Carl Emmerson, Peder Beck-Friis and Sonja Gibbs.

Q124 The Chair: Good afternoon and welcome to this session of the Economic Affairs Committee. I am delighted to welcome three witnesses, one of whom is virtual. Would you like to introduce yourselves to the committee? I am going to start with Sonja Gibbs, who is joining us from Washington.

Sonja Gibbs: Thank you. It is a pleasure to be here, George. I am managing director and head of sustainable finance at the Institute of International Finance, a DC-based think tank and global association of financial firms. We have 400 members in 60 countries, so I bring in some international perspective, including on global debt issues. It is very nice to be here. Thank you for the invitation.

Carl Emmerson: I am a deputy director from the Institute for Fiscal Studies in London. I work on the UK public finances.

Peder Beck-Friis: I work at PIMCO as an economist responsible for looking at UK macro. That includes monetary and fiscal policies, but I also look at other developed market nations.

The Chair: Thank you all very much for joining us. I should put on the record that Sonja Gibbs and I work together on various issues in my role as adviser to Banco Santander. Let me start by asking a broad and general question. I might start by asking you, Carl Emmerson, to comment on this. I saw the article by Paul Johnson in which he wrote a few weeks ago, “The trouble is that with high debt, higher interest rates and low growth we risk being stuck on a treadmill, or in a ‘doom loop’”. I always find now in these sessions that I come out feeling very depressed. Can you tell us how worried and depressed we should be?

Carl Emmerson: The concern is that we have elevated debt because, through three crises, the financial crisis, the Covid pandemic and the cost of living crisis, for understandable reasons the Government have racked up a lot more debt. We have had a period of remarkably low productivity growth going all the way back to 2007. We are now entering an era where it looks like the ultralow interest rates of the 2010s are behind us.

That combination of high debt, interest rates that are not ultralow and low productivity growth makes all of the economic challenges we face more difficult. If you want to make reforms in difficult areas, it is always easier to do so if you have money to spare because you can use that money to compensate some of the losers to help grease the wheels and make the reforms go through. You can think about changes to planning laws, environmental regulations or tax policy. There are lots of different areas of government policy where you might be looking to do a reform to enhance growth. It is much harder when you have the public finances in such a weak state.

Peder Beck-Friis: As a baseline, it looks fairly sustainable in the near term. If you look at what is priced into financial markets and bond markets, it is all fairly orderly. Yes, interest rates have increased, but that has to do mainly with factors other than debt sustainability, such as inflation expectations, very much anchored in financial markets.

Having said that, let me make two points. First, as interest rates have increased, debt dynamics all over the world look worse than they did pre-pandemic. Risks may have increased over the last few years. Against that, there is still a lot of fiscal credibility in the system, certainly in the UK. The UK now appears to be running one of the most orthodox fiscal policies of developed market nations. We have seen a lot of shocks to the system over the last few years and the system is still intact, which to me speaks of resilience rather than vulnerability.

The second point that I want to mention when we speak about risks and whether we are worried is that, for a country such as the UK that has access to its own central bank, the risk seems to be higher inflation as opposed to an outright default. This is very different from other countries that do not have their own central banks, for instance many eurozone countries.

Sonja Gibbs: I was going to add a little bit of international context here. Clearly, we are all worried about the increase in debt levels over the past 15 years and the era of ultralow rates. When you look at the G7, for example, the UK is at around 82% of government debt to GDP. Japan is at almost 240%. Italy is at 135%. The US is at around 120%. The UK is actually sixth among the G7 in debt-to-GDP levels, with only Germany lower at around 60%.

The other mitigating factor here is that debt per se is not a bad thing, especially if it is used to fund capital investment that supports growth. Overall, G7 debt levels are well above the traditional benchmark of around 60%. You have to think about the whole cottage industry of economists who are asking the question, “Does that benchmark still make sense in a changing world?” There are lots of ways to justify higher debt levels.

The underlying problem is that higher debt is going to bring more risks, including financial stability risks and challenges, if it is not accompanied by steady and sustainable economic growth. That is the wildcard here. Government debt to GDP has declined from the Covid peaks. We were 25 percentage points higher in the UK during Covid than we are now. Inflation has helped. It has flattered debt-to-GDP levels as real borrowing costs rise. Higher inflation also pushes up debt service costs, so that is another source of concern. Then you have UK inflation not expected to reach the 2% target before 2025.

Overall, G7 budget deficits are still significantly higher than pre-pandemic levels. We have not cut back on spending in the UK. It is 7.3% of UK GDP, which is up from a little over 5% back in pre-pandemic times. Part of the reason, and this is something that we have to think about in the new world, I guess you might say, is that higher debt service costs are with us for some time. We have overall higher aggregate debt levels and now we have normalised interest rates. In terms of revenues to interest expense, this is getting to be a more problematic question, for mature economies also, not just for emerging and developing economies, for which the problem is far worse. That is something we all need to think about.

The Chair: Thank you for that. That is a very good overview.

Can I pick up on something Sonja said and put it to Peder and then Carl? Sonja mentioned this new world. Are we in a brave new world? Maybe that is the wrong description, but a world that is very different from when we have previously had very high levels of debt. You can pick up on that.

Peder Beck-Friis: It is a good question. When we think of quantities in economics, government debt being one of them, we need to ask ourselves what is driving the quantity higher. Is it higher demand or supply for government debt? We come from a long period now, really since the 1980s, when government debt globally has been increasing but interest rates have been decreasing. To me, that suggests that a big portion of why government debt is high is that demand for government debt has increased. Real interest rates have been low and trending low.

There are big question marks about what will happen to real interest rates going forward. I can think of arguments why it may be a little bit higher. If I think about these structural factors that have been pushing down interest rates over the last 20 or 30 years, they very much remain intact. As a baseline, we at PIMCO think that real rates will remain fairly low going forward, which helps with the debt dynamics.

Carl Emmerson: The challenges in getting debt down are harder now than previously. When we previously had high levels of government debt, we subsequently had periods of very strong growth, fuelled by surprise high inflation, which perhaps looks less likely to occur now, and by strong economic growth, helped by favourable demographics.

The demographics for the UK are not looking that favourable going forwards. Admittedly, other countries seem to have demographic projections that are typically worse or certainly no better than the UK. Plus we have had this period of terrible productivity growth, with growth, as I said before, since 2007 much lower than we would have expected given the experience from 1948 through to 2007. So the prospect for high nominal growth to get us out of the hole looks less than it might have looked in, say, 1950.

The Chair: Can I pick up on this point on demographics and whether rates are going to go back down in the long term? To build on that, Sonja Gibbs, does the IIF agree—maybe, Carl, you can talk about this as well—with what Peder said about rates going down from where they are now back to where they were? I am putting words into Peder’s mouth here. What do you think will happen with rates? Clearly some, such as Charles Goodhart, are questioning that because of the demographics.

Sonja Gibbs: Yes, indeed. It is one of the biggish economic paradoxes that we have to confront. Are we in a world where changing demographics, ageing populations and so on, will act as brakes on interest rates and, indeed, economic growth over time, or will we go back to periodic bouts of high inflation and generally higher interest rates? It is hard to summarise, but the camps are pretty well split on that. There are ideas in both camps.

We would argue that, overall, government debt levels have become so high now that there is a lot of pressure being put on policymakers and central banks to keep interest rates at a level that is going to allow this debt to be sustainable over time. It is in no one’s interest to permit rampant inflation. Indeed, the demographic arguments are pretty compelling. If you look at market pricing of interest rates over time, you do not see a prevailing sense in futures markets that interest rates are going to be back to 1970s or 1980s levels on any kind of long-term basis.

The Chair: Carl or Peder, would you like to add to that?

Carl Emmerson: Yes, just a small bit. The OBR, for example, takes market expectations of interest rates for its forecast. They are very volatile at the moment. It is also fair to say that there are quite a few economists who think that it is more likely than not that they will come down a bit further than the market expects. Even so, what we spend on debt interest will be a lot higher than we have been used to in recent decades.

Q125 Baroness Wolf of Dulwich: My question is for Carl and Sonja. Let me start with Carl, if I may. The Office for Budget Responsibility told this committee that long-term debt sustainability will require action over the next Parliament. What expectations, if any, do you have for how government will behave in this regard over the medium term?

Carl Emmerson: Whoever is Prime Minister or Chancellor after the general election is going to inherit a situation where debt is forecast to barely be falling in five years’ time; a UK tax burden that is rising to levels that are not that high by western European or Scandinavian standards, but a record high for the UK; some spending plans that imply, we reckon, about £20 billion to be taken out of day-to-day public service spending; plus a cash freeze in investment spending. It is a very tight set of public finance forecasts, plus the challenges of changing demographics.

