Recent economic turbulence has raised questions about the long-term sustainability of the UK’s fiscal and current account balances – the ‘twin deficits’. The country’s experience over several decades offers insights into the origins of recent troubles and some potential hazards ahead.
In an era of high inflation and rising interest rates, the UK has large fiscal deficits alongside chronic and worsening current account deficits. Fiscal deficits are the annual differences between tax revenues and public spending plus transfer payments (state pensions, benefits, etc.). Current account deficits are the annual differences in the values of imports and exports plus net investment income from UK overseas assets.
If either or both of these ‘twin deficits’ are large, worsening and persistent, that increases the country’s reliance on borrowing from other countries. The twin deficits might spell further economic trouble for the country if it is unable or unwilling to increase net national saving, which comprises net saving by UK households, businesses and government during a given accounting period.
We know when a sector’s net saving is positive as it will engage in net acquisition of financial assets, meaning its financial claims on other sectors will be increasing (Godley and Lavoie, 2016). By contrast, negative net saving indicates a reduction in ownership of financial assets.
As events surrounding the government’s ‘mini-budget’ on 23 September 2022 demonstrated, expectations matter a lot when financing large deficits. But so too do the composition and persistence of the fiscal measures announced – permanent tax cuts will have very different effects to say a temporary rise in public investment.
The UK government would do well to heed these lessons to avoid having its future policy discretion needlessly constrained by spiralling borrowing costs.
Credibility and the importance of expectations
Persistent fiscal and current account deficits have been a notable feature of the UK economy since the early 1970s. In simple terms, this means that the UK government has been borrowing to cover the difference between its outgoings and its tax revenues – the fiscal deficit. The current account deficit indicates that the UK economy as a whole is borrowing from the rest of the world.
Figure 1 shows the evolution of the twin deficits between 1970 and 2021. It is apparent that both the fiscal balance and the current account balance have been progressively deteriorating over time, with the most recent decade since 2010 standing out in terms of the size and enduring nature of the deficits.
Figure 1: Cyclically adjusted fiscal and current account balance, 1970-2021
Source: Office for National Statistics (ONS) Note: Cyclical-adjustment was performed using the Hodrick-Prescott filter at quarterly frequency
Standard analytical frameworks in economics suggest that fiscal deficits are sustainable if the present value of current and future taxes is sufficient to cover the present value of current and future government spending, as well as the initial stock of government debt (Elmendorf and Mankiw, 1999).
A positive implication is that current spending need not be restricted by current wealth, which increases the government’s fiscal policy options. The flipside is that fiscal sustainability relies on either buoyant economic growth in the future (and hence rising tax revenues) or it entails the politically more painful route of having to raise tax rates or restrain government spending.
It is vital that investors believe that the government has credibility in respecting this ‘intertemporal budget constraint’, as economists refer to it, if they are to continue having the confidence to lend. Once this confidence evaporates, it becomes increasingly difficult to find investors willing to loan money at a manageable rate of interest. If this happens, borrowing costs begin to soar.
Similar losses of confidence can also affect the current account balance. In the most extreme circumstances, overseas investors can stop lending completely if they believe that default is likely – a situation known as a ‘sudden stop’ of capital flows.
But even short of a sudden stop, a substantial reduction in net capital flows can still produce serious problems for a country running a persistent current account deficit. In 1976, the UK was forced to turn to the International Monetary Fund (IMF) for a large loan when investor sentiment turned against sterling in the face of large fiscal and current account deficits, and high inflation (Burk and Cairncross, 1992).
In more recent times, the former Bank of England governor, Mark Carney, alluded to the UK’s potential fragility in this area when he noted that the country ‘relies on the kindness of strangers’ in financing its chronic current account deficits. This can be a warning sign of incipient financial instability (Carney, 2017).
The events following the September mini-budget can be understood in these terms. Against a backdrop of high inflation, the government announced a large package of permanent tax cuts to the tune of £45 billion. This came on top of the already large borrowing required to finance the energy price cap.
Investors began to wonder whether the government’s ballooning fiscal deficit (and hence borrowing) was on a trajectory that took it further away from the path of sustainable public finances.
The interest rate paid on government debt (bond yields) increased sharply in a short space of time. This heightened ‘risk premium’ – the perceived riskiness of lending to the UK government – implies that investors were questioning the government’s long-term credibility in being able to honour its outstanding liabilities.
To save or not to save?
