Sunday, April 25, 2021
The Covid debt isn't going away. We will have to live with it
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. Not to be reproduced without permission.

Cast your mind back a couple of years, if you can, to the spring of 2019. At that time, most of the indicators relating to Britain’s public finances were flashing green. The budget deficit, which for the 2018-19 fiscal year came in at less than 2 per cent of gross domestic product, had ceased to be a source of major concern.

It had been a painful process, and some of that pain, such as the freeze on most working-age benefits, was still in place. But the public finances, to all intents and purposes, had been fixed. There was a small current budget surplus, on day-to-day spending, in 2018-19. Public sector debt, at £1.77 trillion, was high, but it was no longer rising very much in cash terms, and is was falling relative to GDP, to a shade over 80 per cent by the end of March 2019.

Maybe we should have known then that something nasty was about to come along to shock us out of what was a false sense of security. It was known that Brexit would damage the public finances, but that was built into official forecasts that showed debt continuing to fall as a percentage of GDP, the deficit falling further and current budget surpluses becoming the norm.

Nobody could have predicted, however, quite how dramatically things would change, as a result of the pandemic and the government’s response to it. Figures on Friday showed that the budget deficit for 2020-21 came in at £303 billion and, while this was lower than the £355 billion projected by the Office for Budget Responsibility (OBR) alongside the budget early last month, a big undershoot, roughly £27 billion of that undershoot reflects expected government write-offs on pandemic loan schemes that have not yet been incorporated into the figures.

The debt, meanwhile, is £2.14 trillion, 97.7 per cent of GDP. And, while it will increase at a slower rate from now on as the deficit comes down, it will increase nonetheless. The OBR predicts that it will peak relative to GDP at just under 110 per cent in 2023-24, but continue to rise in cash terms, reaching £2.8 trillion by 2025-26.

What to do about it? The chancellor had a first bash in last month’s budget, including an increase in corporation tax from 19 to 25 per cent in April 2023 and a freeze in income tax allowances and thresholds from next year. He has also set out some reasonably tight public spending numbers. Those are incorporated in the OBR figures.

A new report from the National Institute of Economic and Social Research, Niesr, funded by the Nuffield Foundation, ‘Designing a New Fiscal Framework: Understanding and Confronting Uncertainty’, should be read by anybody interested in UK fiscal policy.

It includes contributions from two former chancellors, Lords Lamont and Darling, two former chief secretaries, and current and former central bank and government officials, including the government’s chief economic adviser.

As a general point, it argues that Rishi Sunak was right to let the public finances take the strain in response to the pandemic. As Martin Ellison and Andrew Scott, two leading economists, put it in a chapter called “the debt vaccine”: “Debt has done exactly what economic theory tells us it should do – act as a buffer in response to unexpected negative shocks. In a sense, government debt acts as an economic vaccine - protecting a weakened economy from shocks to economic health.”

They make the interesting point that, on the basis of the market value of gilts (UK government bonds) debt is higher than appears, at 133 per cent of GDP. But, while there are risks attached to high government debt, notably an increase in borrowing costs, the chancellor was right to act first and think about how to pay for it later.

As a former chancellor at the helm during the global financial crisis, Lord Darling argues that many countries are in the same boat and should work together. He likes the US proposal for a minimum global corporation tax rate to help pay for the pandemic. With debt set to be more than 100 per cent of GDP in coming years, it is worth recalling that one fiscal rule he was forced to tear up during the financial crisis was that it should be kept below 40 per cent of GDP.

Lord Lamont, chancellor during the 1992 ERM (exchange rate mechanism) crisis, notes the very different interest-rate environment now compared with then. When he became chancellor in 1990, Bank rate was 14 per cent and remained in double figures for most of his tenure. Today it is 0.1 per cent and the “bond vigilantes”, who traditionally punish governments running up debt, are quiescent. He fears they will not always be so.

To keep them at bay, the government needs to have a credible fiscal framework, which is the nub of the report, as summarised by its editors, Jagjit Chadha, Niesr’s director, Hande Küçük and Adrian Pabst. They preface their chapter with a quote from Ernest Hemingway: “How did you go bankrupt?" Two ways. Gradually, then suddenly.”

Fiscal rules have been frequently changed by governments, they point out, and are often set for political reasons, not economic ones, and tied to parliamentary timetables which the economy does not follow.

They propose a five-pronged approach. First. the dates of fiscal events like budgets should be known and fixed well in advance, like meetings of the Bank of England’s monetary policy committee, not sprung on people for the convenience of the government. They should also be subject to greater parliamentary scrutiny.

Second, the OBR should publish reports ahead of these events, addressing the key issues and numbers. Currently it only does this privately to the Treasury. Third, the chancellor should outline what it describes as “fundamental fiscal choices” under different scenarios, to be assessed by the OBR.

Fourth, the government should set up a body of independent fiscal experts, in addition to the OBR and, finally, there should eb more joined-up fiscal strategy across the regions and countries of the UK, looking at a range of measures, including distribution, productivity, wellbeing and the environment.

The chancellor is drawing up a new set of fiscal rules. They did not see the light of day last month because of continued uncertainty but it will be surprising if they do not include some or all of the suggestions in the Niesr report.

There is no magic or easy way of dealing with the extra debt the country has taken on as a result of the pandemic. Its legacy will be higher public sector debt for years to come. Maintaining the confidence of the markets in this will be crucial.