With UK debt to GDP reaching 100%, the highest level since the early 1960s, fund manager Anthony Rayner explains why the figure is little more than a psychologically important one.
We often get asked by clients what we think about the sustainability of government debt levels. The implication being that there must be a breaking point, where the holders of financials assets, normally the bond and the currency in the first instance, are punished.
There is renewed urgency to the question. Last week, UK debt to GDP reached 100%, the highest level since the early 1960s. Indeed, the Office of Budget Responsibility expects the number to reach 274% in 50 years’ time.
UK debt to GDP
Source: Bloomberg 31.10.1994 – 31.08.2024.
It seems an unnecessarily precise forecast, but the direction of travel is difficult to challenge and if it reaches this level, it would be higher than at any time since the 1700s. The two recent peaks were after the first and second world wars, at about 200% and 250% respectively. If you go back further in history, peaks in debt to GDP were virtually always conflict related, as debt was issued to fund the war effort. It’s fascinating that this time elevated levels have been reached through financial and economic crises, rather than being conflict related (see chart).
100% is a psychologically important number but is that all it is? Lots of work has gone into when debt levels become unsustainable and when they become a drag on growth. The most famous piece from the economists Reinhart and Rogoff, entitled “Growth in a time of debt”, suggested that economies with high levels of debt to GDP grow more slowly, indeed they came up with 90% as a ceiling. Published in 2010, this was very timely, as governments such as the UK and the US were heading towards that number and the research was embraced as a rationale for programmes of austerity. Since, the work has been somewhat debunked and indeed always suffered from questions around causation, i.e. is low growth caused by high debt levels, or are high debt levels caused by low growth.
It very much reminds me of the economic question of the time when I first started out in the industry, some 30 years ago. The concern was around the sustainability of current account imbalances. Fast forward to today and many countries have been in current account deficit for decades, such as the US and the UK, and many have been in surplus, such as Japan and Germany.
This time around it’s debt not trade but the concept is similar: surely there has to be a mean reversion towards some sense of “normal”? A similar argument was, and still is, made around quantitative easing, i.e. that injecting such a significant quantity of money into an economy and its financial assets has to implode at some point. Of course there are unintended consequences of all of these imbalances, in the case of QE contributing to inequality, but they don’t necessarily get expressed in financial asset blow outs.
In terms of government debt to GDP, there are many countries with higher levels than the UK, for example Italy and Japan, which stand at around 140% and 255% respectively. Whilst it would be difficult to argue that either of these economies are dynamic and high growth in nature, the debt has been sustained, in that they aren’t in default.
There is also the wider point now about being too big to fail. So many economies have much higher government debt to GDP levels now, we’re no longer talking about the odd basket case like Argentina, which bond vigilantes find it easier to pick off. That’s not to say defaults don’t happen in modern times in developed economies, take Greece which defaulted on its debt in 2015. However, there are higher systemic and contagion risks now which policy makers are well aware of.
As ever, there is a political angle. For example, most would agree that many Western economies have material infrastructure deficits, the narrowing of which should lead to a more productive economy. But how do politicians address these long-term issues and allow voters to see the benefits within relatively short-term electoral cycles. They will see much of the cost but little of the benefit. There is also a demographic angle, with ageing populations adding to the dynamics of higher debt to GDP.
In short, debt can be a force for good and can improve welfare but too much debt can limit the degree to which governments meet their part of the social contract, even if there is no hard and fast level where debt starts to become a drag on growth.
Our view is that financial markets and economic trends often go on much longer than the consensus thinks possible. Therefore, in portfolios, we wouldn’t position for imbalances to suddenly become unsustainable but rather focus on unintended consequences. For example, the unintended consequence of the massive fiscal stimulus being undertaken in the US via the CHIPS Act and Inflation Reduction Act, in the region of something like $450 billion. We are more comfortable arguing that this is likely to be inflationary, which informs our medium-term base case that inflation will accelerate, rather than arguing that US Treasuries and the US dollar will self-destruct in the medium term because of it.
Anthony Rayner
Premier Miton Macro Thematic Multi Asset Team