The hope is that whoever forms a Government takes a longer‑term view, starts to think seriously about growth across a whole range of policy areas, implements reforms with a laser-like focus on getting that growth and is patient in getting sustained growth. The fear is that we muddle by and continue to push up unreformed taxes, which will do more damage than putting up reformed taxes. If we want to squeeze spending, for example, but we do not do it in a strategic way—“What things do we really want the state to be providing?”—and instead just look for short-term wins, that is a concern. I do not know what I expect, but I know what I hope for and I know what I fear might happen.

Baroness Wolf of Dulwich: Following up, and I will ask the same question of Sonja, given what we are talking about, which is debt sustainability, do you think that there is a real risk that we will see financial repression? If so, what form do you think it might be most likely to take?

Carl Emmerson: I would describe that as not a great way of taxing. There is a fear—a well-founded fear—in the sense that, if you want to be pessimistic, you would say that all the UK taxes are not well designed. They could all be improved. The fear is that we will raise taxes but not in a fair or efficient manner and do more damage to the economy than is necessary. I would put that in that same camp.

Baroness Wolf of Dulwich: Sonja Gibbs, looking from the other side of the Atlantic, how would you respond to the OBR view? What would you possibly expect of the UK Government in this context, including my follow‑up question?

Sonja Gibbs: Again, I will put this in an international context. Overall, when you think about debt sustainability, it is not really an end in itself, but it allows government to have a good, prompt response to economic shock and of course enables long-term investment. You need that kind of debt sustainability that gives the Government fiscal space to use tax and spending to help implement long-term growth strategies.

It is this credibility question. If there is one ask for government, it is to really help maintain that market credibility. When you think about the ratings agencies and the questions that they look at, will this rise in debt to GDP continue? Will it be kept under control? What kind of growth will there be in tax revenues and spending? Critically, what are financial market perceptions of government macro and fiscal policy?

No country is immune to criticism, even wealthy economies. Think back to the euro area sovereign debt crisis and Greece. Think about the periodic concern about China’s debt levels going through the ceiling. Japan is a traditionally very high-debt economy and yet it has managed to go on quite nicely for years and years. The US had its AAA credit rating cut last year and in the UK you saw that very sharp market reaction to the fiscal path proposed in the September 2022 mini-Budget.

At the end of the day, debt sustainability requires sustainable growth. You have to create a growth-friendly policy environment to attract foreign investment, incentivise private investment and so on. That is a job for government. Finally, wearing my sustainable finance hat, the whole sustainable finance and climate finance agenda offers us a big opportunity to boost capital investment in growth and new job opportunities. In an international context, the UK is way out in front there and we would like to see that continue, with greening government spending and so on.

On financial repression, I would agree. The UK is not really the poster child here for financial repression. If you think about restrictions on entry to the industry, the UK Government are pretty good about that. There was the Financial Services and Markets Act and so on. Also, who are the big creditors for the UK Government? When you think about the pensions system, the rates paid to pensioners do not indicate any financial repression. Those have been well above real rates in markets. So financial repression would not be our biggest concern.

Q126 Lord Blackwell: Carl, it appears from what you have all said that the current level of debt is not necessarily an issue, other than in reducing our resilience to future shocks. We have framed this in terms of sustainability of national debt, but it sounds like the real issue is the sustainability of government spending. Whether it is in the next Parliament or beyond, the answer has to be about a redefinition of what is sustainable in terms of government expenditure and expectations of government spending.

Carl Emmerson: The way I would put it is that we barely have debt falling in the fifth year of the forecast horizon. There are really good reasons to aim to be getting debt down over the medium term, because one lesson of the last 15 years is that every so often a bad shock comes along and, for very good reason, government wants to step in and support households, businesses and public services. Therefore, debt will go up in those periods. We cannot have debt not going down in the okay and good years, and yet going up every time a bad shock hits. We need to aim to get it down.

We have choices about how to do that. We could say, “No, we want to have higher taxes”. As I said before, while they are already at a record level for the UK, it is true that there are other economies in western Europe and Scandinavia with much higher levels of tax. If we do that, I would strongly recommend that we reformed our taxes, so that we could put up taxes that did less damage. Alternatively, we could say, “No, we want to have taxes no higher than they are already and to cut back on spending”, in which case I would recommend a strategic approach to asking, “Which areas of spending do we want to cut back on and how are we going to provide those services? Where should we really be looking to scale back?”

I would note that, if we take that approach, it would be particularly challenging in a context of an ageing population and, in particular, not so much the UK’s state pension bill, but actually the NHS bill. That is where we look relatively exposed compared with other countries. I would question a desire to reduce the size of the state over the next, say, 30 or 40 years and whether that is achievable in an era where it is pretty likely that NHS spending will rise as a share of GDP. In recent decades, how have we paid for that? We have cut defence spending as a share of GDP. I suspect that, over the next 30 years, we will not be cutting defence spending as a share of GDP and we might well want to go on increasing NHS spending.

Q127 Lord Griffiths of Fforestfach: I would like to ask Sonja a question. Sonja, you talk about growth being the real answer to our problems. I completely agree with you, but I have to say that I am not sanguine about growth in the UK. If you look at the demographic factors, the skills and the inactivity that we have in the labour force, we have a major problem in the UK. We have had low growth now for really some time. Every Government, and I am sure every Prime Minister and Chancellor, would love more growth. It takes time to get it. I am in a way pessimistic because I cannot quite see what the trick is going to be to really get it moving.

Sonja Gibbs: It is a question for the ages, is it not? I do not know whether it is much comfort, but certainly in an international context the UK is far from alone. So many countries are struggling with this, even emerging markets where traditionally they have had fast-growing populations to help support growth.

The demographic question—I do not know whether that will be asked separately later—is an interesting one on what government policy can do there. Other than providing incentives for people to have bigger families, there is the whole immigration question. To what extent is that going to be relaxed such that talented workers can come in and support the economy in that way, with skills training, retraining and so forth?

Inactivity in the labour force is a very common issue, particularly post‑pandemic. I see this in my own office, where it is very difficult to hire people and, when you do hire them, to get them to put in the hours that we all grew up with. It is a changing mentality or a changing approach to work and work/life balance. It is very difficult to get to.

Again, in an international context, the way that the UK approaches financial regulation tends to be broadly growth supportive. There just has to be care taken in particular areas, for example capital requirements on funding for project finance and infrastructure or how we incentivise green finance. There is no silver bullet to improving productivity and growth, but there are a lot of steps that can be taken and the UK certainly has a good track record of being creative and inventive when it comes to ways to spur productivity and growth, and in finding new markets. Think about, for example, the green finance hub that the UK is establishing. That is quite a way of incentivising growth in new industries that are going to continue to flourish in the decades to come. So I agree with your concern, but there is also reason for some optimism.

Q128 Lord Lamont of Lerwick: Good afternoon. I am afraid that my question is very open-ended, but none the less I will put it. What do your short and long-term expectations for economic and geopolitical developments across the globe mean for the likely sustainability of the UK’s debt? Perhaps in order to confine it a bit we could talk a little about China and the US as the main drivers, because it is so open-ended. Perhaps we could start with Carl.

Carl Emmerson: Others are probably better placed to answer that one than I am.

Peder Beck-Friis: When thinking about debt sustainability, as you know, there are many factors to consider and forecast, interest rates being one and growth rates being another. There is also fiscal credibility and what Governments will do on the primary balance side. To reiterate what I said in my introductory comments, we tend to think that real interest rates are probably going to remain fairly low going forward.

If we think of trend GDP growth globally, if the world moves into focusing more on resilience than efficiency, so more spending on healthcare, nearshoring, deglobalisation and defence, there may be arguments to expect trend GDP growth to be low going forward. This goes back to the US and China, and ongoing geopolitical tensions, as well as not a deglobalisation, but the slow globalisation that we are seeing.

Sonja Gibbs: I would agree with all of that. There are two areas where economic and geopolitical developments are going to make a difference. One is in the path of long-term interest rates and real rates, which we have already discussed. To the extent that those stay a bit lower for longer, obviously that is helpful in terms of UK debt sustainability.

The other is, of course, on growth. Here, there is a lot of reason for concern, as was posed in the question about the US-China tensions and how that will spill over into global fragmentation. Here at the IIF, we look closely at global capital flows. What really concerns us is the slowdown and stagnation, if you will, in trade flows. A lot of that is related to these trade rivalries. If you look at the availability of export credit and the supply chain disruptions, all these things are deeply negative, in a sense, for the UK, which has such a presence, and has always had, in global trade. Then of course you have the geopolitical strains, such as the tensions in Russia/Ukraine and the Middle East. None of that is helpful in any sense at all.

However, it also offers opportunities. If we look at our UK member firms, the big financial firms in the UK, one thing that is very clear to us is how active they are in very fast-growing areas such as Asia. Even if that means separate, complex negotiations with individual countries, whether that is China, Vietnam, Indonesia or what have you—as well as Singapore and Hong Kong—obviously all the UK’s strong relationships are going to be helpful in mitigating these broader risks from economic and geopolitical strains.

