Does the UK have a debt problem?

The most common debt measure is Public Debt to GDP. While theories vary, it is accepted that beyond 60% of GDP, public debt begins to affect growth, as interest payments grow large. Beyond the 90% threshold growth, issues become larger. Japan, which has been running Debt to GDP above 150% for over two decades and has seen very little growth is a testament to that. 

At the end of Margaret Thatcher’s tenure, UK public debt to GDP stood at 27%. Following years of fiscal expansion, and higher growth by Tony Blair, the number, which rose to 43% by the turn of the century, rested at 33% by 2002. The Global Financial Crisis, which saw a sharp drop in GDP higher borrowing kicked the number above the first threshold, to 74%. After the pandemic, the number blew past the second threshold, to 104%, and it’s projected to go up a few points, nearer 110% by the end of the decade.

Governments, especially in democratic countries where they have strict term limits, often find it easier to run high deficits and increase their debt, than having to face the voters’ wrath over austerity or recessions.

Debt has a habit of becoming onerous in a non-linear way. It may take years of build-up and only days for the system to collapse. Investors, once happy to take on government debt for a yield, could quickly pile on top of each other to sell first at any price and shut a country off from the global financial system.  Greece’s example is all too recent. A fast-growing economy with “developed” status, fuelled by debt, was forced a few years ago into a debt haircut and saw a sharp drop in its GDP, by about a third within the space of a few months. The drop in living standards was comparable to the Great Depression in the 1930s. Britain, a much larger country enjoying G7 status, experienced a market run on its debt in late 2022, following Liz Truss’s mini-budget announcement.

Is the UK in trouble? And if so what is the remedy?

The answer is complex. Debt sustainability depends on several factors:

• Who’s the creditor? Countries which lend internally more than externally have higher debt tolerance and are less subject to a market run.
• Does the country have monetary autonomy? A strong central bank can intervene during a market run and buy the country’s debt, thwarting market runs before they spiral out of control.
• What is the maturity of the debt? Countries with longer maturities have effectively managed to kick the can down the road.
• What are the terms of the debt? Will it be paid in local currency or a more “hard currency”? Will the debt settlement happen domestically, in the country’s courts, or in a more international venue?

The UK, on the back of its G7 status, scores well in most of these categories. Additionally, debt tends to be viewed in a comparative fashion, as many investors are forced by their mandate to hold some fixed income. So if everyone owes, investors who have to buy debt, simply prefer the strongest amongst borrowers. While 104% debt might sound like a big number (and it is), the average for advanced economies at the end of 2022 was over 113% up from 53% at the beginning of the 1990s. So the UK is actually better than most of its competitors. As high as the number sounds, it is not necessarily alarming.

Yet governments know that one can’t borrow at an increasing pace ad infinitum. Debt tends to produce more debt at a faster pace and eventually weakens the country’s political position against its creditors.

If a government chose to reduce the debt, how would it go about it? There are three commonly accepted methods:

• Austerity: reducing social spending and other activities that don’t improve productivity.
• Inflation: Running inflation at a higher rate than the growth of debt will reduce the value of debt in real terms.
• Super-charging growth: increasing GDP faster than increasing debt. This requires targeted tax cuts and debt to be deftly invested in activities that generate faster growth, as opposed to social spending.

Austerity is usually forced upon a country by creditors or due to tight market conditions. Cost-cutting creates a lot of resentment and usually damages a government’s chance for re-election.

Some have argued that debt could be inflated away. The idea is that if debt remains stable and inflation reduces the value of the Pound, then real debt levels would be reduced and nominal GDP levels would rise at the same time. However, the notion is a bit misguided. For one, OBR’s chair Richard Huges said last July that average debt maturities are significantly lower than in the past, to around two years. Because of low maturities, higher interest rates feed into government spending much more than in the past. Second, a lot of UK debt is inflation-linked, roughly 25%. This is much more than other G7 governments. So higher inflation would simply increase government payouts for its debt, in essence causing austerity and lowering growth.

Pro-growth governments, usually prefer the third method: laser-focused tax cuts to spur growth.

On the back of lower lending figures in December, there has been increased talk of tax cuts ahead of the general election, being funded with debt of course. Given the current levels of debt, is such a tax cut palatable?

The long and short of it is “mostly yes”.

The UK is presently running a 5.6% deficit, higher than most of its peers. However, its overall level of debt compared to GDP is lower than the average of developed economies. Tax cuts that spur growth are usually welcome, not feared by markets. However, governments need to be careful. If there’s one thing markets hate, is surprises, as Kwasi Kwarteng found out. “Talk of” is really code for “testing the water”. If there’s an adverse market reaction, it is easy for governments to deny “talks” taking place. So far, “talks of” tax cuts haven’t had an effect on Gilt rates. Should this continue, and assuming global markets are calm around the time of the actual announcement, then increased borrowing to spur growth is not something the UK’s lenders would likely punish. And as long as all debt globally continues to grow, then the UK’s fiscal position is not in real danger, for the time being at least.

PS: The irony of a Greek writing about how the UK can indeed take on more debt is not lost on the writer. But the fact remains that the UK is not Greece. It is a G7 country, has a much stronger fiscal position than Greece in the 2010s and, most importantly, monetary autonomy.

George Lagarias, Chief Economist

Originally featured in the FT Adviser - 'Is the UK in debt troubles?' - FTAdviser