Several outlandish proposals over the UK's escalating debt have been aired – but we must look to the post-war period for sane solutions
Getting business flowing again after lockdown is overwhelmingly the most important economic task facing the Government. It also holds the key to preventing various forms of financial disaster that may yet cause a second wave of economic collapse.
Prime among these potential financial problems is the high and rising level of public debt. Admittedly, some people say that this just doesn’t matter. Yet the debt ratio cannot expand ad infinitum. Eventually the cost of servicing the debt would consume all the Government’s tax revenue. Long before that point, there would either be a default or resort to inflation.
Sometimes we need the debt ratio to expand in order for the state to be able to provide essential financial support in a crisis. Nonetheless the ratio needs to fall back in order for the state to be able to do the same thing in a future crisis.
Over recent weeks, various quack cures for the debt problem have been circulating. Some say we can get the central bank to buy the debt without limit – as the ECB has empowered itself to do – without engendering inflation.
Others say that, far from trying to avoid inflation, we should be promoting it as the solution to the debt overhang.
I take issue with these supposed panaceas. Historical experience points the way forward.
The UK achieved a remarkable feat in reducing the ratio of government debt to GDP from over 250pc at the end of the war to a low of 23pc in 1990 (this compares to about 80pc before coronavirus). This was not done by clobbering the economy and accepting depressed output and consumption. Quite the reverse.
So how was it done?
Many people suspect that inflation is the answer. But this is only partly true.
When inflation takes off, all nominal values that are free to rise will do so, including money GDP and tax revenues. Meanwhile, government bonds which are fixed in money terms will not.
So the real value of debt falls and the ratio of government debt to GDP drops back. Mind you, once investors wake up to what is happening, they will sharply increase the interest rates at which they will lend to the Government, thereby increasing the Government’s borrowing costs.
Our experience in the 1970s and 1980s offers useful lessons.
From 1971 to 1980, inflation averaged 13pc and this helped to reduce the debt ratio. But it only fell from 56pc to 42pc.
What limited the improvement was a disappointing average economic growth rate of about 2pc, an average annual budget deficit of 4pc of GDP, and a sharp upward movement of gilt yields. Moreover, yields stayed high even as inflation was subsequently forced down.
In the ensuing decade, the real yield on 10-year gilts averaged almost 6pc. This kept the cost of borrowing high and also raised real interest rates throughout the economy, with serious negative effects on growth.
The period from 1953 to 1967, running from just after the end of the Korean War to the devaluation of the pound under Harold Wilson, makes a remarkable contrast. Mostly under the Conservatives, the debt ratio fell from 156pc to 80pc. Most strikingly, this was not primarily because of inflation. Over these years the inflation rate averaged just over 3pc.
What really made the difference was sustained economic growth, as you can see in the chart below. During these years, the average growth rate of GDP was 3.3pc.
These were years of greatly increasing prosperity for ordinary people. It was in 1957 that the Prime Minister, Harold Macmillan, said “most of our people have never had it so good”.
Fiscal discipline also played a key part, not that government spending was reduced in real terms. Quite the opposite. But over the period 1953-67 as a whole, excluding interest payments, the Government ran an average budget surplus of 2.7pc of GDP. Even when interest payments were added, its deficit was only 1.7pc of GDP.
Significantly, this followed a period of extreme fiscal stringency under the Labour Government led by Clement Attlee. In some years it ran primary surpluses of over 9pc of GDP.
What are the lessons that we can draw from this period? For now, we can and should let the debt ratio rise. But at some stage we will have to stabilise it and subsequently bring it down.
We can do this gradually, without slashing spending or imposing huge tax burdens. Ensuring strong growth is key. We will need to deregulate, reform energy policy and the tax system, and break away from protectionist EU trade policies.
We have three substantial advantages: after the virus crisis is over, the debt ratio should be less than half what it was after the war; interest rates are negative in real terms; and before the crisis struck, excluding interest payments, the budget deficit was next to zero.
But we will have to be disciplined. We will not be able to have everything, that is to say, government spending rising by 3pc per annum in real terms, constant, never mind lower, taxes, a stable debt ratio, and continued low inflation. Something will have to give.
We could let higher taxes take the strain, but this would be a huge mistake and could be counterproductive. Instead, if we can keep the growth rate of state spending significantly below the growth of GDP we can reduce the budget deficit sharply and even turn it into a small surplus. The history of the economy in the post-war years shows the way.
Roger Bootle is chairman of Capital Economics [email protected]