Why Britain is trapped in a never-ending debt nightmare

Yahoo

2 days ago

Britain is broke and broken. Not exactly the optimistic words you'd expect to hear from a new prime minister. But that was the phrase deployed by Sir Keir Starmer's office just weeks after Labour took power.
While it set a gloomy tone, his sentiment wasn't wrong. Repeated crises have left Britain's economy in bad shape.
The financial meltdown of 2008 destroyed productivity, leaving a permanent scar on wages. Lockdown changed our work ethic and Vladimir Putin's war in Ukraine showed just how vulnerable the country is to higher energy prices. The result? An economy struggling with more welfare, more problems and more debt.
Rachel Reeves is poised to add even more to the debt pile over the next few years as the Chancellor sets out her first spending review on Wednesday focused on hundreds of billions more for investment.
Reeves has so far shown she is another tax-and-spend Labour chancellor. A £40bn tax raid last autumn has triggered job losses and is weighing on the economy.
But could you do a better job? Perhaps you think the Government should be leaner? Or welfare should be cut further? Maybe you're even brave enough to scrap the pension triple lock?
Try our tool to see if you can balance the books, and read on to discover why Reeves's debt nightmare is only just beginning.
The numbers speak for themselves. At £2.7 trillion, Britain's debt pile is now almost the same size as the economy.
Successive economic shocks have seen public debt repeatedly leap higher and successive chancellors have struggled to bring it down.
Four factors influence Britain's debt trajectory: taxes, spending, borrowing and growth.
In the past, chancellors could relatively easily borrow their way out of trouble, hoping that additional spending would stimulate the economy and ease the burden of the extra debt down the road through higher growth. This had the added bonus of allowing politicians to avoid tough choices on public spending.
But Labour no longer has this luxury. A surge in interest rates since the pandemic means borrowing now comes at a heavy cost.
The debt interest bill averaged roughly £40bn a year in the decade before the pandemic, with falling gilt yields often offering a happy surprise for the chancellor of the day.
The Office for Budget Responsibility (OBR) overestimated the cost of servicing Britain's debt by roughly £27bn on average between 2010 and 2016, handing the chancellor of the day extra wriggle room to cut taxes.
Today, that room has evaporated. The UK will be forced to fork out more than £100bn a year until the next election to service Britain's debt. That's almost twice the defence budget and more than Britain spends on education every year.
Debt interest costs as a share of tax revenues have risen faster than any other G7 nation, even though the US is now quickly catching up.
Former chancellor Sir Jeremy Hunt is concerned that we could already be on the precipice.
'If markets start to question our ability to pay our way, we will be forced into a doom-loop of ever more growth-destroying tax rises and ever lower growth,' he warns.
Rising debt in and of itself isn't always a problem. It's being able to manage that debt that is the real test. And Britain is failing.
Economists call this equation 'r - g', where 'r' is the average interest rate the Government pays on its debt, and 'g' measures how fast the economy is growing.
As long as the economy expands faster than the cost of servicing the debt, it will remain sustainable.
This was true for most of the 2010s, even against a backdrop of anaemic growth and high borrowing. Rock-bottom interest rates meant even a weak economy could cope with debt costs.
But this is no longer true after a surge in interest rates to tackle inflation post-pandemic.
It's looking particularly ugly for the UK.
Britain now has the worst so-called growth-corrected interest rate in the G7, analysis by Deutsche Bank shows.
This means Reeves will have to impose even bigger spending cuts or tax rises to ensure debt starts to fall.
Sanjay Raja, at Deutsche, says: 'The resulting higher interest charges seen this year will only put upward pressure on debt unless offsetting fiscal action is taken, or indeed, potential growth increases.'
The needle Reeves must thread is trying to reduce the debt burden without damaging growth. Slashing spending or raising taxes pose risks to growth, which could hurt Treasury cash receipts and make the debt position even worse.
Lord Lamont, who served as chancellor in the early 1990s, describes this as a 'huge challenge'.
He says: 'The overall arithmetic doesn't look good, but the real challenge that's coming along is the ageing population and the ratio of the working population to the pensioner population, which is going to cause severe problems.'
Official projections show that the number of over-65s living in the UK is expected to grow from just under a fifth of the UK population today to more than a quarter by 2074. At the same time, the working-age population is set to shrink from 62pc to 57pc.
