Coronavirus spending: How are we going to pay for it all?

Analysis: Government borrowing north of £200bn expected this year, the national debt heading to 100 per cent of GDP. Some say it will ultimately mean more austerity. Others warn of inflation. Or could it result in the breaching of some old central banking taboos? Economics editor Ben Chu investigates

Friday 17 April 2020 14:03 BST

We’re in the big-spending phase now, as ministers pull out the policy stops to protect jobs and livelihoods amid the economic cataclysm brought on by the Covid-19 lockdown.

Some analysts think the UK government’s deficit this year will exceed £200bn. That would translate into a tenth of our national income, or gross domestic product (GDP).

The state hasn’t borrowed so much since the peak of the global financial crisis in 2009.

What will be the impact on the national debt?

That depends on how long the crisis lasts, and how much those job and income-support spending measures remain in place.

But it’s possible the share of the government’s debt as a share of our GDP could top 100 per cent, up from 80 per cent today.

So, yes, we're in the spending phase - and economists are remarkably united in arguing that this is exactly the right policy for this time.

But that won’t last forever. So what happens after that? How, as the familiar question goes, will we pay for it?

A time for tax?

This was, of course, the question posed in the aftermath of the global financial crisis too.

Before the fall of Lehman Brothers, which set off a global financial emergency, the UK deficit was around 2.5 per cent of GDP. By 2010 it was running at 10 per cent. The national debt, which had been around 33 per cent of GDP, had roughly doubled to 63 per cent was on a steadily rising trajectory.

How to pay for it? The answer from the Conservative chancellor George Osborne was austerity. This came partly from tax rises – the headline rate of VAT, which had been cut to 15 per cent in the recession to encourage households to spend, was hiked to 20 per cent.

But most of the austerity imposed in the decade after 2010 took the form of large spending cuts imposed on public services – everything from education, to policing, to local libraries – and also slashing spending on infrastructure and welfare. The health service budget continued to rise in real terms, but the money did not come close to keeping pace with growing demand for NHS services.

By last year the deficit had been reduced to around 2 per cent of GDP and the national debt share had just started to decline, although it’s important to note that many economists argue premature austerity actually impeded the consolidation of the public finances because it held back overall GDP growth.

That aside, will the aftermath of the Covid-19 pandemic force another decade of public sector austerity to reduce the deficit?

Numerous commentators have raised this prospect, including David Cameron’s chief adviser Steve Hilton, now a populist commentator on Fox News.

Most economists think there is little likelihood of further spending cuts given the huge reduction in capacity inflicted on public services by the last round. The consensus is that these budgets need to be increased, that the cuts went too far.

“The public pressure to spend on services like the NHS and social care will surely be huge,” notes Ian Mulheirn of the Tony Blair Institute.

But there is a growing expectation that tax rises will be necessary to shore up the public finances.

“No consolidation should come until we are out of this crisis, but it will come eventually. And when it does tax rises are going to be doing the work they conspicuously didn’t do post-financial crisis,” says Torsten Bell, the director of the Resolution Foundation think tank.

That view is shared by Nick Macpherson, the former top civil servant at the Treasury.

“We are going to have to tax people more – this is going to have to be paid for one way or another,” he told a Policy Exchange webinar last week.

That will be resisted by libertarians and low-tax Conservatives, who point out that UK tax revenues as share of GDP were already heading to the highest sustained share – around 35 per cent – since the Second World War even before this crisis.

But other economically successful developed European countries have long collected more than 40 per cent of GDP in tax so it’s by no means clear that this would be fatal to the UK’s economic dynamism in the way often asserted.

There’s also the question of who would pay these taxes. The nature of the Covid-19 crisis – with younger people being forced to suffer serious hits to their livelihood in order to protect the lives of mainly older generations – has prompted some to argue that the scene will finally be politically set for new taxes on wealth and, in particular, high-value housing given how these assets are disproportionately concentrated among the postwar baby boomer generation.

A time for inflation?

But are there other national debt lessons from further back in history?

When the UK emerged from the Second World War – a crisis that puts even coronavirus in the shade – we had a debt to GDP ratio of more than 250 per cent. How did we pay for that?

The answer of economic historians is that governments dealt with it through a combination of forces. First there was strong economic growth in the decades after the war. That increased GDP rapidly, helping to reduce the debt to GDP ratio.

But there was also relatively high inflation, low interest rates and a banking system that channelled people’s savings into government debt. A combination of these factors created what economist call “financial repression”.

So savers bore a considerable part of the burden of the costs incurred in the Second World War.

