Britain’s macroeconomic policy framework needs an overhaul to tackle the risk of an unsustainable ratcheting up of debt.
That’s the view of the Resolution Foundation think tank which has published Built To Last, a report that claims successive crises have left the UK with fast rising debt levels.
A key driver of this rise has been what the foundation calls Britain’s ‘debt ratchet’ – where huge fiscal interventions in economic crises drive up Britain’s debt, but only small falls in debt in between.
If the UK stays in a new higher interest rates environment in the longer term, as markets currently expect, and fiscal policy follows both main parties’ current policy of aiming to put debt on a gently falling path in the years between recessions, Britain’s debt ratio is on course to climb to around 140 per cent over the next half century, says the report.
This will put severe pressure on the cost of servicing this debt, which could rise to around five per cent of GDP – its highest sustained level in over 70 years, and more than the combined departmental budgets for energy, defence and transport.
The authors caution that a return to a lower interest rates world, particularly if it is matched by lower growth, could lead to even greater upward pressure on debt. That’s because very low rates will put more pressure on fiscal policy to support the economy during downturns.
In this lower rates world, additional fiscal support during economic shocks equivalent to the average recessionary interest rate cut would see the size of the debt ratchet in each crisis increase to 20 per cent of GDP. As a result, Britain’s debt ratio would almost double to 190 per cent of GDP over the next half century, even with debt gently falling between shocks.
Avoiding this ratcheting up of debt would require the government to run a three per cent primary budget surplus outside of recessions. This is implausible given the scale of permanent tax rises or spending cuts that would follow – the UK has achieved this level of annual surplus just three times in the past half a century.
Easing this pressure on the UK’s public finances therefore requires a reset of Britain’s approach to monetary and fiscal policy, say the authors.
The two priorities should be to reduce the pressure on fiscal policy to support the economy in a downturn by ensuring monetary policy has more scope to act, and to get a bigger bang for each buck the Treasury spends supporting the economy.
The report proposes a new approach to monetary policy that secures greater capacity to cut interest rates in a downturn – taking steps to allow negative rates of up to minus one per cent, and raising the inflation target to three per cent.
The foundation claims that Denmark and Switzerland have shown that negative rates (of minus 0.75 per cent) can work. A new inflation target should be introduced carefully, only if we return to a low-interest-rate world, only after the current two per cent target has been hit, and ideally in coordination with other advanced economies.
Governments must also make fiscal policy smarter, building the policy tools to deliver targeted support for when economic shocks inevitably hit in the future, rather than the more expensive universal support deployed recently.
It highlights two recent examples of poorly targeted support – generous grants to self-employed workers who did not report income falls in the pandemic, and energy support provided to high-income households more recently. Had it been possible to target the schemes at those who actually needed financial help, their overall cost could have been reduced by £35 billion.
This new macroeconomic framework would mean that primary budget surpluses of around one per cent would be needed to prevent Britain’s debt ratio rising over time in the face of inevitable shocks. While still tough, this is much more in line with experience towards the end of the 20th century, when the UK ran a surplus of one per cent or more in three out of five years.