Only people who are working can fund public services. Children are a drag when they go to school, while retirees also tend to take more out than they pay in as they begin to draw their state pension and use the NHS more.
The OBR estimates that the average teenager in Britain costs the state £21,600 every year to educate and keep healthy. By the time someone reaches their 70s, they take roughly £20,000 more from the state than they pay in, rising to almost £50,000 a year for nonagenarians.
The looming pressure on the public finances cannot be overstated, with the ageing population set to push debt to 274pc of GDP within 50 years on the current path.
Despite the costs, the Chancellor is still rolling the dice on borrowing.
Last October's Budget represented one of the largest increases in spending, tax and borrowing of any Budget in history. A total of £70bn of spending was paid for with £40bn of tax rises and £30bn of extra borrowing.
Changes to the Chancellor's fiscal rules freed up space for hundreds of billions in extra borrowing to bankroll infrastructure projects over the next five years, with the details of more than £300bn more in departmental spending to be set out on Wednesday.
This is far from austerity.
While this is within the spending envelope already outlined by the Chancellor in October, unforgiving investors will be watching her every move.
Gilt yields have already climbed substantially since the October Budget, with even small adjustments such as the reversal of the cuts to winter fuel payments creating ripples in the bond market on Monday.
Sources suggest there is an ongoing tension in Downing Street between Labour aides who want to turn on the spending taps and Treasury officials mindful of bond market jitters.
Lord Hammond, another former Tory chancellor, knows who will win that argument. 'Unfortunately, politicians don't run the country, the bond markets do,' he says.
'As Donald Trump has also found out, if the bond markets decide enough is enough and this is too far, the game will stop.
'One might say that so long as politicians can borrow money, they will borrow. So in the end, the bond markets are the disciplinarian of last resort.'
Worryingly for Reeves, it does not look like borrowing costs will come down any time soon. Michael Saunders, at Oxford Economics, who served on the Bank of England's interest rate setting committee, notes that 10-year forward rates, which predict what borrowing costs will be a decade from now, are at their highest levels since 1998.
The difference – or spread – between UK and eurozone 10-year forward rates is up to about 2.3 percentage points. This is almost double the gap three years ago and the widest gulf in about 20 years, even though the UK and eurozone have 'identical inflation targets and similar sluggish productivity growth trends', he notes.
Saunders says this may reflect a range of factors, including the UK's sharp rise in debt over the last two decades as well as stubborn inflation and pressure to spend.
Nuwan Goonetilleke, at Phoenix Group, the UK's biggest long-term savings business, who manages more than £40bn of savers' cash, says the rise in the cost of longer-term debt will have particularly negative consequences.
Reeves has made a big bet on infrastructure investment as a way to try to stimulate growth. Higher long-term borrowing costs could be hugely detrimental to that effort.
'If you've got an infrastructure project, property project, or something that requires any kind of long-term funding, it's going to be more expensive,' says Goonetilleke.
'That leaves a real choice: do you go shorter and accept an amount of rollover risk, or do you pay up knowing that you are paying a premium, because that's what the market is demanding for that uncertainty.'
Another concern is the changing face of Britain's creditors. Boring and predictable pension funds and insurers are being replaced by hedge funds that are more likely to be fair-weather friends.
Sir Dave Ramsden, a former deputy governor of the Bank of England, recently highlighted that roughly 30pc of gilt sales now involve hedge funds, up from roughly 17pc in 2018.
Pension funds and insurers invest over decades and are willing to ride out short-term crises. Hedge funds are motivated by short-term profits and are more likely to ditch investments if they go sour, threatening to make any fiscal crisis worse.
If borrowing is becoming difficult, what about tax? It has certainly been Reeves's favoured lever and Angela Rayner believes she should raise even more.
The Chancellor refused four times last week to rule out further increases to help pay for the spending binge. Analysts at JP Morgan believe tax rises of £24bn could be on the way this autumn as defence spending heads towards 3pc of GDP.
Labour has committed not to raise income tax, National Insurance or VAT on working people. That leaves Reeves with few options.
Extending the freeze on thresholds will raise £9.2bn, according to the Institute for Fiscal Studies (IFS), and is one of the options on the table.
But the tax burden is already on course to rise to a peacetime high of 37.7pc of GDP in the next few years and further tax raids threaten to crush the economy, which would fail to shore up the finances as intended.
