Margaret Thatcher did not approve of big budget deficits. “The problem with socialism,” she once said, “is that you eventually run out of other people’s money.” In 1981, in the teeth of a deep and painful recession, her chancellor Geoffrey Howe unveiled an austerity budget, provoking a condemnatory letter from 364 economists.
Safe to say, then, that were she still alive, Thatcher would be horrified that a Conservative government was running a deficit of around £300bn this year and that Britain’s total debt was nearly 100 per cent of GDP. In his March budget, Rishi Sunak did announce (postponed) tax rises, together with a fresh bout of (postponed) austerity for public services, which will supposedly bring the deficit under control in the end. But his plans, even if realised, won’t make much of a dent in the total. The Office for Budget Responsibility forecasts that the headline stock of debt will exceed national income for the next five years.
This shift in approach reflects a change in the political and financial environment over the last 40 years. The rules that seemed to operate when Thatcher took office no longer apply. In particular, the markets are much more forgiving of high budget deficits than they used to be. In 1981, it cost the Treasury 16 per cent to borrow money for 10 years; the cost today is under 1 per cent. In the 1980s and early 1990s, there was much discussion of the “bond market vigilantes” who would punish profligate governments by pushing up their borrowing costs. In the 21st century, those vigilantes have mostly been asleep at their posts. Governments initially responded to the global financial crisis by allowing deficits to surge, and have done the same again, in spades, with Covid. Barring a single exception that I will come to, they have run into no market resistance at all.
More recently, the political calculation has also changed. As late as 2010, the Conservative Party was able to regain power (albeit in coalition) by promising to cut the deficit faster than Gordon Brown. It even managed to be re-elected in 2015, after years of painful cuts. But these wins may have been driven more by dislike of Labour than any great enthusiasm for austerity economics. The 2016 Brexit referendum revealed public anger against the governing elite, and the Tory majority vanished the following year. By the time of the 2019 campaign, Boris Johnson had banished the word “austerity” and was promising government spending to “level up” depressed parts of the country. He was rewarded with the Conservatives’ best election result since 1987.
A fate worse than debt
In short, there are no current political rewards in pursuing austerity and no financial penalties for running a deficit. The temptations are obvious. But what of the traditional—and apparently sincere—Conservative reverence for prudence as a virtue in itself? Thatcher regarded personal debt and government debt as equivalent and favoured thrift over extravagance. “Any woman who understands the problems of running a home will be nearer to understanding the problems of running a country,” she said in 1979, the year she came to power. In 1980 she doubled down on the ethical dimension: “it is neither moral nor responsible for a government to spend beyond the nation’s means.”
“There are no current political rewards in pursuing austerity and no financial penalties for running a deficit”
This may have been a gut feeling—or a campaigning technique—rather than an economic philosophy. But the Thatcherites also had three more sophisticated arguments against big borrowing. The first was that government spending “crowded out” investment by the private sector. Given the choice between investing in safe government bonds, which merely bankroll the welfare state but are backed by the power to tax, and the riskier debt issued by companies, which could finance productivity-improving investments, savers would choose the former. This would ultimately depress economic growth. The second argument was that budget deficits would eventually require higher taxes to fund them, and these taxes would damage the incentive to work. A third argument, initially half-eclipsed by the monetarist fixation on the money supply, soon reasserted itself too: namely, that budget deficits stoke overall economic demand and thus lead to higher inflation, a tendency that seemed to be borne out by the big spending policies of Lyndon Johnson, American president from 1963 to 1969.
But over the course of the last 40 years, all three of these arguments have been undermined. There has been no sign of “crowding out” of the private sector. Companies are still able to borrow heavily; according to the Institute for International Finance, corporate debt reached a record high of 95 per cent of global GDP in the first quarter of last year. And they can borrow cheaply as well; yields on the riskiest debt, known as junk bonds, fell below 4 per cent this February.
As for the argument that big deficits now mean higher taxes later, look at Japan. Its financial bubble burst 30 years ago, and its government debt has been swelling ever since, from around half of GDP to well over double. But it has learned to live with high debt and its cost of borrowing is lower than Britain’s. When it has tried to raise taxes to cut the deficit, it has achieved nothing beyond cratering its economy.
