Austerity may be dead, but what about government debt?

The financial crisis, recession and a slow recovery played havoc with the UK’s public finances, leaving the government with the largest ever peacetime budget deficit.

The process of repairing the public finances has been slow. But, over time, tax rises and a squeeze on spending have worked. Last year government borrowing dropped to the lowest level since 2001. This year borrowing will be significantly lower.

Meanwhile surveys show that the British public have grown weary of austerity. The National Centre for Social Research reports that the proportion of voters who favour increased public expenditure and higher taxes has nearly doubled from 31% to 60% since 2010. The Prime Minister tapped into this mood at the Conservative Party earlier this month, proclaiming an end to austerity.

This represents a major change in policy and a daunting challenge. Three obstacles stand in the way.

First, eight years of austerity have only slowed the deterioration in the public sector balance sheet. The government is still at least five years away from being able to repay debt or reverse the decline in the public finances. Last week the International Monetary Fund ranked the UK as having the second weakest public sector balance sheet - comparing assets against long-term liabilities such as debt and pensions commitments - of 32 nations. Only Portugal ranks lower. Several developing economies, including Russia, India and Turkey, have stronger finances.

Second, demand for public services is set to rise for decades to come and from a starting point of stretched provision. An ageing population means that spending on social care, health and pensions is set to soar. The costs are eye watering. The ratio of public debt-to-GDP currently stands at 85%, or £1.8 trillion, the highest level in over 40 years. Unless entitlements are cut, or taxes raised, the government’s independent budget watchdog, the Office for Budget Responsibility (OBR), estimates that the debt-to-GDP ratio will rise three-fold, to 280%, in 50 years’ time.

Third, the OBR expects Brexit to slow GDP growth over the next five years. This comes on top of a decline in the OBR’s estimate of the UK’s long-term growth rate caused by a reassessment of the outlook for productivity. So the official view is that a sustained rebound in growth – the usual catalyst for big reductions in public sector indebtedness – is less likely to come to the rescue this time.

So can the government end austerity?

On the debt front the government’s main target is to eliminate the deficit by the mid-2020s. To do so, and end the squeeze on public spending, will need faster growth. That is not what the official forecasters, or independent forecasters such as the Institute for Fiscal Studies, expect.

If stronger growth doesn’t materialise the only way of balancing the books and raising public spending is to increase taxation.

The head of the OBR, Robert Chote, recently said that “small tax rises of 1.9% of GDP each decade” would offer a realistic and politically palatable way to do so.

As is the case in so much of economics there are no easy solutions only trade-offs. For public sector austerity to end without pushing the UK further into debt is likely to mean a dose of private sector austerity – in the form of higher taxes.

The last word on all of this belongs to the Oxford economist and academic, Martin Slater, who recently published a brilliant account of two centuries of UK government spending and borrowing, “The National Debt, A Short History”. Other than cutting spending or boosting taxes the only way of eliminating a deficit, Dr. Slater writes, is through, “a return to higher rates of economic growth, or improvements in the efficiency of delivery of government services, but the latter is much easier to imagine than to implement. History suggests that actually the likeliest saviour is always economic growth”.

We must hope that history is on our side this time.

PS: In last week’s Monday Briefing we noted that the Bank of England chief economist Andy Haldane said there is “compelling evidence of a new dawn breaking for pay growth”. Evidence that this dawn may be upon us came last week with the release of official data showing that UK average earnings grew by 3.1% in the three months to the end of August on a year earlier, the fastest pace since the financial crisis.