Lord Lamont of Lerwick: Sonja, you mentioned fragmentation. I know that, when Dr El-Erian gave evidence to this committee, he mentioned fragmentation. It is true, is it not, that there is more and more emphasis being placed by national Governments on resilience, supply chains and self-sufficiency? Although these are wonderful words, there seems to be a creeping protectionism, or a de facto protectionism, going into the world economy, although I know that the growth of trade is surprisingly resilient. Is that not a major worry?

Sonja Gibbs: I could not agree more. This is a year when we have something like 60 or 70 elections around the world and half or two-thirds of the world’s population is voting. That is only going to get worse. There are so many reasons for this fragmentation and a lot of it has to do with political and geopolitical strains. The only weapons we have to fight this are in global governance bodies, such as the G20, which is trying to write rulebooks that are consistent with strong global trade and capital flows, and having effective supply chain management.

Also, I would note here the role of the international financial regulators. They can play an important role in allowing at least private sector financial intermediation to support growth and trade around the world, so that capital can flow freely across borders and, even in a world where we have these very difficult macropolitical forces weighing against us, the private sector can carry on, to the extent possible, with strong business relationships. The UK, with its exceedingly strong financial sector, is in a good position to lead the charge here, I would argue. But, yes, it is deeply concerning.

Q129 Lord Razzall: Sonja, could I raise the issue of Japan? One of our witnesses last week suggested that we needed to keep an eye on the Japanese market, which, as we know, has for the last 10, 15 or 20 years basically funded its debt from domestic Japanese sources. The suggestion was that Japanese interest rates might well start to rise substantially, in which event Japanese debt would be much more attractive to international investors. First, do you think that that is a possibility? Secondly, if it is, is that a threat to the sustainability and availability of our debt funding?

Sonja Gibbs: That is a really interesting question. As you say, if you look at the holders of government debt in Japan, these are largely domestic these days. Many would argue that the Japanese government bond market is essentially dysfunctional—kind of a closed system.

The concern about a potential rise in Japanese interest rates has been raised periodically over the years and it has not really materialised. There is a strong command and control element, it seems, in Japanese policymaking, with yield curve control and suchlike. The central bank is the key government bond buyer and so on. It exercises a lot of domestic control and clearly it is very much in its interests not to let that happen. That said, if it were to materialise and come to pass, you would get a little more normalisation of rates, including in Japan.

The international potential of the JGB market is huge. In past years, it was a significant attraction to foreign investors. People had significant allocations of Japanese government bonds. It could, in theory, happen again. The likelihood, though, is perhaps not a huge risk. To the extent that that happened, it could impact foreign demand for gilts, with JGBs being a plausible alternative, but it does not seem to be the biggest risk on the horizon.

Q130 The Chair: Peder, to what extent should we be worrying more about the US, given where its debt is and debt interest payments exceeding what it is spending on defence? Or is that irrelevant given its reserve currency status et cetera?

Also to you, if I may, from everything we have said so far, the UK does not seem to be an outlier. Is it the case that what Charles Goodhart says could happen? He says, “We’re in for a fiscal crisis down the road” because of the demographics in particular. I am not saying that he is saying that specifically about here. To come to my specific question, if we do not take action in the next, say, five or seven years, the next Parliament, on tackling the demographic challenge in particular, could there be a fiscal crisis here, or are we just jumping around at shadows? Could you answer those two points, the US and the fiscal crisis?

Peder Beck-Friis: They are all fairly interlinked in terms of the global comparison. On UK compared to US debt dynamics, the US looks worse from pretty much all metrics. There is roughly similar debt to GDP and a much wider deficit. In terms of the interest rate growth differential, it is perhaps a little more favourable than the UK. The main difference is that the UK set out a path to a tighter fiscal policy and we have not seen that in the US. If you look at debt dynamics, the US looks worse than the UK. As you mentioned, it is not a completely fair comparison because the US, as you know, is a reserve currency in the world, so the demand for these assets will be much higher than demand for those in the UK.

In terms of the comparison across the developed market more broadly, we have been speaking about growth a lot. The UK looks fairly similar in terms of debt trajectories to the other main countries, but they differ based on various factors. The interest rate growth differential in the UK is a little worse than many other countries. Debt to GDP is broadly in line with many others. Again, the UK is running more orthodox fiscal policies in terms of the tightening path ahead. Globally speaking, the debt dynamics look fairly similar across the main countries. Japan is interesting and I am sure we are going to come back to the ageing demographic.

The ageing demographic has many effects on debt dynamics. There are different views, as you said. Goodhart thinks that it will raise inflation. Many economists, including myself, think that the ageing demographic tends to depress interest rates because people save more and companies invest less as the labour force shrinks. We have seen that in Japan. Much more ageing demographics certainly puts pressure on the deficit, but at the same time the interest rate falls. Somehow, the markets have this fantastic way of clearing. So we need to think about these things in a general equilibrium fashion, not only spending in isolation.

The Chair: That brings us to Lord Verjee quite nicely.

Q131 Lord Verjee: I have two questions. They are very different, so I am going to ask them separately. One is more technical and one is more philosophical, I would say. What implications does the structuring of the UK’s national debt have for its short and longer-term funding? How does it compare with other developed nations in terms of sustainability?

Peder Beck-Friis: There are two aspects where the UK differs a little from other countries. The first is foreign ownership. We have been speaking about this. If I am not mistaken, about 25% to 30% of gilts are owned by foreigners. It may, at the limit, add more vulnerability. Foreign capital tends to be a little more flighty than domestic capital.

You could make the argument that it makes gilts a little more volatile. I do not think that that is necessarily the case. For instance, France has a higher share of its government bonds owned by foreigners and French government bonds are not as volatile as the UK’s are. That is one aspect where the UK differs.

The other is on the inflation-linked side. The UK, as you know, has a big share of its liabilities inflation-linked. Not only that but I should say that the Bank of England did not buy these securities in recent QE programmes—except during the Truss Administration very briefly—whereas the Federal Reserve in the US bought these securities. So having a lot of inflation-linked bonds in private hands, certainly in times like this, when we have high inflation, adds vulnerability.

In the UK, there is structural demand for these products from the pension industry. We know that because, if you look at what is priced into these assets, it is fairly high inflation going forward. Pre pandemic, the UK could borrow at minus 2% or minus 3% real yields. That was a benefit. I have not done the net present value calculation, the cost versus the benefits, but we need to think about both those factors when considering these technical factors.

Carl Emmerson: Following on from that, thinking about what risks the structure of UK debt leaves us more exposed to, the high share of foreign‑owned gilts means that we have to worry a little more about what happens if the next big bad shock that comes along is UK-specific. Maybe it is okay if it is Europe-wide or global, but if it is UK-specific you might worry a bit more about the potentially more footloose nature of the purchase of UK gilts.

In terms of inflation linking, if we get loads of inflation coming along that is domestically generated, that is balancing the risk in the public finances because you will be spending a load more on debt interest, but that domestic inflation will also generate a whole load more tax revenue for the Exchequer. What you have to worry about when you have lots of index-linked gilts is if you have inflation of the type we have had over the last couple of years, where it is generated by imported goods. Then you get the hit to your economy, but you do not get the extra income tax, tax on profits or VAT, so you do not get the revenues to help cover that debt interest spending. The type of inflation really matters there.

Thirdly, also because of the way in which quantitative easing works, it means that the effective maturity on UK gilts is much, much lower than you would expect. Essentially, a lot of the Government’s debt financing is done at the contemporaneous bank rate, which clearly leaves us more exposed to worlds, such as we have had recently, where increases in bank rates do not coincide with stronger growth. If we had stronger growth bringing in more revenue and the Bank of England was putting up rates, we would not worry so much about the higher debt interest bill. It is the fact that the higher bank rate is pushing up the interest bill at precisely the time when we are not getting strong growth that is causing the problem.

Sonja Gibbs: Could I add one quick point again with an international lens here? It is absolutely right to talk about the average maturity of UK government bonds and the average maturity on net debt because of the Bank of England asset purchase facility and so on. However, on a pure absolute basis, UK government debt in an international context has a fairly long average maturity of around 14 years. To put that into context, France is close to 10 years, Japan around nine, Germany seven and Italy seven. The US is on the low side there, at around 6.5. That provides some measure of buffer to changes, acknowledging the points made earlier about net debt and so on.

Q132 Lord Lamont of Lerwick: I wanted to ask Peder a question. Are the losses that might be crystallised in the gilt market through QT ever a factor in market expectations and analysis?

Peder Beck-Friis: They are. QT more broadly is very much factored into markets. There are question marks around the effect QT has had on interest rates so far.

Lord Lamont of Lerwick: I meant the actual monetary losses.