Inflation, meanwhile, has proved to be the dog that didn’t bark. The UK has not recorded prices rising at over 5 per cent in a full calendar year since 1991.
What has driven this change in conditions? Globalisation for one thing. The opening of China under Deng Xiaoping and the emergence of eastern Europe from communist rule saw the world flooded with low-cost manufacturing and cheap labour. That enabled multinational companies to hold down costs—wages included—in developed markets. Meanwhile, the internet revolutionised logistics—allowing companies to track sales, manage stockpiles, and control costs far better.
At the same time, the shift in manufacturing to the east reduced trade union power in the west, and broke the old stop-go cycles that had dominated economic life in countries like the UK in the 1960s and 1970s. Back then, expansionary policy soon ran into supply bottlenecks, leading to pressure on wages and other costs, which fed back into prices. To arrest that wage-price spiral, interest rates would be jacked up, stalling growth. The end of stop-go cycles facilitated two of the longest expansions in world history: first in the years before the financial crisis, and then again between the recovery after 2008-2009 and the pandemic. But the era of low inflation has brought its own problems: downward pressure on wages in the developed economies has fuelled political discontent and inequality has come to dominate the economic discussion.
On top of their role in lowering costs, the Asian economies have played a big part in the bond market. In 1997 and 1998, many Asian countries suffered from currency crises, and faced an unenviable choice. They could push up interest rates to defend their currency, and send themselves into a slump. Or they could devalue and risk widespread bankruptcies among those companies that had borrowed in US dollars, whose debt repayment bills would then soar. After that crisis, many countries resolved to run trade surpluses and build up foreign exchange reserves; those reserves formed a pool of capital that was invested into government bonds, providing the US Treasury and certain other western states with a guaranteed customer. In this way, Asian prudence worked to lock in western largesse.
Also important in allowing governments to borrow so cheaply is the changed attitude of central banks. Not so long ago, they were steeped in orthodoxy. The worst sin was the idea of “monetary financing”—printing money to fund a budget deficit. In 1923, the Reichsbank under Rudolf von Havenstein had followed this approach to the notorious hyperinflationary point where wheelbarrows of banknotes were needed for ordinary purchases. It became taboo for decades. But many contemporary central banks—starting with Japan but then, within a couple of years of the global financial crisis, most of the other big players too—have pursued quantitative easing (QE), monetary financing in all but name. True, they do not issue money directly to the government, but instead buy bonds from investors in the market, crediting their accounts with the newly created money. But those investors are willing to buy bonds in such quantities only because they know there is almost no risk, since the central banks are reliable buyers with bottomless pockets. Indeed, keeping bond yields low is an undisguised aim of QE. Once governments realise they can contain the costs of borrowing by recourse to the electronic printing press, they don’t worry about debt in the same way.
The exception that proves the rule
What about the eurozone crisis of 2010-2012, which seemed to show that high government debt was still a severe problem for some nations? Indebted Greece suffered terrible austerity and social unrest for years. At the time, George Osborne, Britain’s chancellor, argued that Britain needed to pursue an austerity path to avoid Greece’s fate.
But, as many experts said at the time, Greece was in a different position from Britain or the US. Its debt was denominated in euros, a currency that the central bank of Greece did not control. Before joining the eurozone in 2001, Greece had followed a predictable pattern for decades. It borrowed in its own currency, the drachma, and then periodically devalued its exchange rate, which eased the burden of the repayments. For a foreign investor, this meant an effective loss. To cover such potential losses, investors routinely demanded a higher interest rate on Greek debt than that of other European countries. One of the great attractions of joining the euro for Greece was that the cost of financing its debt fell, since it had now credibly committed not to devalue again.
But the inability to devalue turned into a trap after the financial crisis of 2008. The problem of borrowing in a foreign currency is that a country cannot create the money to pay back its creditors. Doubtful about the Greek government’s finances, investors now demanded a higher return for lending to it. In turn, that made Greek financial prospects even shakier. Soon the Greeks were dependent on lending from other European countries to help them out, a hard sell because Greece was notorious for indulging tax evasion, and the Greeks could retire many years before many other Europeans, including the Germans. The Germans had tried to preclude such bailouts in the Maastricht Treaty that set up the single currency. But as the EU dithered over how to respond, more countries such as Italy, Spain and Portugal were drawn into the mess. Ultimately Greece did get a bailout package, but with such harsh conditions that its economy shrank by 25 per cent, and the impoverished state faced continuing questions about its solvency.
