The repetitive wrangle between American politicians about precisely how much the richest country in the world can afford to borrow would be merely tedious if it didn’t also carry the risk of inadvertent financial crisis. But as public debt mounts worldwide the underlying question has become more urgent, particularly for governments who - unlike the US - can’t borrow in their own money. Total public debt now, for the first time, exceeds global income, adding to the difficulties of macroeconomic management and the risks to less creditworthy borrowers. And demands for public funds keep rising. Time for more grown-up conversations with voters.
Let’s start by dispelling a myth: pubic borrowing isn’t a Bad Thing. Provided they haven’t a history of debt defaults, governments can borrow more cheaply than individuals or companies, and for extended periods. Money to spend now is, of course, borrowed at a cost to be met by our children and grandchildren, but - subject to the difficulty of getting governments to manage investment projects well - if it’s used to create infrastructure from which those descendants will benefit, fair enough. And ever since John Maynard Keynes dignified the simple idea with (his) brand name, public borrowing in recessions has been the standard tool of counter-cyclical macroeconomic policy.
That’s all very well and good during downturns. The trouble comes during upswings. “Counter-cyclical” policy should then mean that you stop borrowing (at least to fund current spending) and start repaying, but governments’ bucket lists are as long as ever, elections may be looming and the chance is so often missed to allow the natural recovery in public finances to balance the books again. In the cliche of public debate, governments persistently fail to “fix the roof while the sun is shining”. Until deficits get frighteningly large, there are more votes to be won with extra spending or tax cuts than with fiscal rectitude.
So the willpower to keep public borrowing under control is usually only created by bitter experience. Experience, that is, of allowing the stream of borrowing (and the stock of debt) to rise to levels that make debt service crippling and lenders vanish. Governments are then forced to fall back on the lender of last resort, the International Monetary Fund (IMF), and/or “restructuring” that will need very careful management if you want to be able to borrow again.
Argentina is currently the country most indebted to the IMF, followed (at some distance) by Egypt and Ukraine. Argentina has a long history of bail-outs and fall-outs with the IMF, but is only one of a group of developing countries on near-perpetual IMF life support. But even amongst advanced economies, there’s enough humiliating experience (the UK in the mid-1970s, just for example) to make Finance Ministries, at least, keen to maintain some self-discipline. Rising borrowing costs aren’t enough of a restraint, so they have increasingly turned to the setting of “fiscal rules”.
Oddly, the most famous rule - the US debt ceiling - was first introduced not to curb borrowing by the federal government, but to make it easier. It first came about in 1917, to enable the government to issue debt - to finance participation in the First World War - without constant recourse to Congress. Now, of course, it is the focus of a highly political debate between Republicans and Democrats as to the scale and content of fiscal policy, as US debt climbs past its previous COVID-related peak.
It wasn’t until the 1990s that rules came into general international fashion. In the UK, they weren’t formalised until 1997, when Labour’s Finance Minister, Gordon Brown, inherited an economy in good shape and feared his spending colleagues might run amok. His “golden rule” was that current spending should not exceed revenue over the economic cycle. A focus on current spending was common amongst rule-makers, on the reasonable grounds that this was water under the bridge, while investment should yield returns. But it’s not easy to draw the boundary between them, particularly when it is so often blurred by politicians. Is all education spending “an investment in our future”, or only the construction of school buildings?
And meanwhile, of course, the question of where one is in the “economic cycle” is highly debatable. So braces were added to the golden rule belt: a “sustainable investment rule” that net debt should not exceed 40% of national income - again, “over the cycle”.
This broadly followed the “Maastricht criteria” developed by the European Union in 1991 in preparation for its single currency (and designed, ironically enough, by a British civil servant). The basic criteria were that the public deficit should not exceed 3% of gdp, and public debt (defined gross rather than net) should not exceed 60%. They were put in place largely because low-inflation Germany feared the Mediterranean countries would in a monetary union gorge themselves in the debt markets with the implicit support of the Bundesbank.
In the way of these things, however, Germany itself set a bad example barely a decade later, by blowing the Maastricht deficit ceiling and forcing Brussels to cancel its sanctions procedure. Since then the Maastricht Criteria have gone through more than one tortuous process of amendment: the latest set, announced in March, have a loopholed complexity that has attracted a certain amount of derision.
