Government Debt Framework – UK Follow-up

Relevance to the present

Previously, we looked at the UK government debt in the post WW2 period.

Two clear questions arise –

“How did the UK manage to keep its rates so far below nominal GDP?”
“Should we expect to be able to do the same in the future? “

The key to inflating away national debt is the ability to force domestic investors to hold government debt at well below the yield they would get in a free price-setting environment.
Sometimes this is reported as financial repression.

Again, this paper does a really good job of giving the details of the post WW2 period.

Comparison post WW2 period to Current

I am interested in the extent to which the situation could be the same for other countries today.
My bias is that it would be significantly more difficult and we should not assume that because it worked in the 1950s it will work today.

  1. Ability to force domestics to hold govt debt
    This is probably the easiest and we are seeing plenty of this at the moment.
    e.g. pension funds and banks being required to hold government debt for “liquidity” or “prudence”

But the danger of the current system is leakages

  1. Capital controls
    Post war Bretton Woods we had globally imposed coordinated capital controls that reinforced home bias. In effect, countries agreed not to compete for capital through the price mechanism. I see this as a form of cartel which managed to hold together until the 1970s. We are a long way from that kind of cooperation today.
  1. Ownership of debt
    It is much easier to coerce domestic investors than foreign ones. In many heavily indebted countries, the issue is that debt markets are owned by foreign investors. This was a big factor in the Asian crisis of 1997/8 and the Mexico crisis of 1994. Currently, the Gilt market is 25% owned by overseas investors which makes it perhaps a little vulnerable. In contrast Japan has a higher debt level but virtually all the debt is owned by domestics.
  1. Trade surplus/deficit
    Post WW2, the UK was close to balance and now has a large deficit (over 4%). This deficit needs external funding which currently comes from FDI. All this adds extra pressure and vulnerability to the situation.
  1. Sensitivity of average rate on the of debt
    In ideal world, the debt market would be structured as conventional Gilts with as long tenor as possible whilst running a primary surplus to offset the interest payments. Even if short rates and inflation rose, the rate paid on the debt would stay the same thus somewhat mitigating rollover risk or the risk of paying much higher rates overall. Unfortunately, this is not the case in most developed countries as QE has been making situation worse.

QE shortens duration of the debt market

One way to think of QE is as a shortening of the duration of debt issuance (another post I think) then the impact on the debt profile is to significantly shorten it. In this light, QE on the Bank of England’s balance sheet simply means that rather than having a £435bn liability of long duration it is paying overnight rates on bank reserves. When (/if?) the Bank raise rates then they are immediately paying higher rates on the debt. (note debt and liability mean the same thing here).

Below is a chart of the average duration of the Gilt Market since 2000


Final Thoughts

I have frequently read the argument that we can inflate our way out of our current debt problems by having faster growth and inflation. The obvious flaw in this argument is it requires independence of nominal GDP growth and interest (i.e. Central Banks would not raise rates in the face of higher nominal growth which is clearly not the case). In the modern market economy, nominal growth and interest rates are highly related and so just assuming they are not is both bizarre and surprisingly common. Alternatively, you can concede that there is a link between growth and interest rates but remain very confident in the ability of modern nation states to impose financial repression with no leakages.

From my understanding of the modern financial system, I do not share that confidence that current debt levels can be easily reduced and therefore, I do not think they can be raised with impunity. It does not however follow that I become an austerity-hungry debt and deficit hawk.

This debate that I read between economists and political commentators appears depressingly partisan with far more noise and anger than analysis. What really matters is whether the current situation is risky enough to merit policy action or, as investors, some active asset re-allocation. This is highly complex but in my view, economic analysis is falling short in its ability to help. If your answer to the question of whether government deficits should be higher or lower is the same at all times, across all countries, then I would suspect that your economic model is not going to be very helpful in making policy or investment choices.

Government Debt Framework – UK


For anyone interested in the long-term investment outlook for fixed income, or more simply the future of our current sovereign nation states, an understanding of government debt must be a key element. Much is written on this subject but I find a lot of it confusing with partisan politics dominating analytical perspectives and terminology which is often inconsistent and emotive.

In this note, I want to focus on episodes where large debt level has been managed.
The large debts of WW1 and the Great Depression were reduced, on the whole, by various types of default. These always come with large economic costs and are to be avoided.
The period after WW2 is more interesting, commonly used as evidence as grounds for optimism and as grounds for opposing “austerity”. (in quotes as this term is generally emotively used by the opponents of current fiscal policy and has a pretty loose definition and usage)

(This paper by Reinhart and Sbrancia does a nice job of laying out the economic history.

Government Debt Model

So, I thought I would start by making a simple framework within which I can look at debt dynamics. Breaking down the change in government debt into 2 parts:

  1. Primary surplus
  2. Interest payments

(put simply Overall Deficit = Primary deficit + interest paid)

Note, this is not intended to be a complete model as there are clearly other factors which can change the debt level. For example

  • Change in currency level for foreign-denominated debt
  • Change in yields leading to change in market value of the debt
  • Due to Extraordinary items e.g. the government takes on additional debt which for accounting reasons they do not show up in the primary deficit

But it is pretty decent and captures the vast majority of the debt dynamics, certainly all of the ones which drive long-term trends.

Model UK Gilt History

Here is the model vs actual data since WW2 for the UK.

There are two clear episodes (~1974 and ~2008) when the actual increase in government debt were far larger than the model would suggest. It would be nice to understand what drove it (for example, in the financial crisis, did the government balance sheet absorb private sector banking debt without having it showing up in the deficit?)

Below is the chart of UK debt since WW2


It is commonly described that the UK ran deficits thought this period and the debt level was brought down by high growth. This is not incorrect but I find it a bit narrow and misleading.

Budget Deficit v Primary Deficit

First, the idea that the UK ran deficits. Well it is true but if you split the deficit into primary surplus/deficit and interest payments then the picture looks quite different.


During the 1950s and 60s, the UK run a deficit virtually every year. But we can also see that the UK ran a primary surplus for the entire period. So the reason the UK ran a deficit was simply that the debt levels were very large and so the interest payments were very large.

Whilst it is true that the main way the UK brought down its debts level was running nominal GDP at a higher rate than the interest rate paid on its debt, compounding effects are huge (running this for a long time) particularly when the debt level is large.

Between 1947 and 1951, debt levels fell from 246% to 165% of GDP. The cumulative primary surplus over that period was 29%, so the balance, about 2/3, of fall in level came from the impact of nominal GDP vs the rate on the debt. compared with only 1/3 from running large primary surpluses.


Relevance to the present

How did the UK manage to keep its rates so far below nominal GDP?
Should we expect to be able to do the same in the future?