The UK government hopes to protect industry and public sector bodies against energy costs with a package that is similar to price caps and support payments recently promised to households. But these significant interventions come with a huge and uncertain price tag that raises serious doubts about the government’s future finances.
By keeping retail electricity and gas prices in check, the new strategy aims to keep energy prices affordable for energy companies. The Bank of England, meanwhile, has extended £40 billion of credit lines to energy companies that have struggled to manage gas price volatility this year.
The total bill for the Treasury from these bases will depend on how high the war in Ukraine is and how long wholesale prices remain elevated. The new energy secretary believes this will cost billions, but independent estimates are in the £100 billion to £150 billion range, even before the latest escalation of the Russia conflict.
These figures exceed the £70 billion spent on helping businesses and households through the COVID-19 pandemic and the £23 billion given to banks during the 2007-8 global financial crisis.
The new chancellor, Kwasi Kwarteng, has sought to allay fears about this financial windfall ahead of his September 23 budget update. They argue that the UK is still well below any borrowing limit, with the lowest ratio of public debt to GDP of the G7 major industrial economies.
Ahead of the September 23 financial statement he signaled plans to scrap the tax hikes introduced by his predecessor Rishi Sunak, while promising enough funding to relieve growing pressure on the NHS, social care and other public services.
A borrowing spree
Running an expansionary budget—that is, spending more and taxing less—is the standard response to a recession that most forecasters and business groups now expect. The idea is to inject demand into a faltering economy when households are buying less and businesses are investing less, hastening a return to economic growth.
But the starting point of the latest crisis challenges the common assumption that governments can get out of this mess. Borrowing to fund successive emergency measures raised the UK’s public debt to record levels for a period not immediately following a major war. And it now significantly exceeds GDP on World Bank measures.
The UK has had public borrowing since 2008, with elevated levels of household debt, helped by more than a decade of ultra-low interest rates. This meant that government (and household) debt service costs continued to fall relative to their income, even as their debt-to-income ratio rose again.
The Bank of England maintained these low borrowing costs by continuously buying back government debt from private investors, increasing the appetite for new debt issuance. The government’s ability to place significant new debt on the central bank’s balance sheet has encouraged the view that it can borrow whatever it needs to mitigate a recession.
And because the UK borrows mainly in sterling, its finances are strained by the pound’s decline, unlike low-income countries that borrow mostly in foreign currencies.
Reaching the credit limit
But this new burst of debt comes at a time when the Bank of England is pushing interest rates upwards and financial markets are raising yields (a measure of the return on investment over time) that the Treasury will have to pay on its latest bond issues. The government’s interest bill in August was 19% higher than a year ago and the highest on record dating back to 1997.
Debt service costs are also rising as yields on a quarter of the government’s outstanding bonds are linked to inflation, as measured by the Retail Price Index (RPI). This is a way for the government to assure investors that inflation will not destroy their assets. The RPI inflation rate reached 12.3% in August, significantly higher than the headline rate based on another measure of inflation, the Consumer Price Index (CPI).
All of this means that while energy price caps will initially reduce inflation, borrowing to fund them can increase prices, as it places additional demand on already stretched supplies. Fiscal stimulus on the current scale is usually applied when there are spare resources and plenty of people looking for work.
At the moment, however, even on the eve of recession, the UK has historically low (3.6%) unemployment and supply-chain breakage that is outside the energy sector.
Given this environment, the Bank of England still expects inflation to top around 13% later this year and so it announced a second big base-rate cut on September 22 to try to return inflation to its 2% target.
The Institute for Fiscal Studies concluded on the eve of the mini-budget that the combination of higher spending and tax cuts would leave the UK’s public finances on an unsustainable path unless GDP started to grow significantly faster.
Although Prime Minister Liz Truce’s new team is confident this will happen, fueled by a new drive for tax cuts and deregulation, UK growth has been unusually anemic for the past 15 years. It averaged just 2% even in the interval between the financial collapse and recession due to the pandemic.
Debt sustainability becomes a serious concern when interest rates on public debt rise above the real growth rate of the economy. If GDP does not grow faster than its recent steps, the government could free up the fiscal space needed for any further efforts to revive the economy.