Europe is not alone in that. UK first fiscal rules survived, more or less, until blown up by the financial crisis, after which borrowing soared. The rules changed frequently, became “rolling” targets and in place of hard debt ceilings merely set ambitions to bring debt down between years A and B. The latest set, applied from March this year, were certainly a reassurance to the markets after the fiscal fairy tales of the brief Truss period, but are far from rigid. They decree that debt should be falling and borrowing below 3% of gdp in the fifth year of the forecasts made by the Office for Budget Responsibility (OBR). Using an independent arbiter with the status of the OBR certainly helps credibility (using the National Audit Office proved hopeless) As that end date retreats as time passes, such targets allow for continuing near-term bulges in borrowing and debt.
So fiscal rules have lost a lot of their early glamour, rather as monetary targets lost their glitter with constant changes in measures and ranges. That’s of course not to say that Governments don’t still try to cut. Germany cut its debt very substantially between 2010 and 2018, as - in the “austerity” years - did the UK. Then the pandemic sent it soaring again, and though it has come down from that peak, it is still substantially higher than pre-COVID. The UK is above the average for the industrialised world; its public debt now, according to the OBR, amounts to about £95,000 per household (which easily outweighs the average household’s mortgage debt).
Worried by the seemingly universal nature of this problem, the IMF devoted a special section of the April 2023 World Economic Outlook to an analysis of “soaring” public debt and the difficulties in bringing it under control. Problem one is that sharp reductions in borrowing tend to slow economic growth, making the best option - to grow your economy out of its debt burden - that much harder. The IMF argues that raising taxes will do more damage to growth than cutting spending; but that leads to Problem Two. Deep cuts in spending tend to rebound politically (suppressing public sector pay is an obvious example).
History abounds with examples of countries which, deliberately or accidentally, tried the other obvious way of reducing a debt burden expressed in nominal terms, which is to let inflation rip. The risks with that are even more obvious: a slide in the exchange rate, coupled with difficulty in borrowing. The IMF, you may be surprised to learn, does not recommend it.
But why have these eternal problems seemingly become more insoluble? The first and most obvious cause is that governments that have enjoyed decades of cheap borrowing are now seeing the cost of servicing their existing debt rise sharply. In the UK, it’s still well below historic peaks: debt servicing costs reached 16% of revenue at the end of the second world war, and high interest rates in the 1980s made even public debt pretty expensive. But servicing costs are already more than the UK spends on education, and with a quarter of public debt index-linked, higher-than-forecast inflation is going to push them up still more.
The second obvious reason is that, at the IMF points out, it’s a lot easier to bring borrowing down when the economy is expanding. And although it has very recently changed the sign on its output forecast for the UK this year from a (small) minus to a (small) plus, while the US economy continues to defy attempts to slow it down, among advanced economies overall growth still looks weak.
And - most importantly - there are two other growing problems that hang heavy on governments: the burdens of ageing societies and climate change. The first adds relentlessly to current public spending: raising borrowing to pay for that really is robbing the grandchildren.
The second, however, requires investment, public and private, arguably for their benefit: so does that justify a big hike in borrowing? That’s certainly the argument that lies behind President Biden’s demand to lift the US debt ceiling. The trouble is, it’s the kind of investment that will feel like running to stand still - ie, to enable the next generation not to enjoy a higher standard of living, but merely to go on enjoying a standard of living enjoyed by their parents, while mitigating the environmental risks that previously were ignored. (Take flood defences, for example, which don’t make houses any nicer but simply stop them being trashed.) Somewhere along the line innovation may deliver some free lunches in the process of transforming our economic model, but right now there looks to be a heck of a lot of cost involved.
All of which points to the need for governments to have more grown-up conversations with their electorates about what can, and cannot be afforded, and how different public spending pressures should be met: which elements by specific taxes, which by general taxation, which by borrowing, and which by saying sorry, but no. There’s no simple answer to the question of how much it is right for governments to borrow. But now public debt is running, in many countries, at roughly twice the level considered appropriate in the early 1990s, more rigour is needed in its justification.
Financial markets, patently not interested on how money is spent, but simply on how much, may still like simple fiscal rules. But voters need something more - a clearer identification of the different purposes of public spending with the different ways of meeting the cost. Finance Ministries hate hypothecated revenues, even more than hypothecated borrowing, fearing a reduction in their freedom of movement. But looking at the two growing burdens of healthcare and climate adaption, it’s time for some freer thinking.
Guest Author: Baroness Sarah Hogg, Former Frontier Economics Chairman