Thursday, February 28, 2013

Doomsday Deferred

Maybe we can stay lucky

BOM has always been concerned about the rising burden of government debt interest, and we've blogged it many times. But we must admit that so far, it has not been quite the problem we feared. In fact, in the two years since we clocked off, official debt interest has only increased by £4bn pa - a surprisingly small sum when set against annual borrowing of £100bn plus.

The reason of course is that for the last five years government borrowing costs - gilt yields - have remained at historically very low levels. Right now, the yield on ten-year gilts is back below 2%, which means new borrowing is cheap, and refinancing old maturing gilts with much higher yields actually cuts overall debt interest payments. So the doomsday machine has remained quietly dormant, at least for taxpayers (although savers and retirees taking out annuities have suffered grievously from low interest rates).

However, nobody should assume this situation will last for another five years.

For one thing, the Bank of England will not go on buying up the government's debt indefinitely. The bulk of its £375bn Quantitative Easing asset purchases have been government debt, and when the QE programme ends, so will the purchases. At a stroke, one of the main factors holding down gilt yields will be removed.

Second, all around the world central banks are pumping money into their sickly economies. So far inflation has been quiescent, but the lesson of history is that sooner or later, open money sluices overflow into raging inflation. Bond investors head for the hills, bond prices sink and yields surge. There's no good reason to think this time will be any different.

True, the official debt interest projections do not incorporate this doomsday outlook. They assume that gilt yields will rise gradually to just 3.4% by 2017-18. But they also tell us that every one percentage point above their base assumption adds another £8bn pa to debt interest by the end of the period. So even if yields merely returned to their average during the decade immediately before the Crash, it would add £12-15bn to annual debt interest. And if inflation does take off, yields will go a lot higher.

There's a further point, one we have also blogged many times: the official measure of debt is a serious understatement of the Real National Debt. Among other things, the official debt figures ignore the government's pension obligations - both to public employees and state pensioners - and PFI. Which means that to get a true measure of debt servicing we need to add on to the cost of debt interest, the annual costs of servicing those obligations. Which is what we've done in the following chart (all figures taken from latest OBR, DWP, and HMT projections):

What we're saying here is that by 2017-18, payments in respect of the government's past debt obligations will amount to £200bn pa. Which means that getting on for one-third of everything taxpayers hand over is going to service debt. The amount left over for everything else - health, education, defence, law and order, and all - will be severely squeezed.

Doomsday may have been deferred, but even without the likely blow-out in the gilt market, servicing the government's debts is set to make life increasingly difficult.


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