Peder Beck-Friis: It is something that people discuss. I am not sure that it matters too much for the outlook in the pricing. Where the UK differs, as you know, from other central banks is that the UK Bank of England is crystallising this by actively selling bonds in secondary markets. On a net present value basis, it does not matter too much whether you crystallise these loses today or maintain a higher balance sheet on which you will have to pay a cost going forward. It is not a big thing that financial market participants look at.

Q133 Lord Turnbull: This is also for Peder. Can you recap for me what you were saying about the effect of an ageing population on savings? Is it going to depress it or increase it?

Peder Beck-Friis: There are many factors. This is the one that Goodhart would point to: if you think of a consumption‑smoothing model over the lifecycle, you save when you work and you dissave when you retire. As a share of population becomes retired, you would dissave, which would push up interest rates. That is the Goodhart narrative, but there are other factors to consider as well.

The first, and dominant, factor is that, as we live longer, which we do, whenever we work we have to save more to finance our retirement. The second one is important as well. As people leave the labour force into retirement, the amount of capital versus labour increases in the economy, meaning that the demand to invest in new capital decreases, which tends to have a depressing effect on interest rates. That is on the investment side and the household channel is on the saving side. There are discussions among economists on this, but I think that Japan is an interesting example here that is ahead of the rest of the developed world—and interest rates have been very low there for a long time.

Lord Turnbull: You are not supporting the Goodhart thesis. You are supporting more the Japan thesis.

Peder Beck-Friis: Yes. Net, I would expect demographics to have more of a depressing than increasing impact on interest rates.

Lord Turnbull: Interestingly, your predecessor at PIMCO gave evidence last week or the week before. I think that he was in the other camp. There was this idea that there were going to be excess savings, but now he does not really believe that. He is probably more of a Goodhart‑ist.

Peder Beck-Friis: There are reasons to potentially expect interest rates to go up. If I had to mention one clear risk, for me it would not be demographics. It would be on the productivity side and the wildcard here is AI. We do not know what the impact of AI will be; I do not think that anyone knows. I think that we can all agree that the impact will probably be positive, but estimating the magnitude is very difficult.

What matters for debt sustainability is not growth rates in isolation. It is R minus G, interest rates minus growth rates. To the extent that productivity growth, for instance, lifts growth, but also lifts interest rates, it is not clear that it will have a beneficial impact on debt sustainability.

The Chair: Lord Verjee, I think you may want to come back.

Q134 Lord Verjee: I had a very different question that I would say is philosophical. I just want quick answers. There are some commentators, and I find this very hard to understand, who say that the concept of national debt is crazy. When you issue your own currency, it is a mirage. It really does not exist. It is an illusion. Sonja, could you comment on that? Are we wasting our time here talking about national debt when you are issuing your own currency? It is irrelevant, really.

Sonja Gibbs: It is a fair worldview, given that we have had so many years now of countries with particularly high debt levels, such as Japan or China, that are not going to end up in a fiscal crisis because it is their currency and they have a lot of control over what they do. That said, history shows us that it only takes one big upset in global circumstances, or a pandemic or whatever, to put us in a different place where having these debt levels over time really could be consequential. So it is all good until it is not.

Peder Beck-Friis: Is the question about how, in a sense, we can always finance national debt by printing more money? Yes, so that goes back. For countries with their own central bank, the risk for the bond market is not really that we are not going to get the money back. The risk is that we get money back when inflation is much higher. So there is real default and nominal default. This is very different from countries that do not have access to their own central bank, the eurozone being a clear example. Italy, for instance, pays about 150 basis points above German government yields as a credit risk, because it does not have access to its own central bank. For a country such as the UK, the risk is higher inflation and not necessarily a debt default.

Carl Emmerson: When the UK Government are borrowing, as we said before, they are often borrowing in part from people overseas who choose to lend the UK Government money. One of the most growth-friendly things we can do in the UK, therefore, is to have a strong set of institutions. We can give people a sense of faith that we are going to, for example, strive to keep inflation low and stable, look after the long-term public finances, et cetera. That is one of the most growth-friendly things that we can do, because one thing it will do is to help us borrow more cheaply than if we did not do those things.

Sonja Gibbs: Can I add one quick point on the credibility issue? No government bond market is an island in that sense. It is true that Governments who have the ability to print their own money, fund their own deficits and take care of themselves are in a better position. However, they are not immune from a broader increase in risk perceptions in financial markets. For example, if you had a big government debt default in emerging markets, say, it could have a contagion effect and the perceptions of market risk could simply be higher. That would make the bar for credibility and having strong institutions that much higher, so it could percolate through financial markets.

Q135 Lord Rooker: Good afternoon. My questions take us into a bit more detail on the demographics. We have a prediction of a steady rise in the dependency ratio from the OBR over the next few decades. What would be your recommendations to government in the sense of pressures on the public finances? Bearing in mind that it all depends on us being able to measure our population and workforce, which seems to be in some doubt, what confidence can we have in the demographic assumptions underpinning the debt projections?

Carl Emmerson: In terms of pressures on the public finances from changing demographics, we know that there is a pressure on the state pension. There, the main pressures come from two factors. One is the triple lock, where I would recommend the Government decide what level they want the state pension to be relative to average earnings and then pledge to keep it at that rate over the longer term. That would be a better system than the triple lock. Yes, that ratchets up the value of the state pension over time relative to earnings, but it does it in a rather unpredictable way, because it does that ratchet up only in the bad years, essentially. Therefore, it has been pretty successful at increasing the generosity of the state pension since it was introduced because we have had such a regular spell of bad years.

The other thing on the state pension is the state pension age, which is perhaps the obvious lever to pull when you have people who are living longer lives, as long as those are longer and healthier lives. Increases in the state pension age then need to go hand in hand with thinking about employment rates just below and just above the state pension age, what policies we can put in place to support those who are unable to work in the years up to state pension age and what other policies we can have to help those who can work to remain in work. That is what would really help the dependency ratio, not just putting up the state pension age but actually creating more workers relative to the number of people who are retired.

The really big pressures seem to come from the projections of health spending and social care spending. They are much bigger than the projected increases in state pension spending. We need to look at productivity in those services. Clearly, if we can deliver productivity gains there, that would really help. One reason why the OBR numbers look so gloomy in this is that they assume that we continue to do as badly in terms of unlocking efficiency savings in the healthcare system as we have done over the last 50 years.

Aside from that, we have choices about what the healthcare system provides free at the point of use. As I said earlier, one big challenge is that in the past we have increased NHS spending as a share of GDP, but been able to do that at the time when we are cutting defence spending very dramatically. There is a challenge. I note that the current Government and the Labour Opposition have both signed up to the NHS workforce plan for England, which implies pretty substantial increases in the workforce over the next decade or so and is going to require continued increases in NHS spending as a share of GDP. If we are going to do that in an era where we cannot cut defence spending, you reach the conclusion that it is going to be quite hard to reverse the big tax rises we have had in recent years.

Sonja Gibbs: I would agree with all that and that was very well said. We would also have recommendations to government of ways to increase the current working population base, such as through immigration policy, which is obviously politically sensitive, or incentivising changes in workforce practices that entice more people into the labour force, make it easier for people who have stepped out for whatever reason to come back in, encourage more female participation and so on. High-qualified immigration too is tremendously important.

It is also really important to consider how the future labour market will be impacted by automation. To the point about what confidence we have in future demographic assumptions that underpin debt forecasts and so on, what we are really getting at is tax revenues, coming in part from taxes on employment. To the extent that overall levels of employment can go to a new normal if we are in a world where we have much more substitution of capital for labour, that makes a different set of parameters. All of these are important for government to consider.

Peder Beck-Friis: I have nothing to add to that.

Lord Rooker: Funnily enough, you have nothing to add but I have a supplementary about something you said in answer to an earlier question. You said that we are all living longer. Carl has just implied that, but it is not true. Since 2010, life expectancy in the UK has flatlined for the first time in 120 years. The reports from Professor Marmot and his team at UCL have repeatedly made the point. Therefore, with a long period like that, that is bound to affect, is it not, the demographic assumptions?

Then put that with the preventable ill health, if that comes into play. We had a waiting list of 4.6 million before Covid. It is 7.6 million now. If we deal with preventable ill health, we will get more people in the workforce to create more pensioners with more pressure on the system. It will change the ratios. If we are flatlining on life expectancy, that is bound to affect the assumption, surely.

Peder Beck-Friis: This is not my area of expertise in terms of individual tax and spending policies. To my point on living longer, UK gilt yields very much depend on global factors, not only what is going on in the UK. Globally, life expectancy has been increasing. As a result, globally we have seen falling interest rates, so that very much affects UK yields. On the individual tax and spending policies, perhaps Carl would be better placed to answer that.