Labour has already placed a heavy burden on companies through changes to employers' National Insurance contributions. Almost 40pc of the money British businesses pay to employ a member of staff now goes to the Government – up from below 32pc 25 years ago.
Andrew Wishart, an economist at Berenberg Bank, says this share is approaching the level which German businesses had to pay at the turn of the century, a policy that forced the economy into a 'lost decade'. Only when it cut benefits and taxes did Germany take its place as a strong nation again.
The economy is already 'maxed out on tax', Hammond adds.
'We are at the point of diminishing returns,' he says. 'If the Government thinks that it's going to be able to solve the problems just by taxing ever more and more, I think it's going to get into a terrible mess.'
Of course, Reeves could always cut public spending in an effort to tackle debt. But this looks difficult in an era when voters have become used to state support and Labour backbenchers are pushing for more.
Hammond laments Britain's drift towards entitlement.
'The modern welfare state has turned from a culture of mutual self-help to a world that is based on rights,' he says. ''It's my right to be protected by the state.' 'It's my right to be fed and housed and clothed and provided for with healthcare and everything else, regardless of whether I contribute or not.' That's a very different cultural approach to the challenge of the balance of the state versus the individual's responsibility.'
A silver bullet would be found if ministers could find a way to improve public sector productivity.
'If you can get public sector productivity to just under 2pc a year, you can stabilise debt,' says Hunt. 'That is why, when I gave the NHS £3.4bn for their IT systems in 2024, the deal was they had to sign up to 2pc productivity a year.'
Official figures show productivity in the public sector remains 7pc below its pre-lockdown levels.
Hunt says: 'I'm afraid Labour's done an appalling job caving in to public sector pay demands whilst not asking for any productivity in return.'
This crisis is more than just a headache for the Chancellor. It is a problem for us all. Not only does it threaten higher taxes, it likely means higher mortgage costs and borrowing rates for businesses, as government borrowing costs serve as a benchmark for borrowing rates elsewhere in the economy.
Goonetilleke, at Phoenix Group, says: 'There are real-world consequences from higher yields that will eventually feed back to the consumer. For example, corporations have been able to absorb a lot of price rises recently, but with higher rates they'll be less able to do so and that forces them to pass on more of that to consumers.'
Wishart fears the Bank of England will not be able to cut rates again this year. As a result, he estimates mortgage rates will settle at around 4.5pc – rather than the 4pc they would have reached without Reeves's Budget.
He estimates that this additional half-percentage point on mortgage rates will cost households around £2.8bn in the next year, or equivalent to an extra £820 of repayments for the average borrower taking a loan or remortgaging in the next 12 months.
Can Reeves find a way out?
Hammond believes fundamental questions must be asked about the role of the state if we have any hope of tackling the debt mountain.
'It just doesn't make any sense to carry on trying to do everything the state is doing, but to do everything badly by underfunding everything,' he says.
'It makes much more sense to have an honest debate about the scope of the state, and this has come into sharp contrast now because of the need to increase defence spending.'
He suggests that the Labour architects of the welfare state would be turning in their graves.
'I genuinely think that the Labour politicians who invented the welfare state would neither recognise it nor approve of it today.
'It was created by Labour politicians who had a very clear ethical basis for what they were creating. It was that everybody must work hard. Everybody's got to contribute.
'But the deal is, if you really are sick, if you really are disabled, if you really are too old, the state will support you. But that compact only works on the basis that every person gives their all.'
Official data suggest this simply isn't the case today. Nine million people of working age are neither in work nor looking for a job, with roughly 2.8m claiming they are too sick to work.
Meanwhile, the welfare bill for sickness and disability is on course to climb to nearly £100bn by the end of the decade.
Of course, all would be fine if the economy would start growing. As the IFS points out, if it just got back to the growth rate it enjoyed in the three decades before the financial crisis, Reeves would have an additional £28bn to play with at the end of the decade.
That's enough to more than reverse her damaging increase to employers' National Insurance.
Mohamed El-Erian, the chief economic adviser at Allianz, says: 'Growth is the only answer to a problem of over indebtedness. Every other answer has massive collateral damage and unintended consequences.'
In a warning for Reeves, he cautions that there is a point where increasing taxes 'becomes anti-growth'.
This tax-and-spend Chancellor will do well to heed this message.
Tool development by Mariana Hallal.
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