Pick a number, any number

When it comes to managing public debt, it seems as if the chancellor is picking random numbers out of the hat to show us he’s ​‘fiscally responsible’. In last week’s budget, Rishi Sunak announced that the government should ​“not allow debt to keep rising” over the medium term (next five years). Based on the treasury’s red book budget document, it looks like this means keeping the public sector net debt (excluding the Bank of England’s own debt) at a debt-to-GDP ratio of around 100%.

The debt-to-GDP ratio measures the amount of gross debt that the government has as a percentage of gross domestic product (GDP). GDP can also be seen as the national income. Economists often use this ratio as a key indicator for the sustainability of government finances because it is supposed to give some indication of whether debt can be repaid or not. According to the government’s current plans, a target debt-to-GDP ratio of around 100% over the medium term will be achieved through a combination of tax rises and yet more spending cuts to unprotected departments like transport and local government.

The chancellor wants to stabilise debt levels at the debt-to-GDP ratio of 100% — meaning that the government shouldn’t have a debt which is worth more than the size of the UK economy. He fears that otherwise Britain’s creditors may think that the government will be unable to pay back its debt and respond by raising the cost of borrowing (interest rates).

But the truth is that this ratio doesn’t actually tell us very much. There is certainly no sound basis for any particular level of debt-to-GDP being of any particularly importance in the academic literature. Just as with the various other debt-to-GDP thresholds over the past decades — 40% under Gordon Brown, 60% under the EU’s founding treaty, and 90% in the now-discredited Reinhardt and Rogoff research that helped lay the grounds for austerity – a possible 100% target is at best arbitrary, and at worst reflects narrow ideology or short-term political expediency.

This becomes clear when we look at other countries. Japan’s debt-to-GDP ratio, for example, rose to nearly 240% before the Covid pandemic struck – and the country been running a ratio over 200% for well over a decade with no signs that it would default on its debt. Likewise, if Germany used the same metrics as the UK to calculate its debt-to-GDP, pre-pandemic it would have been around the 180% mark. The US debt-to-GDP ratio reached 135% in the pandemic. But despite having debt-to-GDP ratios much higher than 100%, all of these countries – like the UK – continue to borrow money at the lowest rates global financial markets have to offer.

“Far from fiscal responsibility, implementing harmful austerity policies based on fears around public debt and arbitrary targets is fiscally irresponsible.”

Far from fiscal responsibility, implementing harmful austerity policies based on fears around public debt and arbitrary targets is fiscally irresponsible. Not least because previous experience has suggested that austerity, in the form of spending cuts, has hurt living standards and but also because it is not even effective on its own terms in reducing government debt levels.

But if there is one agreement amongst economists in this subject area (from progressives, to mainstreamers, to conservatives) it is that no one actually knows what the appropriate debt-to-GDP ratio should be. This is because the appropriate level of debt and borrowing is really determined by a wider set of complex macroeconomic and policy factors, and cannot simply be measured as a mere ratio of some part of the public sector’s balance sheet (like government debt) to GDP.

One factor is that the current policymaking approach to fiscal sustainability ignores that high-income countries like the UK are ​‘monetarily sovereign’: they have debts denominated in their own currencies and a floating exchange rate (an exchange rate determined by wider market forces). As such, unlike households, the UK government cannot default on its debt because such debt is merely a promise to pay money created by the central bank. The Bank of England can always create new money to repay the government debt given that government debt is issued in the currency the Bank creates.

Of the £2.5tn worth of debt (107.4% of GDP) the government is forecasted to owe by next financial year, the Bank of England will own £895bn (that’s around 36% of total government debt). Given the Treasury owns the Bank of England, if the Bank ends up permanently holding this amount of debt because the government cannot pay it back, the debt will effectively be cancelled. This would put the public debt-to-GDP ratio back to 69%, and would offset the new debt accrued during Covid more than two times over.

Another often neglected factor is that the Bank of England has substantial influence over the borrowing costs (interest rates) of the government. Looking back through time, contrary to the assumptions of current policymakers, higher levels of public debt don’t correlate with higher borrowing costs, nor with new annual borrowing and borrowing costs. In fact, since the turn of the 20^th century it has been the opposite (see Figures 1 and 2).

Figure 1: There is no correlation between the UK stock of debt and long-term borrowing costs

Figure 2: There is no correlation between UK annual borrowing and long-term yields

At the same time, conversations around public debt often neglect that the Bank of England’s monetary policy can lower government borrowing costs. Indeed, the Bank of Japan has been successfully targeting the interest rate on 10-year government loans at 0% for some time now. There is a much stronger positive correlation between the policy interest rate set by the Bank of England and the government’s borrowing costs, than the level of government borrowing or debt and borrowing costs (see Figure 3). Of course, there are number of different factors that contribute to this relationship, and causality may run in a number of directions. But descriptive observations such as these generally support monetary literature, that monetary policy has more of an influence over borrowing costs than financial markets. So targeting a specific arbitrary debt-to-GDP ratio in fear of financial markets reacting to higher debt levels could be misplaced.

Figure 3: There is a strong positive correlation between the Bank of England policy rates and UK government borrowing costs

Given the Bank can always create new money to pay back government debt, and that it has significant influence over the government’s borrowing costs, there are actually no real financial constraints on UK government borrowing. The appropriate level of debt and borrowing is actually determined by a wider set of complex macroeconomic and policy factors. Of course, the central bank cannot keep on printing money forever, and will be limited by are other important macroeconomic constraints like inflation, the availability of real resources in the economy, and the current account (the subject of a forthcoming NEF paper).

Importantly, neglecting complex macroeconomic dynamics in favour of simplistic ratios of the government’s balance sheet against GDP means at least half the puzzle is missed. It risks throwing out accuracy and credibility in favour of spurious precision. Without a more holistic and empirically grounded understanding of fiscal sustainability we risk imposing dangerous arbitrary constraints on the government’s borrowing capacity. That’s not to say the constraints aren’t real or that they don’t need to be properly accounted for by policy, but for that to happen they first need to be understood. Put differently, how do we know what a sustainable level of debt is if we are not even attempting to measure the real constraints to begin with?

And until we do have a better understanding, there is also a case to go further. Instead of fetishising debt reduction and balanced budgets based on weak indicators and poorly researched thresholds, the government should be prioritising important human, economic and environmental outcomes – like creating well-paid green jobs, lifting millions out of poverty, and implementing much needed green infrastructure projects. If we look after unemployment and the environment, we might just find the budget will look after itself.

Image: Open Government Licence v3.0