Living with High Debt – Investor Chronicle
How will the government reduce the debt it incurred to partially shield the economy from the pandemic? There is one answer that will not fit – that it could erode the debt through high inflation.
This won’t work partly because almost a quarter of the debt is now indexed and will therefore increase as inflation rises. It will also fail because if investors anticipate a permanent rise in inflation, they will sell gilts, which will drive up their yields and increase the cost of servicing debt. It’s only unexpected inflation that erodes the debt, but that’s hard to achieve even if it were desirable (which it isn’t).
Which does not mean that the public debt cannot fall rapidly. It can. After the Second World War, public debt was equivalent to 259% of GDP (today it is 99.2%). But over the next 20 years, it fell to just 80.7%. It wasn’t – for the most part – because it was being eroded by inflation. This averaged only 4.3% during this period: it was not until the 1970s that inflation significantly reduced the debt.
Instead, two things did the trick. The first was that the government ran consistent surpluses on its primary balance (i.e. excluding interest payments) and on its current account. It only borrowed to invest in infrastructure. The other was that economic growth was strong and interest rates low: in the 20 years since 1946, real GDP rose 3% per year, while bond yields averaged only 0.3% after inflation. This meant that the debt-to-GDP ratio was falling because GDP was growing faster than the cost of debt. This confirmed what Maynard Keynes said in 1933: “Take care of unemployment, and the budget will take care of itself.
Unfortunately, however, we are unlikely to repeat this trick. After the war, there was enormous pent-up demand for civilian capital goods, housing and consumer goods. This had two effects. One was to fuel strong economic growth not just in the UK but around the world, thereby boosting exports as well as domestic demand. The other was to ensure that private sector investment equaled and sometimes exceeded savings – both personal and corporate. As a simple accounting identity, the counterpart of this financial deficit was a public sector surplus: if the government receives more than it spends, someone else must spend more than it receives.
But while there is some pent-up demand now, there is far less than after 1945: the pandemic did not destroy housing stock or factories. In fact, there is no serious reason to believe that it has ended the long-term stagnation we experienced before it hit us.
So maybe we can neither inflate nor increase the debt. Nor can it be greatly reduced by fiscal austerity, as this depresses economic activity and therefore tax revenues.
Which lets us just live with it. From an economic perspective, this is not a problem: the same low growth that keeps debt high also keeps the cost of servicing that debt low. But that doesn’t mean it costs nothing: it means we will continue to hear claims about “black holes” and debt “burdens”. The main cost of high public debt is the noise pollution it causes.