Britain must overhaul its macroeconomic policy to avoid decades of rising debt or austerity

Britain’s macroeconomic policy framework is largely unchanged since the 1990s, and now needs an overhaul to tackle the risk of an unsustainable ratcheting up of debt that will hamper its ability to respond to economic shocks or fund public services, the Resolution Foundation said today (Thursday).

Built to last – the 46th report from The Economy 2030 Inquiry, funded by the Nuffield Foundation – notes that several ‘once-in-a-lifetime’ economic crises over the past 15 years, coupled with weak growth in between, has left the UK with fast rising debt levels. The UK’s debt-to-GDP ratio has trebled over this period, from 36 per cent in 2007 to around 100 per cent, the largest peace-time debt rise in over 300 years of fiscal data.

A key driver of this rise has been Britain’s ‘debt ratchet’ – where huge fiscal interventions in economic crises drive up Britain’s debt – but only small falls in debt in between.

Policy makers are currently focused on the short-term problem of higher rates, with each one percentage point rise in rates currently adding around £15 billion to government borrowing in five years’ time.

If the UK stays in a new higher interest rates environment in the longer term, as markets currently expect, and fiscal policy follows both main parties’ current policy of aiming to put debt on a gently falling path in the years between recessions, Britain’s debt ratio is on course to climb to around 140 per cent over the next half century.

This will put severe pressure on the cost of servicing this debt, which could rise to around 5 per cent of GDP – its highest sustained level in over 70 years, and more than the combined departmental budgets for energy, defence and transport.

The authors caution that a return to a lower interest rates world, particularly if it is matched by lower growth, could lead to even greater upward pressure on debt. That’s because very low rates will put more pressure on fiscal policy to support the economy during downturns.

In this lower rates world, additional fiscal support during economic shocks equivalent to the average recessionary interest rate cut would see the size of the debt ratchet in each crisis increase to 20 per cent of GDP. As a result, Britain’s debt ratio would almost double to 190 per cent of GDP over the next half century, even with debt gently falling between shocks.

Avoiding this ratcheting up of debt would require the government to run a 3 per cent primary budget surplus outside of recessions. This is implausible given the scale of permanent tax rises or spending cuts that would follow – the UK has achieved this level of annual surplus just three times in the past half a century.

Easing this pressure on the UK’s public finances therefore requires a reset of Britain’s approach to monetary and fiscal policy, say the authors. The two priorities should be to reduce the pressure on fiscal policy to support the economy in a downturn by ensuring monetary policy has more scope to act, and to get a bigger bang for each buck the Treasury spends supporting the economy.

The report proposes a new approach to monetary policy that secures greater capacity to cut interest rates in a downturn – taking steps to allow negative rates of up to -1 per cent, and raising the inflation target to 3 per cent. Denmark and Switzerland have shown that negative rates (of -0.75 per cent) can work. A new inflation target should be introduced carefully, only if we return to a low-interest-rate world, only after the current 2 per cent target has been hit, and ideally in coordination with other advanced economies.

Governments must also make fiscal policy smarter, building the policy tools to deliver targeted support for when economic shocks inevitably hit in the future, rather than the more expensive universal support deployed recently.

It highlights two recent examples of poorly targeted support – generous grants to self-employed workers who did not report income falls in the pandemic, and energy support provided to high-income households more recently. Had it been possible to target the schemes at those who actually needed financial help, their overall cost could have been reduced by £35 billion.

This new macroeconomic framework would mean that primary budget surpluses of around 1 per cent would be needed to prevent Britain’s debt ratio rising over time in the face of inevitable shocks. While still tough, this is much more in line with experience towards the end of the 20th century, when the UK ran a surplus of 1 per cent or more in three out of five years.

James Smith, Research Director at the Resolution Foundation, said:

“Britain’s recent run of major economic shocks has given us the largest peacetime debt increase on record.

“Continuing on a path of debt rising in each downturn but not being reduced between shocks will leave the UK’s public finances on an unsustainable path, requiring implausibly large tax rises or spending cuts.

“We need to reset the UK’s approach to macroeconomic policy. The Bank of England needs greater monetary firepower, secured by enabling slightly negative interest rates and taking steps to move to a 3 per cent inflation target if we return to an ultra-low interest rate world. The Government should plan now to be able to provide more targeted support in future recessions, having overspent by £35 billion on poorly targeted schemes in the recent past.

“This reset would ensure we can support the economy in bad times and fix the fiscal roof when the sun eventually arrives.”

Notes to Editors

  • The Economy 2030 Inquiryis a collaboration between the Resolution Foundation and the Centre for Economic Performance at the LSE, funded by the Nuffield Foundation.
  • The Nuffield Foundation is an independent charitable trust with a mission to advance social well-being. It funds research that informs social policy, primarily in Education, Welfare, and Justice. The Nuffield Foundation is the founder and co-funder of the Nuffield Council on Bioethics, the Ada Lovelace Institute and the Nuffield Family Justice Observatory. The Foundation has funded this project, but the views expressed are those of the authors and not necessarily the Foundation. Website: Twitter: @NuffieldFound