Don’t be seduced by the sweet spot of low interest rates and low inflation – government debt still needs to fall if the nation is to prosper, says James Sproule
Elections are all about choices, and while some may see few differences between the parties, this is not our view, particularly on some crucial economic questions.
While there is broad agreement on the need to somehow reduce the budget deficit, there is less harmony on the best way to do this, and whether a budget should be in surplus or only current spending needs to be balanced. This highlights one of the significant differences emerging around the issue of infrastructure investment.
For many, the argument is clear: with UK interest rates at all-time lows, could there ever be a better time to invest in infrastructure? Others say that unless the budget is in surplus, the national debt is not being reduced. If a government is not reducing the stock of debt after a seven-year economic expansion, it never will.
We urge reflection. As a nation we are in a sweet spot of low interest rates and low inflation. Long may this continue, of course, but it would be dangerous to assume that such benign circumstances were the new norm. From the likes of Nassim Nicholas Taleb to Judith Rodin, cutting-edge thinkers are emphasising the need to avoid fragility and embrace resilience.
So how fragile is the UK? First of all, its debt burden remains considerable at £1.4trn, or 78.8 per cent of GDP. If UK inflation were to emerge, the cost of servicing that debt would rapidly rise. The Institute for Fiscal Studies has calculated that for each one per cent increase in interest rates, the cost of servicing the national debt rises by £5.3bn per annum, equivalent to a 1p increase in the basic rate of income tax. Quite a double whammy.
If, however, the UK were to slip into deflation – unlikely but not impossible – the debt burden would increase. This is what has happened to Greece and why debt there has gone from onerous to insane. In the case of deflation, debt-servicing cost would not be the immediate problem, but investors might look askance at the absolute debt burden and decide to invest elsewhere, steepening any yield curve.
Any infrastructure project, public or private, must justify its investment – and over a range of conceivable circumstances. For public sector investment there is an additional hurdle; we are already heavily indebted, and reducing this is neither easy, nor necessarily electorally popular, but it is still essential for our long-term economic health. The single currency’s introduction saw a significant fall in debt-servicing costs in much of the eurozone, bringing a choice between reducing debt or increasing government spending. How much better it would have been for these economies had governments fixed the roof while the sun was shining.