Long ReadOct 3 2022

Can Liz Truss get her fiscal sums to add up?

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Can Liz Truss get her fiscal sums to add up?
Prime minister Liz Truss (Alastair Grant/Pool via Reuters)

For those tracking the wild gyrations of the UK gilt market since chancellor Kwasi Kwarteng’s "mini" Budget of September 23, that has become a highly pertinent question.

Until recently, the economic orthodoxy was that high levels of government debt were to be avoided, and budget deficits should be addressed quickly.

This approach underpinned the period of austerity under the Conservative-led government of 2010-2015 in the aftermath of the global financial crisis.

When attempting to calculate debt sustainability there are only two cases: either the real rate of interest (hereafter referred to as ‘r’) exceeds the real rate of growth in the economy (or ‘g’), or the real rate of growth exceeds the real rate of interest. As Mr Micawber might have put it, in the first case, result misery. In the second case, result happiness.

In the first case, in a world where the real rate of interest exceeds the real rate of growth (r>g), a government must run a primary budget surplus if it wants to keep its debt-to-GDP ratio steady.

The wider the gap between r and g and the greater the existing ratio of debt to GDP, the larger the budgetary surplus will have to be. If the surplus is less than the required amount, the level of government debt will grow exponentially, without limit. It will explode, in other words.

A different state of affairs

During the period from 1970 to 2000, we estimate that the r-g gap in the major economies averaged some 2.5 percentage points. Of necessity, most governments ran small budget deficits over these years, so that debt grew only slowly.

But for much of the past 20 years or so, governments have got used to a very different state of affairs.

Over the period from 2000 up until last year we estimate that r averaged around 0.5 per cent across the major economies, while g averaged around 1.8 per cent. In this world, a government can run a primary deficit indefinitely and maintain a stable debt-to-GDP ratio.

Even if the deficit is too large to maintain debt stability, the debt-to-GDP ratio will not explode, it will just gradually move to a higher equilibrium level.

Operating in a world where real rates of interest on government debt are less than an economy’s trend rate of growth presents governments with a tempting opportunity.

It seemingly allows them to spend more or less what they like, without having to worry too much (if at all) about how they will pay it back. They appear to have access to a magic money tree (MMT).

Seduced by this approach, some have even taken the MMT acronym and transformed it into a theory: so-called ‘modern monetary theory’.

The difficulty for proponents of the magic money tree approach, and where the current UK government risks coming unstuck, is that long-run real rates of interest move around. So too does an economy’s trend real rate of growth.

The r-g gap is not an exogenous constant. Over the past 150 years it has been on average negative – but it follows a cycle over time, and can turn materially positive, as it did during the 1970s, 80s and 90s. Indeed, the gap has narrowed substantially through 2022 to date.

In an uncertain world where there is a growing risk that the global economy will flip from a period where r is less than g, to one where r is greater than g, investors will want to be confident that governments can credibly, and quickly, transform the sizeable primary budget deficits of today into primary budget surpluses that are sufficient to keep government debt-to-GDP ratios stable.

At today’s high levels of government debt to GDP, that would require a dramatic turnaround, to primary budget surpluses of a magnitude that have never been sustained for more than a few years.

A grave miscalculation?

So what happened in the UK’s fiscal event of September 23?

Boris Johnson’s government had departed from the old economic orthodoxy, that high levels of government debt are bad, in the exceptional circumstances of the pandemic.

Rather than returning towards the old orthodoxy Liz Truss’s government moved further away from it. It appears to have miscalculated and gone too far.

Primary deficits, and high levels of government debt, may demand less urgent attention than was once the case, but that does not mean that they can be ignored. In assessing the validity of a government’s fiscal plans, wise investors will take a probabilistic approach.

Recognising that the balance between r and g can easily turn from positive to negative, they will want reassurance that a government that is allowing deficits to increase has the capacity to move quickly back to surplus should the need arise.

The new Conservative administration has not given that assurance. Instead, having announced a £72.4bn increase in the UK Debt Management Office’s net financing requirement, equivalent to around 3 per cent of GDP, it is refusing to provide any explanation until a period of eight weeks has passed.

It has simply asserted that tax cuts for the wealthy will boost long-term growth and become self-financing. We know of no empirical evidence for that, and nor it appears do investors. 

If the aim is to use fiscal policy to raise long-term growth, the money would be far better spent on research and development, either directly or indirectly through incentives offered to the private sector.

Moreover, despite the Office for Budgetary Responsibility being ready to publish its own independent assessment of the outlook for the public finances incorporating the new measures, the Conservative administration told it to wait.

‘Trust us’ was the message to investors, from a government that has been in place for less than a month and is yet to have its policies questioned by a sitting House of Commons. ‘No, thank you’ was the response.

Long-term real rates of interest on UK government debt, already on an upward trend, have approached 2 per cent in recent days.

They are around 1 per cent at the time of writing. Since the global financial crisis, UK labour productivity growth has averaged 0.6 per cent a year.

Add in the projected absence of growth in the UK working-age population, which is essentially flat over the next 30 years (a situation that would be far worse if it were not for assumed net inward migration), and investors are sending a clear signal that, for the UK at least, r is now uncomfortably close to g and may be above it. They are demanding a clear plan to move the UK public finances from deficit into surplus.

On September 28, the Bank of England effectively restarted quantitative easing, monetising some of the planned increase in borrowing in an attempt to avert financial crisis.

It has said these additional purchases will be time-limited and will not extend beyond 14 October.

If it sticks to its word then something else must happen before that date. A monetary policy tightening is one possibility, even if the monetary policy committee appears to have ruled out an emergency meeting.

That would be the wrong approach as, in the absence of any reform to the fiscal plans laid out on September 23, it would need to be substantial, and sufficient to cause a fall in UK house prices exceeding that seen during the global financial crisis.

That leaves only fiscal policy. It needs to be either a substantial cut in spending, to match the cut in taxes – which in the teeth of a recession would be politically disastrous and economically nonsensical – or a reversal of the tax cuts. My money is on the latter, just.

Andrew Brigden is chief economist at Fathom Consulting