Carl Emmerson: Over the very long run, longevity at older ages has tended to turn out higher than predicted. You are certainly right that, since 2010, we have seen longevity expectations revised down and down again, so we know that that pattern has reversed somewhat. Regarding change, that may mean that, going forward, unfortunately, longevity may not increase as much as we previously expected. That would clearly change the demographic projections.

There is another demographic driver coming through too, which is that the size of each cohort is not the same. The large generations born just after the Second World War are now entering the stage in life where they are putting increasing pressures on the NHS and social care budgets. Even without any change in longevity, you still get these demographic patterns going through, which affect the public finances. Those costs really cannot be avoided.

Lord Rooker: This is my final point. Somebody somewhere, though, must have made some assumptions on the basis that longevity is changing—in other words, we are dying earlier than we were before 2010, and this therefore is going to reduce the pressure on the health service, which is one way of putting it. It is quite crude, and I do not want to be misunderstood with what I am saying, but the fact is that pensioners are going to die earlier than they would have done previously if life expectancy does not start on the up again. Is that not the case?

Carl Emmerson: My understanding is that lots of the NHS pressures actually occur in the last six months of life, and everybody has a last six months of life. It might not be that we are living less long and yet more of our lives are healthier lives; that may not be occurring.

It may save the NHS some money on the state pension, of course, to the extent to which we are prepared to use the state pension age lever. If longevity does not improve as much as we hoped, it might just mean that we do not increase the state pension age as much as we would have done.

You can see that in a recent government review, which looked at the case for bringing forward the increase from age 66 to 67. They have decided to park that decision and not bring it forward in legislation yet. Had longevity increased as we expected back in 2010, maybe that increase from 66 to 67 would have been brought forward. There, you might say that the state pension savings are not as big; we just end up with a lower state pension age than we would have had.

Sonja Gibbs: The preventable ill health question is a very provocative one, coming from a country with massive obesity rates. A comparison of what it would take to improve that ill health versus the benefits that you would get from more people being in the labour force—healthier people creating more tax revenues—could be very interesting.

Lord Blackwell: Assuming the dependency ratio increases in the way we have talked about, without the intervention of government, you would think that the market response to this would be that the wages for people in employment would go up, because they are in short supply, and the share of GDP going to the non-working population, particularly those who are retired, would go down, because of reduced returns on savings and reduced dividends, profits and pensions. Is that a likely outcome in the UK or around the world? Would it necessarily be a bad thing, if it drives up productivity because of higher wage costs?

Carl Emmerson: It depends a bit on how open markets are, whether we are ageing at the same rate and time as other countries, and the bundle of goods that pensioners are buying. If they are buying imported goods, for example, it is not necessarily increasing demand for domestic labour. If they are using social care, that will be domestically supplied labour, albeit at a wage rate that is largely set by the Government. Ultimately, the driver of wage growth for the working-age population will be how their productivity increases, rather than what is happening to demographics.

Sonja Gibbs: Can I add a little US context here? What we tend to see here is that the pensioners are the big voters in the system, so changes that affect their livelihood are less likely. We have a less interventionist Government, in the sense of pushing up minimum wages and generally encouraging wages upwards. Market forces tend to keep wages down and revenues to pensioners rather high in a US context.

Lord Blackwell: The bottom line is that politics and the silver vote, as it were, may prevent market forces coming up with a solution.

Sonja Gibbs: They certainly do here.

Q136 Lord Razzall: I have a question about how we measure our national debt. Clearly, a lot of people use the metric of debt as a percentage of GDP, but there are alternatives, including a balance sheet approach to public finances. The last time we asked this question the three members of the panel did not agree. I wondered whether you do.

Carl Emmerson: The Government should focus on a range of indicators. You do not want them to focus narrowly on public sector net debt; you also want to look at the balance sheet. If you focus narrowly on public sector net debt, it might lead you down the path to just selling certain assets. We saw that a few years ago, where the Government attempted to sell off the student loan book. That would reduce the measure of public sector net debt but I am not convinced it would make the public finances stronger in any real sense.

We should look at balance sheet measures alongside public sector net debt, but we should not just get rid of our target for public sector net debt and target only the balance sheet. We would suddenly see the risk of undesirable policy responses occurring in a different way.

There are also some parts of the public sector balance sheet that are pretty hard to measure, and I worry about how Governments might respond to those changes in measurement. To give you an example, how do we value the UK’s road stock? You could ask, “What did it cost to build it?” You could ask, “What would it cost to build it if you were to build it today?” You could ask, “How much would we get for it if we sold it?” They are all pretty reasonable approaches, and I am pretty confident they would give very different answers.

Imagine a world where the ONS went away and said, “We’ve changed our methodology. We think the road stock is now worth a lot more than we previously did”. I would worry about a Chancellor suddenly saying, “Hey, I can now do some tax cuts or some spending increases”, even though the public finances have not really got any stronger. Whereas if the ONS came along and said, “We have changed our methodology and we now think the road stock is worth a lot less than we previously thought”, I suspect a Chancellor might be tempted to say, “That’s just a technical revision. I don’t need to change my tax and spending policy”. If you keep behaving like that every time these things change, you will end up in a worse fiscal position overall.

Yes, we should look at the balance sheet, and we should not have a narrow focus on public sector net debt. We certainly should not target exclusively whether it happens to be lower in five years’ time than in four years’ time, but we should not throw it out completely and look only at the balance sheet.

Peder Beck-Friis: I am sorry to disappoint, but Carl and I are in agreement here. Debt to GDP is a good, easy measure for international comparison. The asset side raises a lot of questions about valuation and liquidity. Certainly, it makes sense to look at both sides. The ultimate example is Norway, for instance. Norway has a little government debt and a lot of assets. Net debt is negative, if you like. Financial markets incorporate that in their decision‑making.

Lord Razzall: Sonja, are you going to agree or disagree?

Sonja Gibbs: I largely agree, with a couple of caveats. Alternative measures of indebtedness can be helpful, going back to our discussion about growth. Metrics such as debt to revenues, debt to exports and debt to imports can complement debt to GDP and give you a broader picture. On the balance sheet approach, again it is interesting, despite the technical challenges that my fellow speakers have mentioned, as a complement to traditional debt, but it is complicated. Valuation of things such as government contingent liabilities, how you determine the net present value of social security obligations and all of that is very challenging, but it is helpful to look at net debt as another element of debt sustainability.

Finally, in all of this, transparency around debt is incredibly helpful, because it does not do you much good to have whatever metric it is if there is not clear transparency about all the different types of debt, how they are represented, comparability across sectors and so on. Again, the UK does quite well on this score in an international context.

Lord Razzall: Do we think the market would be interested in a balance sheet approach or would it just ignore it?

Peder Beck-Friis: Having worked in markets for some time, I think that they, for right or wrong reasons, tend to focus on the headline numbers, such as headline deficit, primary deficit and headline debt to GDP. For right or wrong reasons, at least in the very near term, they do not focus on the more detailed measures. But these certainly matter, to echo the points made earlier.

Q137 Lord Londesborough: In the spirit of trying to foster some disagreement, it is fair to say that studies have shown a relatively weak correlation between debt to GDP ratios and default on debt or debt crises. Research shows a much stronger correlation between high debt and slow growth, without a lot of agreement as to which is causing which. Do you have any thoughts on that?

Carl Emmerson: With those correlations, it strikes me that countries that can have big debt do and countries that cannot have big debt do not. Countries that cannot have big debt are often poorer countries that have more scope for growth than bigger, richer economies. I suspect there are quite a lot of other factors causing those correlations that we can see in the data.

Sonja Gibbs: To echo that, you get into a marginal utility of debt question here. If you consider that the value of debt is in supporting growth-producing investment—that is our basic reason for taking on debt—you are going to get to a point where the risks and the higher debt service costs outweigh the benefits of the additional investment. I would put it in that context.

Peder Beck-Friis: You are right. The relationship between government debt and interest rates is pretty poor, if you look at just simple correlations. It goes back to my earlier point. It depends on what moves—is it supply or demand that is moving?

A lot of the debt that we have seen over the last two or three decades has been a result of the increased desire by the private sector to save in these government securities. Let me give you one example. If the private sector—for whatever reason; it could be ageing—decides to save more, and so wants to run a surplus, the mirror image of that is that the Government need to run a deficit. They are complicated, these correlations. You need to look into these specific episodes to see whether it is demand or supply driving that.

Q138 Lord Griffiths of Fforestfach: I would like to ask three questions about the fiscal rules. First, do you think a fiscal rule is useful? Secondly, we have a fiscal rule at present in the UK with three dimensions to it. Do you think we could improve on that? Thirdly, two countries that have reduced their debt considerably, to 60% of GDP, are Switzerland and Germany, by having a debt brake. I find that, certainly in the UK, it is slightly dismissed as off-piste or an intellectual issue, but they have been successful in doing it. They have done it in a way that is more sophisticated than its detractors suggest. For example, they have a built-in mechanism to handle a slowing down or speeding up of growth, a recession and so on. In addition, they have both declared special circumstances for Covid, in Switzerland over six years, and for Ukraine.

