The Chancellor should perhaps have begun his spending statement by thanking the Bank of England and the financial markets for their help; very little of the Government’s Covid response would have been possible without the record low interest rates they provide.
Thus it is that although the Government will be borrowing close to a fifth of GDP this financial year to fund its pandemic response, the biggest such proportion since the war, the interest rate bill on this massively expanded pool of national debt is actually falling.
In a higher interest rate environment, the Government and the public finances would be up the proverbial creek without a paddle.
As it is, their position is a precarious one. Any appreciable rise in rates and the austerity which the Chancellor is so keen to avoid becomes a raging certainty. Yet thanks to ultra-low interest rates, the Government does at least get some relief on the cost of its ever growing debt mountain.
The Bank of England’s quantitative easing further helps with this apparent conjuring trick. This is because the Government, in effect, pays no interest at all on the debt the Bank acquires under its asset purchase programme.
By the time the latest tranche of these purchases is complete, the Bank of England will be the proud owner of getting on for half the national debt. The coupons paid on this debt are returned to the Treasury. For the Government, it is like having an interest free overdraft.
Curiously, though, this actually makes the public finances more vulnerable to an interest rate shock, not less so. That’s because historically, the UK Debt Management Office has been careful to finance Government borrowing at relatively long maturities.
In theory, it makes the borrowing more resilient to interest rate changes. But this has been turned on its head by QE, which disproportionately mops up the longer maturities, thereby refinancing them with short term debt at bank rate.
The upshot is that QE has dramatically shortened the maturity profile of UK government debt, with the longer dated stuff falling from about a half the total to a quarter since the financial crisis a decade ago. This reordering of maturities is fine as long as bank rate stays low, but the cost to the public purse of would ratchet up horribly if it starts to rise.
Any return of inflationary pressures, or loss of confidence in the value of UK assets, and the country is in serious trouble. It is small wonder, then, that the Treasury is so keen to make a start on restoring order in the public finances. We see some early down payments on this endeavour in the partial public sector pay freeze and the reduction in overseas aid.
As the horror story of the Office for Budget Responsibility’s latest forecasts make all too clear, tough choices lie ahead. Worryingly for the Government, it will still be consolidating as it heads into the next election.
Just to give a few potted “highlights”, as it were, under the OBR’s central forecast, the Government will still be borrowing £102bn a year, or 3.9pc of GDP, even after five years unless it acts in the meantime, with output 3pc lower than the OBR thought it would be last March.
A rather more optimistic picture is painted by the OBR’s “upside scenario”, with output returning to pre-crisis levels by the end of next year and no permanent “scarring” to the wider economy. In view of encouraging news on the vaccine front, this seems to me to be the more likely outcome. But even if fulfilled, it leaves a humongous hole in the public finances that eventually has to be filled.
What’s more, furlough finishes at the end of March, in theory at least; that leaves a potentially long gap between the end of Government support and the likely completion of mass vaccination, during which a further great swathe of workers could lose their jobs. The Chancellor is desperate to bring Covid related spending down, but it is hard to see how he can as long as some form of social distancing regime remains in place.
The scale of that challenge becomes bigger still under the OBR’s “downside scenario”, where lockdown has to be extended and vaccines prove ineffective in containing the virus. Under this set of assumptions, output doesn’t return to pre-crisis levels until the end of 2024, and is left 6.1pc lower after five years than forecast last March.
In such circumstances, the Government would need to be raising an extra £54bn a year by way of spending cuts and tax increases – or 2pc of GDP – just to balance the books, never mind making a start on repaying the accumulated debt overhang.
Boris Johnson wanted to be remembered as the Prime Minister who brought about a successful Brexit. Instead it is going to be the grim task of pandemic damage limitation that defines him. How understanding the public will be remains to be seen.
As it is, the Chancellor has determined to make an early start on the heavy lifting, possibly prematurely so, by reducing overseas aid, and imposing a partial public sector pay freeze.
Beyond the demands of Covid, there is actually a £10bn reduction in departmental spending relative to what was proposed last March pencilled in for next year. That could be viewed as a mistake in light of the post pandemic fiscal stimulus many economists call for, and opposite numbers on the Continent and the US seem minded to pursue.
Sunak doesn’t at this stage propose overt austerity, even if he hints at it, but the best way of paying down debt is to stimulate growth. Beyond the rhetoric on levelling up and infrastructure investment, there is not much here that seems to support it.
How does the Government's spending review affect you? What did and didn't you like about the Chancellor's statement? Get in touch by emailing [email protected]