It was only when the European Central Bank, under Mario Draghi, promised in 2012 to do “whatever it takes” to save the euro, that the crisis receded. “Whatever it took” turned out to be the ECB standing ready to buy the government bonds of all the troubled countries, just like the Federal Reserve and the Bank of England were doing for their own governments. Greece is still swamped with debt, but is also still in the euro, and with borrowing costs barely higher than Britain’s. The reality has turned out to be—to repurpose a Thatcherite phrase—that “There Is No Alternative” to central banks standing behind big government debts.
Safe as houses, built to last
If we forget Thatcher’s household analogy, there are other potentially more enlightening ways of thinking about contemporary government debt. The first insight is that, if it didn’t exist, it would have to be invented. Just as a balance sheet has two sides—assets and liabilities—while bonds are a debt for the Treasury, they are an asset to everyone else. And as assets backed by governments, they are classed as the safest asset there is—and as such have long been the foundation stone of an effective financial system.
Go back to the late 17th and early 18th centuries, and the success of the Netherlands and Britain was linked to their ability to manage significant debt. The British and Dutch governments were closely tied to their countries’ rising merchant classes, which ensured that the merchants could assume they would be paid back and made them willing to accept a low interest rate. Trade in government bonds helped foster the growth of Amsterdam and then the City of London as financial centres. By contrast, in France, the Bourbons were not viewed as reliable debtors, and it was their impaired ability to borrow that left their finances in a complete mess. Indeed, it was a desperate scramble for revenue that prompted Louis XVI to summon the Estates General in 1789, subsequently setting off the French Revolution. How the king must have wished that France was blessed with a large and liquid debt market.
“Once governments realise they can contain the costs of borrowing by recourse to the electronic printing press, they don’t worry about debt in the same way”
There were somewhat special circumstances in the 1970s, as the Thatcherites rose to power: inflation had been eroding the real value of bonds, which made their apparent security seem like an illusion. But in the decades since, after the Thatcher-era innovation of index-linked gilts in 1981, the UK has issued billions of index-linked bonds, whose repayment value, and interest payments, go up in line with consumer prices, making them truly secure.
And government bonds are today regarded as such a safe asset that central banks are happy to hold “reserves” of a foreign currency in a bond denominated in it. Pension funds and insurance companies are encouraged to own them to ensure that they can pay their scheme members and policyholders. Similarly, they are ideal collateral for those who want to borrow money. The big banks borrow and lend against government bonds every day in a trillion-dollar exercise known as the repurchase or “repo market.”
The role of government bonds in the system doesn’t stop there. Want to know whether it is worth it to buy the debt of big corporations like Tesco or Barclays? The standard approach is to compare the yield on that debt with the yield on government debt; if there is a big margin, or spread, between the two, this either tells you that the bonds are very attractive or that investors think the company is a risky proposition. Want to justify soaring stock market values on Wall Street? When optimists compare the returns on stocks with the very low yield on government bonds, they say that this means investors have to pile into equities.
A decent-sized government debt market, then, is the sign of a sophisticated economy, not an unhealthy one. It is a mistake to imagine government debt ever being “repaid.” True, occasionally—as briefly in the late 1980s in Britain, and again in the late 1990s—a fast-growing economy will produce a government surplus, with the principal paid down for a few years. But in the modern democratic era, even when politicians have been notionally committed to sound finances, it has never been long before political pressure, or economic bumps, drive those finances into the red again.
Mostly, talk of “repaying” the debt conceals efforts to manage it: in 2014, chancellor Osborne announced with some flourish that the Treasury would repay a specific £218m tranche of government debt. Much of this debt dated back to a 1917 bond issue that financed the First World War, although some related to the Napoleonic Wars and even the South Sea bubble in the early 18th century. But despite being four years into his austerity programme, Osborne was still running an overall deficit; he made the move only because it made financial sense to replace high-yielding old debt with less expensive new bonds. The so-called “consols” he retired, which had formed some of the fortunes in Jane Austen’s novels, were designed to pay income “in perpetuity,” which is the reality of government debt. Whatever claims you may hear about “paying for Covid” in the next year or two, the best guess is that taxpayers will still be servicing some of the debt at the end of the century and beyond. Generally speaking, the debt currently being issued will never be repaid, just refinanced.