Carl Emmerson: There is no set of fiscal rules that you can write down that will be perfect and that you would always want to adhere to in every state of the world. In fact, what you are describing are escape clauses for events that we could not possibly have thought of or would not have thought of, such as the pandemic.

On the UK’s fiscal targets, aiming for a balance on the current budget a few years out has much to commend it. It is based on the principle that we want to be aiming to only borrow to invest, which is what Gordon Brown had underpinning his golden rule. It is very similar to the fiscal target that Mr Osborne had under the coalition Government when he was Chancellor. There is much to commend that. By having a forward-looking target, it automatically gives you some space to deal with shocks that might come along. You can look through them and say, “Three or four years out, I’ll be aiming to get to current budget balance”.

There is obviously still a concern. You need your forecasts to be credible. You will need someone such as the OBR to produce them. There are still question marks about the credibility of some of the assumptions that go into those forecasts. The UK’s primary target at the moment is to have debt falling.

Over the medium term, as I said earlier, it is a really good idea for us to aim to have debt on a decisively downward path. I like the principle underpinning that rule. I do not like the practical design and the way it is operationalised, which says that it has to be lower in March in five years’ time than it was in March in four years’ time as a share of GDP. It says nothing about the path of debt between now and then, or indeed thereafter. It is incredibly sensitive to what you think is going to happen to the nominal growth rate in the economy between years 4 and 5. I certainly do not like the way it has been operationalised where, as soon as it looks like it is falling by a bit, that is described as headroom, which we should then use to cut taxes or increase spending. That is a really bad idea.

We actually have a third fiscal target legislated at the moment, a welfare cap, which we are on target to breach as soon as we have a fiscal event at the other side of a general election. That is a slight oddity, in that it is a target for a particular measure of spending and is assessed only in the first fiscal event of a Parliament, which seems like a particularly bizarre way of trying to have some assessment around a fiscal target. The fact that nobody talks about that fiscal target probably says how silly it is.

The Chair: Is it damaging, because everyone is saying it is silly?

Carl Emmerson: I do not think so, because no one is paying attention to it. I suspect what is more damaging is this. We had a period from 1997 through to about 2015 where we did not have that many fiscal targets and the only time they were jettisoned was when we had a financial crisis. In the period since 2015, we have gone through fiscal targets at really quite a fast rate and probably rushed to reintroduce them more quickly than we should have done. We should have taken our time to reintroduce a more sensibly designed set that we would not want to then jettison as quickly.

Lord Griffiths of Fforestfach: Can I ask about the debt brake?

Carl Emmerson: My concern with those types of targets is that they can be too binding, in that they have very firm limits, which you then get up against and you decide, perhaps with good reasons or perhaps not, that it is more appropriate or just easier to break them rather than adhere to them. That is what I do not like about those very firm targets.

Sonja Gibbs: In an international context, when you think about fiscal rules, even if they are not something that the market puts a lot of stock in, it is a useful internal barometer, particularly when you factor in changing political conditions, technology conditions and so on. It is helpful for the Government to have that, bearing in mind that flexibility may be needed. You mentioned the debt brake, and it is a useful example of that need for flexibility.

Fiscal targets can also factor in the potential need, on the flipside of the coin, for growth-stimulating incentives for particular industries, such as AI, infrastructure or what have you. That is also helpful in stabilising fiscal targets to work on the revenue side.

Peder Beck-Friis: I agree. Fiscal rules are sensible. Do they matter? To some extent they do, but the ultimate constraint will be the financial markets and the bond market. We saw that during the Truss episode, where the bond market reacted and forced a reaction from the Government.

I do not know whether there is a perfect rule. As you know, they differ across countries. Sweden, where I am from, has the surplus rule. The US does not have a deficit rule but a debt rule. Eurozone rules are very complicated. I have been working in these markets for a while and I still do not understand all the footnotes of all these rules.

What I would say is that the rules should probably be flexible during times of economic downturn. Government should be the borrower of last resort. To some extent, it may be good to have rules that are a function of the business cycle, not just of the monetary policy cycle. It may be detrimental, for instance, if you have rules that mean that the Government have to run contractionary fiscal policies when the interest rate is zero, so monetary policy cannot offset that, for instance. There is no one perfect, simple rule for these things.

The Chair: Can I pick you up there? Is a flexible rule not somewhat of a contradiction in terms?

Peder Beck-Friis: Yes.

The Chair: What is the point of that?

Peder Beck-Friis: It goes back to my point that the ultimate policing of this is the bond market. If we did not have any fiscal rules, what would change? Perhaps not that much. It may change the political incentives in the near term, but having strict fiscal rules that apply in any market conditions may be a little too harsh.

Carl Emmerson: A very inflexible fiscal rule would not be credible. To give you an example, we legislated a few years ago that we would achieve a balanced budget in 2019-20 and every year thereafter. By my calculations, in around April 2019 we would have to have done a massive in-year fiscal tightening to remain on course to meet that. Then, at the start of March 2020, with the pandemic going on, what would we have done? We would not have kept to it; we would have jettisoned it. You have no credibility in the target, and so I do not think that an inflexible fiscal target works.

Q139 Baroness Wolf of Dulwich: I am following up on what the Chair said. The more I listen to you, the less convinced I feel that these serve any purpose whatever. What you are basically saying is that they are fine during good times, when you would probably be observing it anyway if you are even half decent at managing your government finances, and if you are not, a fiscal rule will not save you. But the minute there is a crisis, or you have for various reasons failed to do what you set yourself to do, you ignore it or you write some more.

Really, this is a question for Carl, because it is going to be UK-specific. Until 1997, we did not have them. We had a few for a while and then, as you have described, we started changing them every five minutes. Are there any things that you can say improved as a result of Chancellors devising fiscal rules?

Carl Emmerson: They are no substitute for having good institutions and, indeed, a Chancellor who wants to do the right thing. We know that they can be gamed; if you are so minded, you can abuse the definitions that are used. They are not perfect.

Can they help? They can help a Chancellor describe what it is he or she wants to achieve in fiscal policy. If you were to speak to the Treasury, it would say it finds them useful when having conversations with spending departments about the run-up to a spending review and how the spending cake might be shared out between them. I suspect, as Peder says, that the markets are looking at a wider set of things than the current Chancellor’s current fiscal targets.

I would not be completely dismissive of them playing a role, but I would like to see them as a rule of thumb that we use as a communications device rather than something we are going to slavishly adhere to until some shock comes along, when we get rid of them and change them for another set.

Q140 Lord Griffiths of Fforestfach: Can I ask about what Peder has just said? I take your point. On the other hand, if things are getting out of hand, what you are saying is that the bond vigilantes are going to move in and clean it up. To me, that is as demanding in the short term as any Swiss or German rule that you could have, as indeed we saw with Liz Truss. In a very short time, the thing collapses, and we have trouble in the pensions industry and so on. As you say, the bond vigilantes sorted the issue out.

What I find interesting about the Swiss and German examples is this. In Switzerland, 55% of the population voted to change the constitution in order to have a fiscal rule. In Germany, there was a two-thirds majority in both houses of parliament in order to change the constitution. On behalf of the public, there was clearly a demand. Whether we have that in the UK, I do not know.

Sonja Gibbs: Maybe the ultimate example here is the Maastricht treaty and the Maastricht debt to GDP ratios. You mentioned the bond vigilantes. It is the ultimate example of them hunting down and punishing infractions of this rule. You are right that there are very different appetites in different European countries for having such rules in place. That was reflected in their willingness to breach them and face the consequences. It is a very nuanced question about fiscal rules.

Q141 The Chair: Carl, joining up the dots here, do you think we should try to create a fiscal rule that has much more long-term projections in it, given the impact of the demographic challenge here and a number of these other things? Is that an impossibility? Are we just searching for perfection that does not really exist?

Carl Emmerson: I like the feature of the Government’s forward-looking current budget rule, laying out the current budget balance in three years’ time. That is pretty attractive. I certainly agree with more focus on the OBR’s long-run projections. I worry that, every couple of years, the OBR produces a report which shows how the UK public finances are actually in a terrible state. If you look at the projections for the next 50 years, yes, there is lots of uncertainty around that and you can change the assumptions, but you still often get pretty nasty answers to how things look. More of a focus on that, and on trying to move to a world where we are addressing those problems earlier, would be a good one.

Q142 Lord Turnbull: There was discussion earlier on about strong pressures to increase spending and hence tax, whether we go ahead with the framework of tax we have at present or whether we go for reforming the tax system. Carl, I do not know whether this would be a house view of the Institute for Fiscal Studies, but do you have in mind a suite of measures that would sustain, or possibly even boost, tax revenues but do no harm to growth and possibly even improve it?