Could that happen again? Developments in the financial system – the opening up of global markets and cross-border capital flows – mean that domestic financial repression may be much harder to implement, even if the Government wanted to.

But some economists, such as the respected former Bank of England analyst Charles Goodhart, think that a burst of domestic inflation is likely, as workers collectively demand – and receive – far larger pay rises than they have been receiving in recent decades.

“Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate,” Mr Goodhart says.

“The excessive debt amongst non-financial corporates and governments will get inflated away.”

Paul Johnson of the Institute for Fiscal Studies is of a similar mind. “My guess is that higher inflation will be accommodated for a while,” he says. “Savers beware.” This, though, is disputed.

“It’s possible that governments may attempt to boost inflation as a way of dealing with the additional debt burden generated by the crisis but any such attempt would require a change to central bank mandates – and would have to overcome formidable disinflationary forces that have become entrenched in the system over the past 30 years,” says Neil Shearing of the Capital Economics consultancy.

And while some argue central banks will have no choice but to keep interest rates artificially low for a prolonged period of time so as not to destabilise highly indebted governments, others counter that its more likely to be nervous savers who, indirectly, keep these rates low by ploughing their spare money into safe assets like government debt.

“Precautionary saving is likely to be higher, and uncertainty is likely to hamper private investment,” says Olivier Blanchard, former chief economist at the International Monetary Fund. “Both imply a lower neutral [central bank policy interest] rate for a long time to come.”

Furthermore, while most economists accept that annual government deficits will need to be reduced when the crisis is over, by no means all believe that the debt as a share of GDP will need to be rapidly brought down, especially if lower interest rates make the stock of borrowing affordable.

The monetisation taboo

Yet the actions of the Bank of England in the aftermath of this crisis could be crucial in another respect when it comes to the “how will we pay” question.

In the wake of the financial crisis the bank bought up £200bn of government debt – known as gilts – as part of its money creation programme known as quantitative easing (QE).

This was designed to prevent the supply of money in the economy collapsing and, also, to stimulate spending. By 2016 the bank’s stock of gilts had reached £435bn, 25 per cent of the total stock.

Last month, to prop up the economy anew, the bank purchased a further £200bn, taking its share of all gilts in issue to around 40 per cent.

The bank’s governor, Andrew Bailey, has insisted that the bank retains the option to sell these gilts back to the market in future and stressed that the bank will be buying gilts in the secondary bond markets – from pension funds and banks – rather than directly from the Treasury.

But a growing number of analysts suspect that the bank will end up holding onto these gilts until they mature, long in the future, meaning they will have effectively been cancelled or “monetised”.

That means one arm of the state (the Bank of England) would have, effectively, lent to another part (The Treasury).

“All the evidence we have is that most of the QE which has occurred over the last decade is, to all practical intents and purposes, permanent, which means our starting point levels of net debt were in fact far lower than our national statistics suggest,” argues the fund manager and author Eric Lonergan.

Some, like the former UK regulator Adair Turner, believe there will be more monetisation to come in the wake of this crisis.

“We are going to have monetary finance ... the only issue is whether we are going to be open and honest that there is going to be monetary finance,” he told the Financial Times.

This matters because if the national debt is destined to be a lot smaller, in effect, than it looks there will be less pressure or need for spending restraint or higher taxes to reduce it.

But who would be paying the bill here? Often in history the cost of state debt monetisations has been picked up by their populations in the form of a damaging burst of inflation, as more money created and injected into the economy has outstripped the ability of the economy to produce goods and services. That’s why monetisation has long been a taboo among policymakers in developed countries like the UK.

Should we fear a slide into inflation, possibly even “hyperinflation”?

It’s not impossible. But there’s some recent history we might bear in mind. Despite warnings from some high-profile economists, we had no burst of inflation as a result of the QE taken by central banks after the financial crisis recessions. A great deal of money was created, but it did not result in more spending, higher wages and higher prices. And Japan, which has a very large public debt (worth more than 200 per cent of GDP) and significant purchases of that debt by its central bank (almost 50 per cent) has seen deflation, not inflation.

Turning Japanese?

Perhaps that sounds promising. But Japan has not been economically fortunate. Its economy has been in the doldrums for the past three decades. Even before the advent of Covid-19 there were fears that western economies were experiencing a form of “Japanification” – high public debt, low interest rates and perenially weak growth.

The biggest danger to our livelihoods may not be that the UK will have to undergo still more austerity or suffer high inflation to pay the cost of these rescue packages but that the great Covid-19 spending spree will be followed by a permanently weaker and less dynamic British economy.

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