The impact of government debt on your clients

  • Describe the risk of inflation as a result of higher debt levels
  • Explain what the multiplier effect is
  • Identify the potential impact on investments of higher government borrowing
The impact of government debt on your clients
 The Bank of England

The response of policymakers across the world to the pandemic-induced collapse in economic activity has been to inject hundreds of billions of pounds of money into the system, in an effort to plug the gaping holes wrought upon the economy by the virus.

Gilles Moec, group chief economist at Axa, says a particular feature of this policy response is the extent to which policymakers and commentators around the world accepted the need for governments to borrow money and spend it at this time. 

Mr Moec adds that while there are a range of potential consequences for advisers and their clients from the resulting increase in debt piles, it would be wrong to focus in the short-term on repaying the debt. 

He said that one of the negatives that typically arises from higher levels of government borrowing is much higher inflation in the short term.

This can happen either because too much cash is pumped into the economy, so demand rises faster than supply, or because the extra currency entering the system leads to a fall in the value of the currency, making imports more expensive.

Were either of these scenarios to play out in the UK, the resultant inflation would be magnified by the additional costs businesses face as a result of the pandemic - for example, from spending money on extra cleaning of premises, or buying masks.

Arguably, government debt never really needs to be paid back; instead it needs to be refinanced - that is, as the bonds mature and investors get their capital back, the capital is repaid with newly issued bonds.

Ten-year bonds issued by the UK government currently have an interest rate of 0.1 per cent.

So while it is not the case that the UK government will in ten years have to find all of the money to repay bondholders then, the uncertainty comes from what interest rate the government will have to pay on the debt in ten years. If it is much higher than the current rate, that will create future funding problems.  

But Mr Moec does not believe inflation is something that advisers will need to worry about in the near term, as he believes the reduction in economic demand has been so severe that inflation will remain low for an extended period.

He draws a parallel with the world in the years immediately following the second world war, when governments rapidly increased spending, but inflation did not rise to unhealthy levels, as the extra expenditure was replacing demand lost in the war, rather than creating an excess of demand. 

Mr Moec says this shows: “There is no need for austerity to be used this time to get the deficit down.” 

Neil Williams, senior economic adviser at Hermes, says the debt level will not be a problem for the wider economy as long as central banks are happy to let inflation rise.