Carl Emmerson: Back in the early 2010s, we concluded a big study of the UK tax system, the Mirrlees review, where we asked the question: how could the Government collect about the same amount of revenue that they currently get and redistribute about the same amount as they currently redistribute, but have a tax system that does less harm to the economy? Once you put that in place, you can then choose whether to increase or reduce those tax rates if you want a smaller or a bigger state, or you can tweak it if you want more or less redistribution in the system.

As I said earlier, if we are to go down the route of increasing taxes, it would clearly be better to be increasing well-designed, reformed taxes. If you are pessimistic, you would say that all of the UK taxes are pretty flawed, and if we are going to push them up it will do damage to growth. If you are of the more optimistic bent, you would say that there is an opportunity here; we could reform our taxes and perhaps push them up, and still do only as much damage to the economy as we currently do.

There are lots of areas of tax, and pretty much all of them have a tax that is not working very well. To take just one specific example, there is not a very good case for having stamp duty on house purchases. It means that assets are not owned by those who value them most and it can cause harm to labour market mobility. There is not a very good case for having a council tax that puts houses in one of eight bands based on what they were worth in 1991. There is a much stronger case for trying to levy taxes based on the best estimate of what a house is currently worth, and to have frequent and regular revaluations.

Taking that together, I would like to see a reformed council tax that was based on up-to-date values and roughly proportional to the current value. If your house is worth three times as much, you would pay three times as much, which is not the case under the current scheme. I would like that tax to raise revenue that would be sufficient not just to replace the existing council tax but to abolish stamp duty, which is not a good thing to have in a 21st-century tax system. That is just one example of a tax reform that we could do. There are others for all other areas of the tax system, essentially.

Lord Turnbull: Say that you have to choose. You can take measures that are likely to improve growth, increase capital spending and so on, or you can decide that the priority is to get debt down. We have had this pattern that it ratchets up and then we hope to get it down, so that by the time the next crisis comes around we are in better shape. What is the priority when we are facing the precipice? Is it measures that boost growth or measures that reduce the debt ratio?

Carl Emmerson: I do not really like choosing. We need to have debt on a decisively downwards path over the medium term. We need to reform all our taxes and make them more growth-friendly. We need to be thinking about our public spending, and doing this as efficiently as possible. We also need to think about growth policies elsewhere, such as in our trade policy, immigration policy, planning policy, competition policy, education policy, et cetera. I would like to see a Government who are focused on a 10 to 20-year view and across the board are trying to deliver more growth, lower debt and improvements to public services where possible. I do not like the idea of accepting that we have to focus on a small set of those things.

Lord Turnbull: You cannot see that one of them at the moment is more urgent than the other.

Carl Emmerson: Improving growth would help debt sustainability and it would help with the challenge in public services. Maybe an across the board focus on growth is the thing that can help the economic problems we face all become a bit easier.

Sonja Gibbs: That is certainly the case internationally. If you look at longitudinal, long-term studies, you find that measures that are growth supportive and help boost revenues are almost always more effective in reducing overall debt than measures increasing the tax take.

Peder Beck-Friis: Following on from the last comment, I very much agree that growth is probably the best way of getting out of debt. It is not strictly necessary. Let me give you one example. Italy has barely grown for 20 years and has a trend growth of barely zero, perhaps slightly positive. It has a much higher debt to GDP stock than the UK, but the markets seem fairly sanguine because it has a long history of being able to run primary surpluses. We need to think about all these factors.

The Chair: Are we going to become the new Italy?

Peder Beck-Friis: That goes back to fiscal credibility and whether the UK would be willing to do that. Fiscal credibility is very important when thinking about debt sustainability. To me, it is the willingness of the Government to adjust the primary balance to balance debt going forward without using inflation. There are many combinations to stabilise debt. Japan, for instance, has a much higher debt stock but much lower R. It has a long history of running a primary deficit. We need to think about all these factors together, not one in isolation.

The Chair: To come back to Lord Turnbull’s point, Carl, it is a trade-off between wanting growth and wanting to cut the debt. At what point will the tax burden rising have an impact on growth, do you think?

Carl Emmerson: I do not see it as a single number that says, “After the tax burden goes above X, growth starts to slow”. As I said before, there are successful western European and Scandinavian economies with higher tax burdens. There are clearly different choices about tax rises. If we wanted to put up taxes and we chose to put up, say, council tax, that would not be very growth unfriendly. If we wanted to put up tax and we chose to put up the additional rate of income tax, I suspect it would raise you next to nothing; it might even cost money. The extent to which tax rises harm growth will depend on which tax you are pushing up and how well designed that tax base is.

Sonja Gibbs: You have to have political support for it.

Q143 Baroness Liddell of Coatdyke: I want to be a bit more specific. Carl, almost in your first sentence you talked about low-productivity growth, and it keeps coming up in the course of our discussions. How significant is it that the productivity puzzle needs to be solved? Do you have recommendations? A couple of weeks ago, we had Professor El-Erian with us, and his idea was to create a productivity tsar. He did not go into details as to what the tsar would be doing, but we have to concentrate on the practical outcomes that can deal with this productivity growth slowdown, which some studies have said is worse than it has ever been in over two decades. Give us some good ideas, please.

Carl Emmerson: The productivity slowdown has been phenomenal. In a counterfactual world where productivity growth had continued growing at the same rate as it had done between 1948 and 2007, we would all be sitting here in a country that was much more prosperous. Although we would have economic challenges, they would all seem much easier. It has been an absolutely dismal period for productivity growth. In the long run, that is the real driver of living standards. It is a huge public policy challenge.

I actually quite like the idea that we need institutional reform that gets us a focus on productivity across the board, because we know it is about policies in a load of different areas. Plus, we need a Government who are going to be patient, because it is sustainable growth that we want. I would quite like it if the idea was something we can do institutionally, which tries to keep the whole of government focused on what we can do to improve productivity. That could be a good step forward.

Baroness Liddell of Coatdyke: Can you focus it on long-term debt sustainability and match the two up?

Carl Emmerson: The idea here would be that, if we achieved greater productivity growth, it would make those economic trade-offs easier. It would make policy reform in a whole load of government areas easier, because you would have revenues to compensate losers. It could help cause a feedback loop, not the doom loop we were talking about earlier but a positive feedback loop. As we have been saying, the nicest way of getting debt to GDP down is to have higher growth relative to the interest rate you are paying on that debt.

Peder Beck-Friis: To add to the last point, and as I have said a few times, it is not growth in isolation that matters for debt sustainability; it is the interest rate/growth differential. Interest rates long term, structurally, tend to co-move pretty strongly with GDP growth rates. Productivity growth has been falling since the 1980s and so have interest rates. If we were to move into a world where, for instance, we boosted productivity growth, it may also lead to higher interest rates, in which case it is not obvious to me that it would have a beneficial impact on debt sustainability.

The Chair: I hear what you are saying, and I do not want to create an argument here. I was just reading what David Miles sent us from the OBR. He said, “If productivity growth is barely positive over the next five years debt would be around £200 billion higher, some 7% of GDP, than the OBR central forecast of November 2023”, which is an astounding figure. Does this not answer Lord Turnbull’s point that we really should be zeroing in on productivity rather than on the other side of the equation of just bringing debt down? It does strike me, reading that sentence.

Carl Emmerson: Where higher productivity growth can help is that it will make it easier for us to run a better primary balance than it otherwise would be.

Sonja Gibbs: What is interesting about the situation for the UK, as well as for many other countries, is that it is not about industrial structure; it is really a lack of capital investment and investment in skills. You get to that question of trade-off. If you increase spending on incentives for investment in strategic industries—things that are going to be very important going forward—and if you spend more on skills training, the impact of that spending on the debt should be offset by significantly higher growth. It is that balance that is important to achieve.

Q144 The Chair: Can I quickly pick up on immigration? We have not really talked about that. The OBR and the ONS are forecasting really quite high levels of migration through the forecast period. Again, it was striking what David Miles said in his written evidence. He points out the benefits of that and then goes on to say, “It is much less clear that persistently high levels of net immigration to boost the labour force can generate sustained fiscal improvements. New immigrants … may generate a favourable balance of extra tax revenue relative to extra public spending for some years. But immigrants who stay grow older and have children so the favourable tax to spending balance does not persist”.

Looking ahead, given the projections, is there a danger that we are looking towards growth being fuelled, in part at least or maybe too greatly, by these high levels of migration? Carl, what do you think about that?

Carl Emmerson: If we have more immigrants arriving in the UK, it is pretty clear that that boosts tax revenues. Many of them will be working; they will be spending in the economy. The way in which it often strengthens the public finances is that, when this occurs, we do not increase public service spending. Essentially, we have the same amount of public service spending going across a bigger population. Clearly, people arriving in the UK are bound to put some demand on some public services. Essentially, you achieve a stronger fiscal position because you have put a squeeze on public service spending and cut public spending per capita in a slightly subtle way.

