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The COVID-19 pandemic has had many consequences. One of them is a spike in public debt as the UK government rolled out costly support measures such as the Job Retention Scheme (i.e. “furlough”), cash grants for struggling businesses and deferred VAT payments. Whilst arguably necessary, these measures have led to record government borrowing which totalled £2.1tn in December 2020, equivalent to 99.5% of the UK’s GDP (gross domestic product).
This has led to many important questions, especially: how will all of this debt be repaid? Another key question, however, comes from investors. How will this enormous UK borrowing affect my portfolio? In this article, our financial planning team at WMM in Oxford offers some answers.
How UK debt links to investments
Economics impacts portfolios. Yet the manner in which it does is complex. First of all, it is key to note that government debt is not, in itself, a bad thing. To offer an analogy, suppose you earn £200,000 per year and have debts standing at £100,000. This represents a 0.5 debt ratio, which is not ideal in the world of personal finance, but at least you have the income to pay it off.
Yet suppose your income was £33,000. Here your debt would be almost 3x your income, creating a big problem. In this scenario, you may never pay it back. Above, we noted that UK government debt now stands at 99.5% of its GDP. To use the analogy again, this is similar to earning £200,000 per year and holding nearly the same amount of debt. This would clearly be a problem for a household, yet is it the same for a government?
Not precisely. One reason for this is that GDP is not a fixed value – and neither is government debt. For example, suppose the former rises by 5% in a given year (a remarkable rate!) but that the interest on the debt is only 1%. In this case, the UK’s debt would have reduced by 4% even without “repaying” any of it, or curtailing public spending.
The UK government tries to balance its expenditure (e.g. pandemic support measures) using taxes. If this income is insufficient, then it issues government debt to make up the difference. One of the ways it does this is by issuing bonds to investors. Here, you can buy a bond to loan money to the UK government (i.e. a “gilt”), where you expect the money to be eventually repaid with interest. For these investors to want to buy gilts, they need confidence that the government will eventually repay them.
Modern Monetary Theory
This, of course, raises the question – can the government become insolvent like an individual can? After all, if it can then gilt holders should understandably be concerned in 2021, since the UK’s debt is so staggeringly high. According to Modern Monetary Theory (MMT), however, the government cannot run out of money due to the simple fact that it can create money. This is only constrained by inflation, which can be managed by cutting spending and raising taxes.
If this is true, then investors in UK government debt should not worry excessively about its debt sustainability in 2021. The question now, naturally, is whether MMT is true. Here, there is a debate to be had. Yet this theory is interesting because it seems to describe well what has happened in many developed economies since the 2008-9 Financial Crisis. Since that time, the UK government has printed enormous amounts of money without seeing a rise in inflation. This is unlike Zimbabwe, for instance, which did so and witnessed hyperinflation since 2007.
Invitation
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