Britain is broke: how inflation-linked debt costs us £60bn

Times

2 days ago

Britain is broke. That was the depressing conclusion of the Office for Budget Responsibility's annual report on the future of the public finances published this week. Of course the fiscal watchdog did not choose those exact words. Instead it used 65,000 other words, but if you were to distil the overall message, it's hard to come to a different conclusion.
The watchdog chose to focus its report this year on the ruinous cost of the triple-lock pension promise and the strain that net zero will place on the public purse. But in Westminster, all the talk is about how a little-known policy decision made decades ago is putting the government in an uncomfortably tight fiscal straitjacket.
That decision was to start promising investors who lent money to the government that their cash would be protected from the ravages of inflation. Or in more technical language, the government started issuing index-linked gilts that were tied to the retail prices index (RPI) measure of inflation.
This innovation meant investors could lend the government money safe in the knowledge that if inflation rose, the amount of interest they would receive and the amount returned at the end of the term of the loan would rise so the real value of their investment would never fall.
Conventional gilts offer no such protection. The lender is just paid a fixed amount of interest each year, and a fixed amount of cash is returned at the end of the term.
The consequences of this policy for the public purse are only now beginning to be felt because of the higher levels of inflation since the pandemic. The numbers are stark. In 2020 the government spent £25 billion a year on debt interest, but in the last tax year it spent £105 billion. By comparison, it spends £60 billion on schools, £55 billion on defence and £20 billion on the police.
So who is to blame and how did we get here? The short answer is politicians. The long answer is more complicated. Decisions on the type of debt to issue each year are made by the chancellor but they are informed by officials and subject the demands of the market.
The record shows that particularly high levels of index-linked gilts were issued under the chancellorships of Gordon Brown and George Osborne. However, the policy itself was first introduced by Geoffrey Howe, who was chancellor in 1981.
Howe made the decision in part because the early Thatcher government was struggling to borrow what it needed after the economic crises of the 1970s, but also because it signalled that the Treasury was serious about cracking down on inflation.
By promising to protect the real value of money lent to the Treasury, investors were reassured that the new government would not repeat the reckless and inflationary policies of the previous decade.
There was also strong demand for this type of government debt from the pensions industry because it helped to fund the inflation guarantees in final salary schemes.
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In the decades that followed, index-linked gilts, or 'linkers' as they became known, were hailed as a clever innovation because they met this demand and actually saved the government money. The reason was that investors would accept a lower rate of return on index-linked loans than conventional gilts because of the inflation protection they offered. Provided the RPI rate remained low — and over the next few decades it generally did — the government benefited by having to pay less interest on its debts.
Indeed, an official analysis in 2023 found that the Treasury cumulatively saved £158 billion by issuing linkers in place of conventional gilts between 1981 and 2022.
However, the equation dramatically shifted in 2022 when inflation surged to a high of 14.2 per cent. Suddenly, the amount the government had to pay to service its debts ballooned.
Britain's public finances were hit uniquely hard because over the preceding decades the UK government had issued so much more index-linked debt than anyone else. By 2022, nearly 25 per cent of Britain's outstanding borrowing was index-lined, more than twice as much as any other G7 country. Italy has the next highest holding at 12 per cent but US debt has only 7 per cent and Germany less than 5 per cent.
This meant that between 2019 and 2022, debt interest costs increased faster in the UK than in every other OECD country.
The proportion of this increase that is down to linkers is subject to debate because the pandemic greatly increased government borrowing generally and the interest rates on conventional gilts also increased.
However, an analysis by The Times of RPI rates and the stock of outstanding government debt, suggests the decision to issue linkers over conventional gilts cost the Treasury £62.8 billion in higher interest payments during 2022 and 2023. To put this in perspective, a penny on income tax raises only about £6 billion.
These higher borrowing costs are set to continue for years to come as linkers mature and are repaid. It is one of the main reasons why the annual bill for servicing the nation's debt is set to hit £132 billion by 2030, according to the OBR.
Whatever the exact cost of linkers, there can be no doubt that they have severely constrained Rachel Reeves's ability to enact meaningful policy, or borrow to invest in Britain's creaking public services.
To make matters worse for the chancellor, investors in the gilt markets are acutely aware of the government's inflation-based debt problem so they scrutinise her every policy decision. Any move that suggests Labour might abandon fiscal responsibility rapidly raises the interest rates they demand to lend to the government. That is a major problem when the Treasury needs to borrow more than £250 billion this year and why these investors have been nicknamed the 'bond vigilantes'.
The bond market really is an ever-present sword of Damocles hanging over the government. Anyone who doubts its power should remind themselves what happened to Liz Truss following her disastrous mini-budget.
Perhaps understandably, no one is jumping to the front of the queue to take the blame for creating this situation. A Treasury source said that successive chancellors had to decide between the 'short-term attraction' of index-linked gilts and the longer-term risk. The 'red hot' demand from the pension industry made those decisions harder. However, the source admitted that, in hindsight, the issuing of index-linked gilts 'went too far'.
While no politicians have publicly blamed the officials who advised them, questions have been asked about the role of civil servants. The principal official responsible for advising the government through the Brown and Osborne period was Sir Robert Stheeman, who was chief executive of the Debt Management Office (DMO), a Treasury agency created in 1998 when the Bank of England became independent.
The DMO took on the bank's role of issuing and servicing gilts, with an objective to 'minimise financing costs over the long term, taking account of risk'.
While there is no public record of Stheeman, who was earning £145,000 a year when he left in 2024, explicitly calling for more linkers, he did repeatedly describe them as a 'key part of the UK financing programme' and emphasised their cost advantages under certain market conditions.
Last year, his replacement, Jessica Pulay, noted the markets' robust demand for index-linked gilts.
However, ascribing any blame to officials at the DMO is tricky because they have no decision-making role and are only there to advise and execute government orders. So as successive chancellors were making merry in the bond markets, drunk on the illusion that inflation was a historic problem, did anyone raise the alarm?
The short answer is very few. There were some warnings but they were muted. For example, in the mid 2010s, the House of Lords economic affairs committee highlighted that the UK's large share of inflation-linked debt made the public finances unusually vulnerable to inflation shocks — however it was presented only as a theoretical risk. Given the extended period of low inflation the country had benefited from, few took much notice.
It was only when the OBR raised the alarm in 2017 that the Treasury decided to act.
In the 2018 budget, Philip Hammond announced the government would gradually reduce the proportion of index-linked gilts it issued. Over the next five years, the share of government borrowing raised using linkers fell from 23.5 per cent to 12.4 per cent.
However, it was too little, too late. Decades of much higher levels of issuance, and the fact that the inflation uplift on these debts kept their value rising, meant that by 2022, when inflation surged, more than 25 per cent of all outstanding gilts were still index linked.
Rumours in Westminster suggest that for years the Treasury did not want to address the risks because linkers were considered a useful tool to constrain excessive departmental spending and the profligacy of No 10. The theory is that having a high proportion of index-linked gilts meant that large increases in public spending would be inflationary and therefore prohibitively expensive.
Whether that theory is true, remains to be seen. However, what cannot be disputed is that Britain's debt experiment will handicap chancellors for years to come.