Over the longer term, what happens is that, if people have children here and retire here, they will start to look much more like the population that is already here, and the public finances will not be much changed. If somebody arrives from overseas, stays here for a period and works for a bit, they may have a higher chance of retiring elsewhere in the world than somebody who is born here, who perhaps has a lower chance of retiring elsewhere. You might get a public finance win then.

Q145 Lord Londesborough: Can we focus on net zero and its potential impact on debt sustainability? Net zero is essentially an unbudgeted commitment over 30 years or so. The Climate Change Committee is estimating a total cost of £1.3 trillion, with a net cost of about £300 billion once net savings are taken into account, but that involves a whole mass of assumptions, including, critically, high levels of private sector participation. The OBR has pointed out to us that net zero will likely require an extra 20% of GDP in further borrowing, and probably more if we continue to drag our heels on the measures. What risks does net zero pose and what policies can mitigate those risks? Can we start with you, Sonja?

Sonja Gibbs: This is a topic that we have spent a lot of time on at the IIF: the role of the financial sector in the transition to net zero. To start with a big picture statistic, to reach net zero on global greenhouse gas emissions by 2050 is going to require something astronomical like $275 trillion of investment in physical assets alone. To get there would amount to an unprecedented reallocation of capital. The devil is in the details. How do we reallocate capital in a way that supports growth and does not constrain it? In this context, the UK Government’s 2023 green finance strategy is looking at how to support companies when they decarbonise and access capital.

The key here is in this question of understanding which parts of the economy will bear the costs of transition and how to offset those costs. Whether it is brown industries that need to transition themselves, or households that face higher costs related to newer, cleaner energy sources, it is really important both practically and politically to face those costs squarely and figure out how to finance it. This can circle back to debt and debt sustainability; if you have the fiscal space to work on this, the cost of transition should be factored into budgeting.

Then you get back to the productivity and growth question. The potential of these new industries to generate growth is really phenomenal. Again, you have to single out the UK here. It has been very proactive on supporting green growth and jobs. In a way, Europe does this as well, but there it is a bit more complex; it is more hemmed in by the regulatory structure. The UK is doing this in arguably a more market-friendly manner.

The other thing the UK does very well here is climate and environmental markets, which are also going to be a strong source of growth and revenues—the development of things such as green bond markets, blue bonds and voluntary carbon markets. All of these things can be revenue and growth generating.

The final point I would make here is really important. I cannot stress this enough. In order to have growth-friendly net-zero transition, the regulatory environment has to be enabling, not constraining. In other words, if you write 500 pages of green taxonomy and you are unduly influenced by a wish to divest right now from everything that is related to fossil fuels or traditional energy, that is a very challenging way to transition and will ultimately lead to political backlash and higher costs.

We need to think through how to get to transition on a dual track; on the one hand, investing in renewables, clean energy and so on to power the economy, and on the other hand, continuing to help fossil fuel and other high-emissions industries transition to a greener business model, which going forward has to happen. It cannot all be done with renewables. That is really going to make this much more plausible in the context of long-term debt sustainability.

Peder Beck-Friis: This is not my area of expertise, so I will pass it on to Carl.

Carl Emmerson: On net zero, the UK has made some pretty good progress in recent decades, but it is fair to say that we have taken the low-hanging fruit, such as big improvements in electricity generation. That is largely hidden from households, and helped by the fact that household appliances have become much more efficient, so they do not become more expensive to run if you do start to use a more expensive way of generating electricity.

Going forward, there are some big challenges. The UK’s housing stock is going to require a lot of investment. It is going to take quite a lot to persuade households to switch from using their current largely gas or oil heating systems.

Another public finance challenge comes from vehicle taxation. At the moment, the Government are collecting over £20 billion a year in fuel duties, but it will not be that much longer before the majority of people are driving around in electric vehicles and that revenue collapses to zero. We need a strategy in place now for how we are going to tackle that. If we do get to a world where there is no tax on motorists who are driving around, the biggest externality from driving is not carbon emissions; it is actually congestion, and our roads will become even more congested. If we wait until the fuel duty revenue has run out, we will have nothing there to compensate motorists with. If we get on with implementing a system of road pricing now, we could at least say, “We’ll cut your fuel duties in return for increasing the road charge now”.

I certainly worry about a world where we keep thinking, “We’ll do that later”, and we end up with no revenue left to compensate. Where then are we going to get the £20-odd billion a year of fuel duty revenue from?

Q146 The Chair: I will sum up, if it is possible, with a question rather than a statement. Would you agree with the following? We are not an outlier now, but a number of other developed nations have seen their debts increasing. Like them, and in certain ways different from them, we have more problems with the structure and the vulnerability of our debt. Therefore, looking at the tail-winds that have become headwinds, and in particular at demographics and the decarbonisation challenge, if we do not address those in the next five years plus a bit, we could be in a pretty difficult position. Would you agree with that, Peder? Is that a summary of where we are getting to here, or is that too gloomy?

Peder Beck-Friis: I half agree. It depends on the world that we will be in in five or 10 years. The most important thing is what the saving demand will be. We have been in a long period now of what Ben Bernanke would call a saving glut, with a lot of the emerging market countries saving. The saving demand has been very strong. As a result, government has been able to run deficits and run high debt levels. That is one of the key questions: what will happen to that? If we were to move into a world with higher interest rates and lower savings, I agree that debt dynamics would look much worse than they did pre-pandemic.

The Chair: Carl, the IFS put out a paper saying that we cannot have a Government who wilfully ignore reality and the need to choose between difficult competing options. Given what you said, I take it that you broadly agree.

Carl Emmerson: I broadly do. The cost will come if we muddle through rather than take a strategic approach, and things such as the adjustment to net zero and the adjustment we need to make because of demographics will be more costly than they need to be. If we take earlier action, and come up with a plan and get it right, it will not be as costly.

The Chair: I am sorry to interrupt you. It might be more costly, but it is not that the debt would therefore become unsustainable.

Carl Emmerson: It is not. The ideal scenario is one where we take a strategic approach and get things right. I can see a plausible scenario where we just muddle through. It would not be that there is a sustainability problem, but dealing with these challenges would become more expensive than it needs to be, which is rather unfortunate. However, I still worry about what happens if there is a UK‑specific negative shock. How well placed are we to deal with that? The shocks we have seen since 2008 have been global or European in their nature.

Q147 Lord Layard: I wanted to come back to the question of the importance of reducing the debt ratio, which I suppose is almost the central issue for this committee. This is an international day we are having today. As was pointed out earlier, our situation is no worse, and possibly better, than that of other countries. Are other countries also committed to reducing the debt ratio? If they are not, why should we in an international capital market?

Peder Beck-Friis: The relative ranking matters. The absolute level of what is going on in the UK matters more, of course. From a relative point of view, there is a mixed picture across countries. The US, at the one extreme, does not seem to have much appetite to reduce the debt or the deficit going forward. Obviously, it may depend on who comes into power at the end of the year. European countries historically have had a tendency to run more contractionary fiscal policies, such as in Sweden, where I am from. In Germany, the word for debt is “Schuld”, which means guilt. There is something in the backbone of these countries that is averse to running debt.

On the fiscal stance this year and going forward, the UK, across the developed markets, is running one of the most contractionary fiscal policies. Off the top of my head, there is no other country that intends to move into a primary surplus, which the UK at least has laid out.

There is an interesting question here, and this goes back to my point about fiscal credibility. Financial markets speak a lot about monetary policy credibility—being able to have 2% inflation—but fiscal credibility is equally important. Once you lose credibility, you may have to overdo it to regain credibility. We speak about this in monetary policy: if you have a lot of monetary policy credibility, perhaps you do not need to raise interest rates, because markets are very anchored. The same applies to fiscal policy. There may be an element of that in what is going on in the UK following the Truss episode. Very briefly, the UK seemed to lose a little fiscal credibility and, as a result, perhaps has to do a little more than other countries to restore it.

Sonja Gibbs: To the question about why we should reduce the debt ratio if others are not, I would throw this in. In addition to the US, Europe and Japan, emerging markets are really concerned with supporting growth. Therefore, just taking on more debt does not seem to be an issue there.

It comes down to putting your pennies aside for a rainy day. That is really important for two reasons. One is the political risk of elections and changing Governments, which is going to make fiscal prudence less and less popular. It is important to think about how you are going to keep your debt under control given that. Then there is the climate transition, as we mentioned. You need fiscal space, especially for those two big reasons.

The Chair: Thank you very much to all three of you. It was a very interesting session. We covered an enormous amount of ground and got a good global perspective. With that, we will end. Thank you all.