Time to start worrying about 2021 deficits
“Don’t worry about today’s borrowing numbers. It’s next year’s that should worry us”
By Carl Emmerson, Benjamin Nabarro, and Isabel Stockton, courtesy of the IFS
The ONS will release its latest monthly public finance estimates at 7 a.m. on Friday 19 June. They will show that across April and May government borrowing ran at record levels, pushing up government debt substantially.
As long as the government can continue to borrow very cheaply, then what really matters for the public finances is not the size of the temporary spike in borrowing that is inevitable during the current lockdown, but rather the extent to which current weakness in the economy persists in subsequent years.
A new report produced by researchers at the Institute for Fiscal Studies and Citi presents different scenarios for the economy over the next few years and what these might mean for the public finances.
Key findings include:
This year will likely see a record increase in borrowing, bringing it to levels not seen since the Second World War. As long as the threat of the virus fades and the lockdown ends, the economy will rebound sharply next year. This – combined with the assumption that the emergency measures implemented since the Budget are allowed to expire – should see the deficit fall very sharply next year.
The real risk from this crisis is that the economy remains weaker than forecast before the COVID-19 pandemic for a protracted period. That is our central scenario – in contrast with baseline scenarios set out by the OBR and Bank of England – reflecting our view that the economy is likely to take several years to adjust. The rapid transition to a relatively rudimentary free trade agreement at the end of 2020 risks hampering the recovery further, potentially compounding the damage to output in the longer-term.
Continued weakness in the economy could leave borrowing at over 5% of national income (or £130 billion) in 2024–25. That would be 3% of national income – or about £70 billion – higher than was forecast in the March Budget. There is clearly considerable uncertainty around this projection, but even under a scenario with a faster recovery we project that borrowing in 2024–25 could still be running about £40 billion higher than forecast in March.
Under all the scenarios we consider, debt would increase sharply this year, and then continue rising. Nevertheless, given the low current cost of borrowing, it would be worth doing additional one-off borrowing now that leads to a stronger subsequent recovery. And any policy action to reduce the deficit should not be implemented until the economy is back to more normal performance.
Despite the much higher level of debt, we forecast that debt interest payments will be lower over the next five years than was expected back in March. This reflects the effects of quantitative easing, the lower bank Base Rate and very low interest rates on government debt.
This crisis will lead to debt being elevated for many years to come:
- If interest rates remain low this need not be problematic. But the public finances would be more exposed to increases in interest rates not associated with stronger economic prospects. This risk is exacerbated by the growing share of government debt that is held by the Bank of England’s Asset Purchase Facility and therefore effectively financed at Base Rate.
- If long run growth rates reach levels forecast in the March Budget, we would still need a fiscal tightening (probably tax rises) of £30-40 billion just to stabilise debt at a level around 100% of GDP.
- If we decide we want to increase spending on welfare, health or social care in the aftermath of this crisis then an even bigger fiscal consolidation (set of tax increases) would eventually be needed.
Ben Nabarro, a UK Economist at Citi and a co-author of the joint new report, said: “Shut-downs resulting from COVID-19 have slashed nearly two decades of growth from the UK economy in just two months. The shape of the economic recovery is now the key question. As the economy reopens, growth will inevitably rebound. However, a full recovery in output is unlikely to be quick and simple. In the aftermath of COVID-19 and Brexit, the structure of the UK economy is likely to change materially. This implies persistent unemployment, weaker household sentiment and a slower recovery. It also makes it more likely the crisis results in significant permanent losses in UK output.”
Isabel Stockton, a research economist at the Institute for Fiscal Studies, and a co-author of the joint new report, said: “This year will see a record increase in government borrowing, most likely pushing it to its highest level since the Second World War. Even so, with current low interest rates, additional borrowing now that boosts the economic recovery would still be worthwhile. The future health of the public finances will depend greatly on the strength of the subsequent recovery. But once we are through the immediate crisis and the economy reaches a new normal, we will be left with elevated debt. At that point a mix of some tax rises alongside an acceptance that higher debt will need to be managed carefully for decades to come seems the most likely outcome.”
Carl Emmerson is Deputy Director of the IFS and an editor of the annual IFS Green Budget. He is also Acting Vice Chair of the Social Security Advisory Committee and a member of the advisory panel of the Office for Budget Responsibility. Benjamin Nabarro is a Senior Associate in the Global Strategy and Macro Group at Citi Research. He joined Citi in July 2016, previously working in Global Thematic Research and is currently based in the London office. Isabel Stockton joined the IFS in 2019 as a Research Economist in the Pensions and Public Finance Sector. Her interests are in applied labour economics and her current research focuses on workforce issues in the healthcare sector.