The national debt, then, is a perpetual burden on taxpayers, but we can’t form a rounded picture of the phenomenon unless we also acknowledge it as a perpetual asset for savers, who are taxpayers as well. A lot of government debt is owed to ourselves.
A bill that never arrives?
Proponents of a fashionable (on the left, at least) economic doctrine known as modern monetary theory (MMT) urge a more radical reimagining of what deficits mean. They argue that the conventional explanation of how government finance works is wrong. Traditionally, the view has been that governments raise money in taxes and use the funds to pay for spending, borrowing to cover the difference. But MMTers say that a government that can issue its own currency can simply create the money it needs to pay for its spending. The aim of taxes is not to fund the spending but to offset the inflationary consequences of the demand that government spending may create. Provided there are no signs of inflation, a government deficit doesn’t matter. There is no need to worry about the government defaulting on its debt, since the government can create new money to pay its creditors.
No government in the developed world is officially following an MMT policy, but in an age of Covid stimulus programmes, it is hard to tell. The OECD club of developed economies reckons that governments in the rich world borrowed $18 trillion in 2020, and that, by the end of 2021, the average debt-to-GDP ratio will have leapt from 70 to 90 per cent in just two years. It makes little difference whether the government is on the left or on the right. Before he was elected, Donald Trump promised to eliminate American government debt within eight years. Instead, by the time he left office, total debt was $27 trillion, around $8 trillion higher than when he started. As soon as Joe Biden became president, he pushed through a $1.9 trillion stimulus bill, which will add another pile to the debt mountain.
Especially during the Covid emergency, putting prudence before prosperity would have wrought worse economic damage. Just like in war or depression, it makes sense to get through the emergency first and sort out the bill later. But it is not only conservatives who feel uneasy about the drift towards presuming the bill will never arrive. Critics of MMT, including some on the left like Paul Krugman, worry that allowing politicians to create their own revenues would be like putting a drunk in charge of the liquor cabinet. Government spending would soar, including on wasteful projects. And while an MMT government may be able to keep the lid on bond yields, it could not prevent pressure on its exchange rate. As the currency plunges, rising import prices could set off an inflationary spiral. More orthodox voices like Larry Summers, a veteran of the Clinton and Obama administrations, describes the current approach as the worst macroeconomic policy in 40 years.
Governments know that spending programmes are popular and taxes are not. Once they get the idea that they can afford the former, without worrying about the latter, then what will stop the largesse? Is there really no constraint on the government’s ability to spend? No matter whether the spending taps have been turned on or off, the British economy has been growing sluggishly for pretty much all of the 21st century. Do the nation’s underwhelming resources really not limit our freedom to run up immense deficits?
For the moment, the politics seems to favour the big spenders. If the Conservatives are thriving and befuddling Labour right now, it is only by defying Thatcher’s ghost. There is no constituency in favour of austerity—the young want more spending on education, the middle-aged on job-generating investment and the elderly on pensions. Everyone wants the health service to be well funded. The issues seem to unite voters in the newly competitive so-called “red wall” seats in the north and those in the south, where most Tory MPs are still found.
What might change this calculation—and see the ghost of Thatcher return to haunt Boris Johnson—is the threat of inflation. It might—one day—prompt investors to demand much higher rates to lend to the British government. Right now, the forces that have tamed inflation—globalisation and technology—remain in play. But suppose the trade skirmishes between the US and China turn into a full-blown trade war, and the west loses access to cheap Asian goods. Throw in the demographic bulge of the boomers switching from building up pensions to running their savings down, and big government deficits, and inflation might someday emerge in a sudden splurge: “shake the ketchup from the bottle, first a little and then a lot’ll.”
As with comedy, though, timing is everything. Suppose that inflation is set to let rip five years, 10 years or 15 years from now. What incentive is there for politicians to impose pain on their constituents today, in the form of reduced services or higher taxes? The problem will be faced by another administration. For now, our states seem destined to test the proposition that we can’t have too much debt.