The role of the current account in this story is not insignificant, not least because investors specifically highlighted the large and persistent current account deficit (a measure of the UK’s borrowing from overseas) as an additional factor that amplifies the risk of ballooning fiscal deficits.
Figure 2 shows the UK’s net national saving. We can see that as it becomes more negative, overseas borrowing increases.
In fact, the two are actually mirror images of each other, and it follows that if the UK’s net national saving became positive, then overseas borrowing would become negative – in which case the UK would lend to other countries and acquire assets in return for doing so.
Put simply, if households, businesses and government are collectively spending more than their income, the gap has to be filled by borrowing from overseas (or analogously by selling UK assets to overseas investors).
There has been a longstanding concern that UK household savings are considerably lower than might be prudent (Weale, 2008), and relative to other comparable economies, this represents an area of persistent weakness in the UK’s financial position.
If overseas investors became unwilling to sustain the UK’s chronic borrowing, then it would require an increase in saving by either households, government or businesses – or some combination of the three.
Were this to be forced on the country very suddenly, it typically spells pain for the economy at large. Consequently, there is much to be said for redressing persistent imbalances in net national saving before a loss of investor confidence.
Figure 2: Net private and public saving, and overseas borrowing, 1987-2021
Source: ONS sector financial balances data
The mini-budget: bad timing or bad policy?
Large fiscal and current account deficits, in tandem with weak domestic saving, are only part of the story. There has been much discussion about the impact of rapidly evolving economic forecasts and their potential role in the mini-budget fiasco.
Particular controversy has emerged over whether the forecasts for future economic growth made during the build up to the mini-budget were too pessimistic. In particular, because stronger economic growth implies higher tax revenues, government borrowing might not have ended up being as high as initially expected.
The uncertainties were compounded by concerns about how gas prices would evolve over the coming months. This is because they would affect both government borrowing (because of the energy price cap subsidy to households) and the UK’s current account deficit, given the impact of gas prices on imports.
The Institute for Fiscal Studies (IFS) was singled out by some commentators who supported the mini-budget for failing to convey adequately the divergent effects of rapidly evolving forecasts on the future path of key macroeconomic variables such as the fiscal deficit. The proponents of the mini-budget believed this painted an excessively gloomy picture.
This raises the question of whether the ill-fated mini-budget was simply a victim of bad timing. If Kwasi Kwarteng, then Chancellor of the Exchequer, had just waited a few more months, would a rosier set of economic forecasts have provided him with the necessary space to pursue highly expansionary policies, without igniting fears around long-term fiscal sustainability?
Economic research points to an alternative and potentially powerful explanation, namely that the type of fiscal policies pursued by a government matters a lot with regard to expectations for both fiscal and current account sustainability (Baxter and King, 1993).
In particular, it is of paramount importance whether the policies announced are expected to be permanentor temporary. The tax cuts announced in the mini-budget were intended to be a permanent change, which carries significantly different implications to temporary cuts in taxes to provide a lifeline during adverse economic conditions.
Figure 3 provides some historical context as to just how big the permanent tax cuts were by contrasting them with other comparable episodes over the previous five decades of UK budgets.
The package of permanent tax cuts announced in the mini-budget amounted to around 1.6% of GDP. These were second only in size to Anthony Barber’s enormous expansionary package in 1972, which stoked the infamous ‘Barber boom’ of rapidly rising inflation and burgeoning current account deficits.
Similarly, a cut in income tax is understood to exert a different long-term impact on the economy compared with an increase in investment spending on transport infrastructure; or a reduction in corporation tax compared with a rise in government spending on education or childcare.
The key point is that both the composition of a fiscal policy – for example, tax cuts versus higher investment spending – and the persistence of the policy (permanent or temporary) matter when it comes to gauging the short- and long-term economic impacts.
Figure 3: Net reduction in permanent taxation by fiscal event
Source: IFS, 2022
Much heated debate took place in the media regarding the ostensible impact of the permanent tax cuts announced in the mini-budget. Proponents of the policies argued that the Treasury’s ‘failed orthodoxy’ had addled the machinery of economic policy-making, and was excessively prone to downplaying the positive effects of tax cuts in fostering incentives to work and invest, thereby resulting in higher economic growth and higher tax revenues.
The detractors, by contrast, claimed that the reductions in corporation tax and higher rate income tax were extremely unlikely to generate anywhere near the necessary increase in growth and revenues to make the tax cuts self-financing. In their view, the inevitable outcome would be a highly persistent increase in the UK’s structural fiscal deficit, with all its negative implications for fiscal sustainability in the years ahead.
