bounce as lockdown is eased and the economy returns to something like normality, it is not clear that the economy is capable of doing better than its subdued, Brexit-constrained growth rate of recent years. Given the way the negotiations are going, it may do a lot worse, something I shall return to soon.

The Covid-19 crisis has resulted in a step-change for government debt. We may have to live with this higher debt, or even higher, for the foreseeable future, hope that we can continue to fund it cheaply, and pray that it does not bite us.