The costs of debt financing

6 July 2012

Reform roundtable seminar on childcare on “the costs of debt financing” on Tuesday 3 July 2012. Introduced by Jonathan Portes, Director, National Institute of Economic and Social Research.

The record low cost of government borrowing in the UK has led to calls to use debt financing to fund capital spending. Jonathan Portes, Director of the National Institute of Economic and Social Research, has estimated that with an interest rate of 0.5 per cent increasing debt by £30 billion would cost £150 million a year. This estimate generated debate over how much debt financed public investment actually costs. What is the impact of inflation? Should the tactic be to simply refinance debt in the future? What would it take to trigger a flight from gilts and are there implications of this borrowing for future generations?

To explore these issues in greater detail Reform recently held a Reformer lunch with Jonathan Portes on the costs of borrowing and the implications for fiscal policy. This event was the second in a series of “austerity debates” and was held under the Chatham House rule.

The first area of discussion was the causes of low long term interest rates. This is significant as if long term interest rates are driven by weakness in the economy and not by deficits and debt then further borrowing could have little impact on rates in the future. It was argued that the risk from greater borrowing could be relatively low as there is significant spare capacity in the economy (implying less crowding out). But it was also noted that even if the Government can currently borrow at low rates this cannot continue indefinitely (there is no infinitely lived indexed linked gilt) and at some debt level market confidence would be lost.

Further, just because borrowing is cheap it should not be assumed that more borrowing will automatically increase growth. Borrowing should not be seen in isolation from what it is spent on. Areas for possible spending include infrastructure and house building and borrowing to fund tax reductions. Yet there was concern that extra spending by government would fail to be growth enhancing and that increased borrowing could reduce the efficiency of spending by reducing pressure on budgets. There was a view that with government spending 46 per cent of GDP there is scope to increase growth through improving the efficiency of existing spending rather than borrowing to spend more.

The role of the business and household sectors was also noted. The Government is not the only actor that can borrow at low interest rates and yet many businesses and households are reducing their debts. This may reflect liquidity issues but could also reflect a desire of businesses and households to build up balance sheets in the face of uncertainty. Problems in the Eurozone are a major cause of uncertainty. (As an aside it is important to note the difference between the UK’s position and that of other European countries as the UK can continue to borrow in its own currency.)

Uncertainty can also reflect doubts over a government’s medium term plan for the public finances. Borrowing will have to be paid back and so more borrowing now means taxes would have to be higher or consumption lower in the future (depending on the growth effects of more debt and what the borrowing is spent on). This, in turn, reduces incentives for investment (although there is debate over whether these conditions (Ricardian equivalence) hold when there is spare capacity in the economy).

Government borrowing also has implications for intergenerational equity. But, again, this reflects, among other things, what borrowed money is spent on. If it is used to create an asset which is passed onto future generations then this may be equitable, but there is much less of a case for borrowing to maintain current consumption. Borrowing can also create a “dead” area of public spending (spending that is “lost” on servicing debt). In this context it was discussed how the Government now is spending more on debt servicing than education, although this is not, by historical standards, unusual.

The difficulty in sticking to a medium term plan to reduce borrowing should not be underestimated. Not only is there the challenge of identifying when the “short term stimulus” should end and be replaced by fiscal prudence, in the face of an ageing population fiscal prudence will involve increasingly difficult policy choices. The UK public has a revealed preference for, for instance, keeping taxes below 38 per cent of GDP, providing public services free point of use, projecting military power onto the world and maintaining free social care to protect children’s ability to inherit houses. Yet it is not possible to have it all. It is inevitable that at some point the bill will have to be paid and the political process will have to answer some hard questions. With the speed at which the UK population is ageing this need to face up to hard decisions will come much sooner than expected.



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