The Chancellor has till mid-2021 to convince the markets that he has a policy to get the deficit under control but a messy Brexit could limit his fiscal options
There is clearly a debate going on in Whitehall about the appropriate size for the UK budget deficit. The Treasury line seems to be that it is now time to start bringing it back under control. Others (including to some extent Cebr) are worried about whether a W-shaped recovery will mean that more stimulus is needed. And yet other modern monetary theorists argue that as long as the government can borrow at close to zero cost, it can increase its borrowing almost ad infinitum.
This note tries to assess what are the options for public borrowing after data released last week showed that the UK had borrowed £174 billion in the first five months of the current fiscal year with the debt-to-GDP ratio breaching the 100% threshold.
Money markets clearly indicate that in the short term there is no bond market constraint on borrowing. Interest rates even on longer dated bonds are near zero. The government can, therefore, print money until it becomes inflationary, which could happen eventually either through the real economy or through imported inflation. Clearly, this isn’t happening at the moment.
Our view is that the biggest short-term constraint on borrowing (and monetary policy) is the foreign exchanges. And if they lose confidence, not only would the pound fall out of bed risking inflation but also the bond market would react and the relationship between yields and borrowing could become vertical. Overseas investors will be concerned if currency risk has to be factored in. Once that happens, the country’s choices get circumscribed, so it is prudent to keep well below the levels of borrowing that risk upsetting the foreign exchanges.
Foreign exchanges assess countries comparatively and the relatively lax fiscal and monetary policies in the US and to a lesser extent the Eurozone allow substantial short-term flexibility for the UK. The US total public deficit (including state and local government) could be close to 20% of GDP this year while their money supply grew by a fifth between February and May alone though it has roughly stabilised since. The Eurozone combined deficit will be much lower (c 8% of GDP) while monetary growth is only 10%. Against that background, the extrapolated budget deficit for the UK if borrowing were to continue at the rate over the past five months would reach £420 billion, close to 20% of GDP. Meanwhile the M4 definition of the money supply was up 12.1% in August. Both numbers seem riskily high and it is not surprising that Chancellor Sunak has decided to end the furlough scheme this month so that his borrowing for the rest of the year will be less. Continuing a deficit averaging close to 20% of GDP for the rest of the year looks dangerous.
Longer term the two checks that the markets impose on fiscal policy are the risk of inflation and the policy’s sustainability. So they would want to see good progress in reducing the deficit in 2021 and evidence that the debt-to-GDP ratio is not explosive. A few weeks ago we proposed a 10 year time frame to bring the deficit down (probably to around 2% of GDP) and a 50 year time frame to get the debt to GDP ratio down to around 60%. The markets could probably tolerate a further short period of rapid (6-10%) monetary growth of less than a year while the economy is getting back on its feet.
All this means that the Chancellor probably has until the middle of next year at most to show that he has a clear policy to get the deficit down. By then he needs to convince the markets that he has the political backing to constrain public spending or raise taxes in a way that achieves this. The more he can convince the markets that his strategy will boost economic growth, the more relaxed they will be about the actual numbers on the deficit and on monetary growth. Amongst other things, this means that if Brexit gets messy, the Chancellor’s options both in scope and time will become circumscribed.
Long term of course the real constraint on policy is inflation. But the forex market constraint on both fiscal and monetary policy will bite much earlier.
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Contact: Douglas McWilliams firstname.lastname@example.org phone: 07710 083652