Covid-19 ensued chaos upon the UK, which has one of the highest death rates per capita in the world, and the most contracted of all G7 economies. UK GDP fell by 10.3% during the pandemic as a result of lack of consumer demand and withheld business investment. This means that there has been enormous pressure for the government to support the economy to avoid mass unemployment and long-term economic downturn. Government schemes such as the Furlough Scheme and the Self-Employed Income Support Scheme (SEISS) have cost an overall £83.7 billion. This and regular unemployment and social welfare benefit payments have contributed to a fiscal deficit increasing to about £400 billion (15% of national income) and total national debt surpassing £2 trillion, over 100% of GDP. This is the first time that the UK government’s debt has exceeded its GDP since 1963. With government debt spiralling due to high public spending and decreases from tax revenues, can there actually be any limit?
When individuals borrow money for mortgages or student loans, there is a limit to how much they can borrow. For example, if you were planning on borrowing money for a mortgage, the bank will look at your salary and savings to see if you can afford to borrow the money you want. One may think that this works with the government too; the complicated experience involving Greece after the financial crisis suggests that countries are also subject to borrowing limits. One of the reasons why Greece struggled was because there were a lot of foreign investors investing into the government bonds prior to the crisis but when trouble soon arrived, these investors sold their bonds and invested in safer, more stable government bonds leaving Greece with an overwhelming amount of external debt which had high interest rates. Greece’s downfall was also due to the competitiveness gap between Greece and other nations. The conditional Eurozone membership in 2001 helped Greece borrow cheaper but also meant that Greece was involved in a vicious cycle where there was the use of only one currency, the euro. Countries like England who have now left the EU can decide on methods to drive GBP down to increase export sales but Greece did not have this ability to decide. Furthermore, the bailout provided by the Eurozone was subject on conditions that Greece had to accept spending cuts which caused a massive recession. This suggests that the main force limiting government borrowing is the bond market.
However, instead of there being a desirable limit for government debt, government limits are more subjective because rather than one party deciding on how much a government can borrow, the market does. An important aspect to consider are the investors who buy the debt. Investors (domestic and foreign) have their own choices which mean they can buy and sell debt at any time and will choose opportunities that look appealing. The problem of there being no investors willing to buy debt becomes imminent when a government spends carelessly. Governments borrow money from the bond market which consists of pension funds and other investment funds. As long as a country’s investment is wise (‘good’ debt), there will be future benefits for an economy and the government retains market credibility; demonstrating how the market limits government borrowing.
As the UK recovers from the Covid crisis and government spending stimulates the economy, nominal GDP will be boosted. However, this short-term spending effect, may cause inflation, and if interest rates climb above the nominal GDP growth rate the market sends a signal to consider spending controls; if the market perceives inflation to be rising and potentially out of control, the market will push long-term interest rates higher as more bond investors sell. Currently, prices of goods in the UK are rising with ‘demand outstripping supply’, as the huge amounts of money the government has recently spent on combatting the virus has put more money into peoples’ pockets, causing an increase in excess demand. In the medium to long term, it is better for the government to spend on increasing economic capacity which means investors are more likely to see their money back. For instance, recent ambitions from the government are to have a high-speed connection between Oxford and Cambridge which will not only improve efficiency but also create many jobs. There are also aims to invest in science and technology industries in the area which could generate up to £200 billion for the economy each year.
Investors also look at how credit worthy a country is so countries are constantly trying to boost their credibility with the market. Greece was hit after the financial crisis as debt approached a tipping point for investors concerned about debt repayment. But on the other hand, Japan which is a HIC has the highest debt to GDP ratio in the world at 234%. Unlike Greece however, Japan’s debt situation is sustainable as the cost of servicing their debt has remained very low. In Greece, investors (especially overseas) demanded higher returns because they were concerned about currency risk and the potential of default. Whereas in Japan, the holders of government debt are predominantly Japanese citizens meaning they are more passive. Japan’s growth-corrected interest (Interest rate minus Nominal Growth Rate) is also negative, which allows them to have this astoundingly high debt to GDP ratio.
Therefore, it is the bond market comprised of individual investors who evaluate how safe an investment is and how credit worthy a country is that dominates the decision of whether a government can borrow or not. The market therefore acts as a check and balance system on government debt limits meaning a government has to be constantly vigilant of the market growing wary. Poor investments from governments will have consequences.
By James Midgley
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