Government Debt Is a Historic Problem, but This Time the Issue Really Is Different

Yet while the decision’s timing was a surprise, Fitch’s central analysis seems indisputable. The agency says the downgrade reflects a “fiscal deterioration over the next three years”, “a high and growing general government debt burden” and “an erosion of governance … that has manifested in repeated debt limit standoffs and last-minute resolutions”. While this doesn’t make a formal US default likely, it surely increases its probability, especially compared with well-governed AAA fiscal stalwarts such as Germany and Switzerland.

Unfortunately, policymakers in America and Britain remain too sanguine about the tail risks of fiscal crises. Every year, the Congressional Budget Office and our own Office for Budget Responsibility publish alarming debt projections and warn about the risks of spiralling public borrowing. But elite economists dismiss these reports, confident that rising debt-to-GDP ratios and ageing populations simply won’t heighten the risk of full-blown debt crises.

This nonchalance stems in part from bad historical frames of reference. For example, last week Paul Krugman, the Nobel prizewinning economist, explained that Britain had avoided fiscal meltdowns despite much higher public debt after both the Napoleonic wars (nearly 200 per cent of GDP) and the Second World War (over 250 per cent) than the US faces today (about 120 per cent of GDP). Why should America, or for that matter Britain, fret over today’s debt-to-GDP ratios given these benign past experiences?

Well, because the economic context was clearly different. After those wars, Britain championed fiscal restraint. Barry Eichengreen, the economic historian, has shown that once the Napoleonic wars had ended, Britain maintained primary budget surpluses (tax revenues exceeding non-interest spending) throughout the 19th century. Similarly, no UK government ran a primary deficit for a quarter of a century after the Second World War. This contrasts sharply with Britain not having run a primary surplus now since 2001-02.

When wars end, governments slash temporary spending programmes through demilitarisation. Today, we’ve built up war-like debts from the financial crisis and Covid-19 but with promises for permanently higher pension, health and social care spending to follow. In fact, so great are these future demographic pressures that if policies were simply left on autopilot, the OBR predicts that the nation’s debt would rise from its present 101 per cent of GDP to about 300 per cent over 50 years.

It’s not only budget policies nor demographics that make debt reduction harder today. Post-the Second World War, macroeconomic conditions were more conducive to reducing debt. Getting the debt-to-GDP ratio falling hinges to a large extent on how real interest rates compare with economic growth rates. The higher economic growth is relative to a government’s real borrowing costs, the less austere budgets have to be to ensure that the debt burden is falling.

From the war through the mid-1970s, real British GDP grew strongly at 2.8 per cent per year, benefiting from technological catch-up growth, a baby boom and more women entering the labour force. Today, growth is weak and is expected to decline to an average of about 1.5 per cent per year, owing to a shrinking relative working-age population and poor productivity growth. Neither the Conservatives nor Labour seem interested in a supply side agenda to improve things.

At the same time, the postwar period had low and sometimes negative real interest rates, because of government repression on interest rates and high levels of inflation. Tight controls on currency and capital made domestic banks and financial institutions captive purchasers of government debt, while the average rate of inflation was about 4 per cent per year through the 1950s and 1960s. This all helped to erode the stock of debt relative to GDP.

Modern financial markets offer less leeway for this chicanery. While unexpected inflation can aid governments, mobile capital will punish them swiftly with higher borrowing costs for leaning on central banks to inflate away debts. With a quarter of the UK’s national debt now index-linked, anyway, and with quantitative easing shortening Britain’s average debt maturity, our recent inflation and the higher short-term interest rates necessary to mitigate it have actually pushed up government borrowing costs sharply.

Nor can governments “inflate away” a triple-locked state pension or promises to deliver hip replacements. No, countries like Britain and America face an unprecedented fiscal challenge over the coming decades, with no easy answers. In fact, the OBR confesses that its debt projection likely understates the challenge, as it “assumes there is no feedback between the level of debt and the interest rate”, “makes no provision for other unfunded policy ambitions” and “ignores potential future shocks”, such as recessions or wars.

Economists cannot predict with certainty the effects of continuing down this path of ratcheting up debt levels, but research does show that higher debt burdens correlate with slower economic growth, that big shocks like recessions or wars occur fairly regularly and that fiscal crises can blindside governments. Suppose another financial crisis or a broader Nato war were to materialise right now: it’s easy to conceive of sharply rising borrowing costs setting off a potential doom loop of high inflation or, later, severe austerity.

Fitch’s US downgrade and the UK’s bond market volatility after Liz Truss’s mini-budget might be early warning signs that surging debt burdens are a bigger threat than perceived. It wasn’t so long ago that economists told us that borrowing costs would stay low forever. It’s disappointing, therefore, that Team Biden reacted by saying “nothing to see here”, in turn confirming Fitch’s fears that America’s governance, across the spectrum, is not taking this issue seriously.