Government Spending, Debt and Inflation: What’s Next?
A personal view of Ian Stewart, Deloitte’s Chief Economist in the UK.
Last year UK government spending rose to 55 per cent of GDP, a level last seen in 1944 at the height of war mobilization. Public debt has skyrocketed across the western world, far exceeding levels seen during the global financial crisis. The crisis is likely to change the role of the state and the levels of taxation and debt in the years to come.
The UK’s latest budget outlines the government’s plans for public finances and is one of the most momentous in decades. The Economics team’s full budget analysis can be found here.
Each year the Treasury Select Committee of the House of Commons examines and reports on the UK budget. Last week, along with four other economists, I was asked to testify before the committee. We covered many topics, but here is my take on the top four questions that came up.
Question 1. What are the risks of high government debt?
Public sector debt has risen to levels last seen in the late 1950s when the UK reduced wartime borrowing. Debt levels have skyrocketed since the turn of the century, with the financial crisis and then the pandemic quadrupling the public sector net debt (PSND) to GDP ratio. Higher debt makes public finances more vulnerable to rising borrowing costs and potentially limits the government’s ability to borrow more in response to future crises.
There are two important caveats. Borrowing costs are lower than ever, leaving borrowing costs at their lowest level in more than 70 years, despite mounting debt. All governments had to borrow more; UK public debt is not out of the ordinary by international comparison and is lower than in a number of other advanced economies, including the US and Japan. There are limits to public debt, but we seem a long way from reaching them. The best way to deleverage is to generate growth, and now is not the time to tighten fiscal policy.
Assuming the recovery takes hold, which seems likely, debt markets will become more focused on inflation risk and sovereign debt levels. The euro crisis has shown that the willingness of the bond market to provide state financing can change quickly. Quantitative easing has increased the government’s exposure to rising interest rates, with the private sector holding reserves on which the Bank of England, ultimately part of the government, pays interest. A 1% increase in interest rates would increase the government’s annual debt servicing costs by about £21 billion and increase overall spending by 2%.
In the budget, I think the Chancellor has sensibly chosen to prioritize short-term fiscal stimulus to stimulate the economy with consolidation in the form of tax increases, starting in earnest from 2023 (the future tax increases, corporate income tax and by not raising personal income tax allowances and thresholds (represents the largest tax hike since the post-1993 recession budget.) Along with higher spending today, the chancellor says he wants to lower debt over the long term. In a highly uncertain world, that balance of near-term fiscal easing and consolidation seems about right.
Question 2. Like the last few, will this downturn be followed by a decade of public sector austerity?
Public spending will fall as £344billion emergency pandemic support scheme comes to an end. Because of this simple measure, the UK and most rich economies will see government and public borrowing contract. But this is hardly fiscal tightening or a return to austerity, as pandemic spending — for example on furloughs or tax breaks — should fill a temporary gap created by the pandemic.
The government’s longer-term plans for public spending don’t look particularly strict either. By the end of this parliamentary term, spending is expected to be just under 42 percent of GDP, above the 40 percent post-war average and closer to spending levels seen during and after recessions (on the eve of the pandemic accounted for about 4 percent of GDP). Health, education and foreign aid are “protected departments” and receive a real increase in funding. Public sector spending on infrastructure will also be significantly higher than it has been in the last 20 years. But “vulnerable” sectors, including local government, transport and the judiciary, which have seen funding fall over the past decade, will face a near-total standstill in spending. This is not a return to full austerity, but it will certainly feel like it in some areas.
In reality, despite an upward trend in underlying spending, the deal outlined by the Chancellor on March 3 looks improbably close. After 2022, little has been accounted for on-going costs of fighting COVID such as testing, surveillance and new vaccines. The proposed end of September’s temporary £20 boost in Universal Credit is likely to be controversial and difficult to sustain. And after a decade of cuts, it may just be impossible to keep spending tighter in “unprotected” spending areas. With polls suggesting voters are weary of austerity and the government showing no inclination to cut public spending, it is likely that public spending will rise further than planned.
Question 3. How strong will the recovery be and will scarring or damage done to the economy by the pandemic weaken it?
We expect the recovery to start in the second quarter. Pent-up demand, fiscal stimulus and a buoyant US backdrop suggest this is a fairly strong recovery. The OBR (Office for Budget Responsibility) forecast of 4.0 percent growth this year looks on the low side; the OECD (Organization for Economic Co-operation and Development) forecast 5.1 percent last week and that should be closer to the mark.
Historically deep recessions damage the economy’s productive capacity by disrupting networks and investment, weakening balance sheets and, most importantly, reducing the skills base. However, these effects are likely to be less pronounced than in previous cycles. The level of support for the economy over the past year has been unprecedented. It has mitigated the damage to production capacity. The OBR, for example, has repeatedly revised downwards its forecast for peak unemployment, which now stands at 6.5 percent, a remarkably low level compared to standards over the past half-century. Corporate bankruptcies hit record lows last fall and, while set to rise this year, are unlikely to reach levels seen during the last recession. Meanwhile, the overall balance sheet position of consumers and businesses is quite strong, an extraordinary result for an economy that has experienced its deepest downturn in 300 years.
We expect some long-term economic damage, particularly in the labor market, but it should be less than in recent recessions. And there’s reason to believe that by encouraging organizational improvisation and the use of technology, the pandemic may in some ways help spur long-term growth. The surge in online shopping, home working, and remote medical consultations over the last year may yet be a harbinger of broader, productivity-enhancing changes.
Question 4. Won’t a combination of economic recovery, quantitative easing and government debt trigger higher inflation?
The pandemic has brought inflation down, but from very low levels, it’s likely to pick up from here. Energy, food and metal prices have risen from last year’s lows and will push inflation higher in the coming months. But with the economy operating at idle capacity and unemployment rising, inflation is likely to stay well-behaved well into 2022.
Further out we see three risk factors. The exodus of perhaps up to 1.3 million foreign-born people from Britain last year has shrunk the labor supply. As the recovery gathers momentum, unemployment rates could fall sharply and to very low levels. There’s a lot of stimulus hitting the economy, and businesses and households abound with cash. As soon as the free capacities are exhausted, prices and wages are likely to rise. Finally, low productivity growth could have lowered the “speed limit” for non-inflationary growth. We might find that even with relatively low growth rates, inflationary pressures are beginning to emerge.
It’s all speculation. What is clear is that central banks are reluctant to risk stalling a recovery to counter early signs of inflation. They appear to be waiting for a sustained rise in inflation before tightening. This is one of the reasons why I have become more confident about the recovery – and more cautious about inflation over the longer term.