It is interesting to observe from a historical perspective how the UK has come full circle in some respects. For example, in the 1960s, the Labour prime minister Harold Wilson was so sceptical of what he perceived as the Treasury’s stranglehold over UK economic policy that he actually sought to break it up.
He created a Department for Economic Affairs (DEA), which was intended to provide a pro-growth counterbalance to the Treasury and take a more strident approach in both contemplating and directing the long-term growth of the economy (Middleton, 2012).
While the experiment was to prove relatively short-lived (not even lasting the decade), there are striking parallels with current critiques emanating from the political right regarding what they perceive as the Treasury’s malign influence on economic growth.
What lessons can be gleaned from the UK’s experience – and what are the potential dangers of ignoring them?
First, experience suggests that fiscal and current account deficits are neither inherently good nor bad. As with so much in economics, context matters greatly.
Running large fiscal deficits, following the global financial crisis of 2007-09, was facilitated by low interest rates and a relatively benign inflationary outlook. By contrast, the economic climate after Covid-19, with an acute bout of inflation and rising global interest rates, is less forgiving.
Recent events seem to have demonstrated that there are clear and binding limits on government borrowing, which markets are capable of enforcing in an uncompromising fashion.
A second related lesson is that both the persistence and composition of fiscal policy matters. This includes whether a debt-financed fiscal expansion is intended to be permanent or temporary, and whether it focuses on cutting taxes, increasing investment in public capital or raising government consumption.
These choices are not innocuous when it comes to the sustainability of the public finances and perceptions of macroeconomic risk during economically turbulent times.
Third, there is a link between the current account balance and the sustainability of the fiscal balance. If the UK government wishes to sustain ballooning fiscal deficits in the long term without risking significant financial instability, then a greater proportion of this increased borrowing may have to be financed through higher national saving. In other words, a reduction in the current account deficit will need to be ensured by increased net saving by households and businesses.
What are the potential costs of failing to heed these lessons? Regarding fiscal policy, perhaps the most feared outcome is a situation of so-called ‘fiscal dominance’. In such a case, the government impels the Bank of England to set its monetary policy decisions with the implicit aim of accommodating the fiscal position of the government.
This is because fiscal dominance entails the central bank essentially propping up government tax and spending decisions that would be unsustainable in the absence of such accommodation. The damage in terms of lost credibility and the resulting rise in borrowing costs, as well as a possible de-anchoring of inflationary expectations, would be likely to be felt for years to come.
A potential ramification for the UK’s external balance (that is, overseas borrowing) could be a sudden stop of capital inflows in light of persistent and worsening current account deficits. This sharp drop in financial flows would cause a rapid fall in the exchange rate. This, among other things, would generate a marked increase in import costs, causing inflation to rise significantly.
Adverse changes in capital flows that increase risk premia on foreign lending to the UK would have a detrimental impact on both current living standards for households and an increased cost of capital for businesses. This could potentially impede investment and diminish future potential.
Where can I find out more?
- An Exchange Rate History of the United Kingdom, 1945-1992: A book that builds and expands on the author Alain Naef’s doctoral research on the fortunes of sterling after the Second World War.
- Truss’s implosion will make sound money a priority for the next generation of politicians: A short but topical read by Jagjit Chadha, director of the National Institute of Economic and Social Research, on the consequences of the mini-budget and its potential policy implications.
- Current account deficits: is there a problem? An intuitive primer published by two IMF economists on the basic economics of the current account balance, and when deficits might start to pose a problem.
- Rational Expectations and Inflation (third edition): A classic book by Nobel laureate Thomas Sargent, which provides a rich examination of the interaction between fiscal policy, expectations and inflation in a variety of different historical case studies.
- British ‘peso’ flags serious UK risks: A short blog post containing some informative data and a concise risk outlook for the UK economy as of late September 2022 produced by the chief economist of a private bank.
- Institute for Fiscal Studies: mini-budget response: A detailed breakdown of the predicted impact of the mini-budget on UK public finances.
Who are the experts on this question?
- Alain Naef (Banque de France)
- Catherine Schenk (University of Oxford)
- Charlie Bean (London School of Economics)
- Jagjit Chadha (NIESR)
- Martin Weale (King’s College London)
- Patrick Minford (Cardiff University)