Professor David Miles looks at debt, taxes and spending in the UK during an era of seismic fiscal shocks
At the end of last year, I was asked to take the lead on economic research at the Office for Budget Responsibility (OBR). That is the independent organisation that makes assessments of the economic and fiscal outlook, which the UK government uses to inform its tax, spending and borrowing policies. I have taken up this role at a time when the UK’s fiscal situation has become unusually challenging: government debt has risen to nearly 95 per cent of GDP – the highest level since 1962.
Why so high? Over the last 15 years, the UK economy has been hit by three exceptional shocks beyond our control: the 2008 global financial crisis and the deep recession it created, and recently the pandemic, followed swiftly by war in Europe. These are seismic events coming in quick succession. Each one might have been thought of as a once-in-50-year event, but we have seen them coming at a rate of one every five years. As a result, UK government debt is now far higher than anyone expected.
To date, remarkably cheap borrowing has enabled the government to fund the debt and run large deficits to help households deal with massive economic disruption. This was very effective during coronavirus (COVID-19): GDP fell by an astonishing 10 per cent in 2020, yet is now back at its pre-crisis level, and unemployment is actually lower. Nonetheless, the situation is fragile, with debt much higher and recent data suggesting growth is slowing, in part because incomes are being hit by higher energy prices. Given all this, what are our economic prospects?
The long-term view
Here it can be comforting to take the longer view. Historically, we have at times been far deeper in debt and seen debt levels diminish with no defaults. Back in the 1700s, the government first began borrowing to finance wars – conflicts have seen the fastest growth of debt. The Napoleonic Wars brought public debt to around 200 per cent of GDP and, in the 20th century, the world wars brought huge increases in UK government debt, which rose to a peak of around 270 per cent of GDP by the late 1940s.
But debt fell sharply in the wake of these wars to around 50 per cent of GDP, thanks to dramatic cuts in military spending, stronger tax revenues as the economy recovered, and bursts of inflation which eroded the burden of debt.
Lower population growth – and the possibility of an absolute decline – bring some benefits
Today, those factors are less likely to bring government debt down fast. Much of the UK’s debt and government spending is index-linked (automatically linked to price rises) and won’t be eaten away by inflation. Much of our debt is linked to short-term interest rates, and these look set to rise. Also, we can’t expect the boost to the private sector that benefitted post-war Britain, because this was largely a result of a sudden peacetime drop in defence spending. So, how do we get out of this?
Part of the answer is that taxes are set to rise. And the OBR's recent central estimate is that the fiscal deficit and debt relative to GDP are likely to fall back. But risks are substantial in the longer term – though thankfully the uncertainty is not all negative.
Interest rates are at exceptionally low levels and, at least in the near term, seem more likely to rise than fall, increasing the cost of government debt. If the conflict in Ukraine presses on, the UK may feel the need to spend more on defence. An ageing population, coupled with declining fertility rates, and the likelihood of lower levels of immigration, means the UK population may plateau, or even fall, and health costs will rise. But lower population growth – and the possibility of an absolute decline – bring some benefits: house prices may stop rising so fast and environmental problems would be eased with a smaller population.
But there is another potential problem emerging: one of unrealistic expectations. Public spending during the pandemic increased enormously and helped shelter households from the worst economic impacts of COVID-19. This came at a massive fiscal cost and may have led to heightened expectations about the ability of government to spare us from the effects of bad economic shocks. During the pandemic, the vast amount of money spent paying salaries and supporting companies worked very well; remarkably unemployment did not rise much and is now even lower than at the start of 2020.
Over the last 15 years, the UK economy has been hit by three exceptional shocks beyond our control
This type of response, which saw public borrowing reach levels of 17 per cent of GDP during 2020–2021, is possible as a one-off, but not as an ongoing policy. To expect government to be able to cushion the financial blows of large economic shocks that come in quick succession just isn’t realistic.
The OBR, as the UK’s fiscal watchdog, has a responsibility to sound the warning and make an objective assessment of the possible without being party political. The fiscal position in the UK – and indeed in nearly all high income economies – is far worse than could have been imagined just over a decade ago. This means governments face tougher constraints, and realism is essential if good decisions are to be made.
This article draws on "Economic policy in a time of plague and war – debt, taxes and spending in the UK", a presentation by Professor David Miles organised by Imperial College Business School's Brevan Howard Centre for Financial Analysis.