UK Debt Crisis: Steady As She Goes Not an Option

The UK's public debt has reached £2.9 trillion, accounting for 94% of the country's national income. This level of debt is reminiscent of the early 1960s. The government adds approximately £128 billion to this total each year, and interest payments already consume one in ten pounds of revenue, a sum greater than both the defence and transport budgets combined.

Some argue that the UK can sustainably carry such a large debt burden indefinitely and even take on more borrowing. However, a new report challenges this view by proposing a plan to keep the debt ratio steady, which essentially means allowing it to rise further. This approach makes no provision for potential future recessions or crises.

Refinancing the existing debt stock at today's higher interest rates will require significant consolidation efforts just to maintain the status quo. High levels of debt also leave the public finances vulnerable to global interest rate fluctuations and transfer the burden of past consumption to future generations, who inherit the mortgage without the corresponding assets.

The report outlines four possible ways for a country that borrows in its own currency to reduce the debt ratio: faster growth, surprise inflation, financial repression, or primary surpluses. However, relying on growth is unlikely due to the potential for an AI-driven global productivity boom, which could raise both interest rates and output, leaving the fiscal arithmetic unchanged.

With higher inflation also being an unlikely solution given that one-quarter of the debt stock is index-linked and markets are highly sensitive to inflation news, the report concludes that primary surpluses or financial repression remain as viable options. A gradual consolidation would come at a cost but its macroeconomic effects would be temporary and could be cushioned by easier monetary policy.

The report estimates that each percentage point of credible improvement in the deficit path lowers ten-year gilt yields by 10-15 basis points, resulting in around £3-4.5 billion per year in savings once the stock reprices. The difficult choice is between a deliberate tightening of fiscal belts now and recurring bouts of gilt-market instability with real economic costs, emergency intervention by the Bank of England, and subsequent rules that steer more national savings into gilts at depressed returns, financial repression, as economists call it.