October 28, 2022

News in Charts: The UK – when fiscal policy confronts fundamentals

by Fathom Consulting.

Economies are most likely to suffer a financial crisis not in the teeth of a major economic downturn but a year or two down the line. Ever since the pandemic hit, Fathom’s proprietary Financial Vulnerability Indicator has warned of a growing global threat of a series of financial crises, with the risk peaking about now. Until recently the UK would not have been particularly high on most people’s list of countries to watch. Nevertheless, former Chancellor Kwasi Kwarteng, having been in post for a matter of days, took the UK perilously close with his ‘fiscal event’ of 23 September. His request effectively to borrow a further £72.4 billion, worth some 3% of GDP, was seen by investors as a step too far. Both Mr Kwarteng and Prime Minister Liz Truss subsequently resigned, and their plans have been largely rescinded. But what about the Truss government’s fiscal plans produced such an adverse market reaction?

As previous Fathom research has highlighted, the policy prescription for stabilising the public finances turns crucially on the balance between ‘r’ (the long-run real rate of interest on government debt) and ‘g’ (long-run real economic growth). For the past 20–30 years, most major economies have been in a position where r < g. That is a good place to be because it means governments can run a primary deficit indefinitely, and government debt as a share of GDP will not explode. If the primary deficit is too high for government debt as a share of GDP to stabilise, then it will simply move to a new, higher, equilibrium and stay there. The intuition is that, when r < g, economic growth generates sufficient additional resources both to cover the primary deficit and to service the debt.

If, however, we are in a world where r > g things rapidly become much more difficult. In this world, a primary surplus is necessary to stabilise a government’s debt-to-GDP ratio. The surplus will need to be larger, the larger is government debt as a share of GDP, and the larger is the gap between r and g. When r > g, government debt as a share of GDP will grow exponentially until a sufficient primary surplus is achieved.

So, how do those two concepts compare for the UK?

The real interest rate (r)

The chart below shows an estimate of the long-run real rate of interest on government debt in different countries measured by the difference between the yield on a 30-year conventional government bond, and the 30-year inflation swap. On this basis, long-term real rates of interest have risen across the board since the beginning of the year, by somewhere between 200 and 300 basis points.[1]

For the UK, this rise in long-term real rates was exacerbated in the days following Kwasi Kwarteng’s fiscal event with the yield on long-dated, index-linked gilts moving closer to 2%, well above the UK’s trend rate of growth, suggesting an urgent need for fiscal consolidation. This rise has subsequently been reversed in the wake of the government’s fiscal policy U-turn.

Another way to think about this is that r<g implies that investors have judged that (a) the fiscal position is sustainable and (b) inflation is under control. If r>g, that is either because a country is in recession or because the investors have revised that judgement. If the investors judge macro policy to be OK then policymakers have a free hand. If investors make the other judgement, then they have basically taken over. The factor that complicates this is QE, which can give the appearance that investors are delivering a favourable judgement (although in reality the central bank is squishing that judgement). But quantitative tightening now invites investors’ judgements back in. In other words, the UK is now feeling the effects of allowing investors the opportunity pass judgement once again — unfortunately for Liz Truss, the verdict was not a positive one.

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The real rate of growth (g)

Conceptually a country is able to grow either because each worker is able to produce more, or because it has more workers, or through a combination of the two. From that perspective, the trend rate of growth is the sum of two parts: labour productivity growth and growth in the working-age population. As shown in the two charts below, not only has labour productivity growth slowed across the board since the Global Financial Crisis, in most major economies the size of the working-age population is projected to be either broadly flat, or to fall over the next 30 years. In the case of the UK, Fathom estimates that the trend rate of growth over the next 30 years is likely to be as low as 0.7%.\

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The r minus g gap

Fathom analysis suggests that, on average over the past month, 30-year real rates of interest on government debt have exceeded plausible estimates of sustainable economic growth over that same period not just in the UK, but also in the US and in Italy.[2] If this is sustained, governments will need to develop a plan for running not just a primary surplus, but a primary surplus that is sufficient to stabilise government debt as a share of GDP. As shown in the chart below, after stripping out the effects of the economic cycle, both the US and the UK have run persistent deficits for the best part of 20 years. Italy has tended to run a primary surplus, but given very high levels of government debt as a share of GDP in that country, and the sizeable gap between r and g, it has not been of sufficient size to ensure stability.

To summarise, the global economy has entered a high-rate, low-growth environment. If sustained, it will create a challenging environment for the public finances, of a kind we have not seen in decades.

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The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

[1].       There are several competing hypotheses for explaining the reversal in real interest rates. First, the conventional wisdom, that one could account for the decline in index-linked yields using fundamentals, may simply have been wrong: part of the decline in what we had considered to be a measure of the global real risk-free rate might simply have been a bubble. Second, there might have been a reassessment of the prospects for global asset demand and supply. It may be that investors believe that improvements in life expectancy are coming to an end, or perhaps they anticipate an increase in asset supply through greater investment in fixed capital. Third, it could be that index-linked yields are no longer an adequate measure of the risk-free rate.

[2].       It is likely that r remains above g even following the fall back in UK yields under the new Rishi Sunak administration once one adjusts for the fact that the RPI measure, on which swaps are based, overstates inflation by 100 basis points or more.

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