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why government support for business could hurt the economy in the long run FindSexyJobs

FSJ News Updates,

The UK government hopes to protect businesses and public sector organizations from spiraling energy costs with a package that parallels the price cap and support payments recently promised to households. However, these major interventions come with a large and imprecise price that raises serious doubts about the government’s future finances.

By reducing retail electricity and gas prices, the new strategy aims to get utilities to share the cost of keeping energy available. The Bank of England, meanwhile, has extended £40bn of credit lines to energy companies, which have struggled this year to cope with fluctuating gas prices.

The Treasury’s total bill for these subsidies will depend on how high and for how long wholesale prices are inflated by the war in Ukraine. The new energy secretary believes it will cost tens of billions, but independent estimates were in the £100-150 billion range, even before the latest escalation in the conflict in Russia.

These figures far exceed even the £70bn spent on helping businesses and households during the COVID-19 pandemic and the £23bn given to banks during the 2007-8 global financial crisis.

New Chancellor Kwasi Kwarteng sought to allay concerns about this fiscal largesse ahead of the September 23 budget update. It says the UK is still well below any borrowing limit, with the lowest public debt-to-GDP ratio of the G7 major industrial economies.

Ahead of the fiscal statement on September 23, he hinted at plans to roll back tax rises introduced by his predecessor Rishi Sunak, while promising enough funds to ease growing pressure on the NHS, social care and other public services.

Borrowing spree

Running an expansionary budget—that is, spending more and taxing less—is the standard recession response that most forecasters and business groups now expect. The aim is to inject demand into a faltering economy as households buy less and businesses invest less, speeding up a return to economic growth.

However, the starting point of the latest crisis challenges the usual assumption that governments can get out of this mess. Borrowings to finance the subsequent emergency measures raised UK public debt to record levels in the period not immediately following the Great War. And it now far exceeds GDP on measures such as World Bank measures.

The UK has been on a public borrowing spree since 2008, along with increased levels of household debt, aided by more than a decade of extremely low interest rates. This meant that the cost of servicing the government’s (and households’) debt continued to fall relative to their income, even as their debt-to-income ratio rose again.

The Bank of England kept these borrowing costs low by constantly buying up government debt from private investors, increasing the appetite for issuing new debt. The government’s ability to essentially place substantial new debt on the central bank’s balance sheet has fueled the view that it can borrow as much as is needed to shorten the recession.

And because the UK borrows mainly in pounds, its finances are not troubled by a falling pound, unlike lower-income countries that mostly look to borrow in foreign currencies.

Reaching the credit limit

But this new burst of borrowing comes as the Bank of England pushes interest rates up and financial markets raise the yield (the rate of return on an investment over time) that the Treasury must pay out on its latest bond issues. The government’s interest bill was 19% higher in August than a year ago and the highest on record since 1997.

Debt servicing costs are also rising as a quarter of outstanding government bonds now have yields linked to inflation, as measured by the Retail Price Index (RPI). This is a way for the government to assure investors that inflation will not erode their assets. The RPI inflation rate reached 12.3% in August, significantly higher than headline rates based on the Consumer Price Index (CPI), another measure of inflation.

Debt servicing costs are rising, including for the government.
William Potter/Shutterstock

All of this means that while energy price caps will initially dampen inflation, the borrowing to finance them could eventually push prices up further as it increases demand for already tight supplies. Fiscal stimulus on the current scale is usually applied when resources are free and lots of people are looking for work.

However, currently, even on the eve of recession, the UK has historically low unemployment (3.6%) and supply chain disruptions that extend far beyond the energy sector.

Given this environment, the Bank of England still expects inflation to peak at around 13% later this year and has therefore announced another large rate hike on 22 September to try to bring inflation back to its 2% target.

The Institute for Fiscal Studies concluded on the eve of the mini-budget that a combination of higher spending and tax cuts would leave Britain’s public finances on an unsustainable path unless GDP started to grow significantly faster.

Although Prime Minister Liz Truss’ new team is confident this will happen, fueled by a new push for tax cuts and deregulation, UK growth has been unusually anemic over the past 15 years. Even in the interval between the recessions caused by the financial crash and the pandemic, it averaged only 2%.

Debt sustainability becomes a serious issue once the interest rate on public debt rises above the real rate of economic growth. If its latest steps do not lead to faster GDP growth, the government may run out of fiscal space needed for further attempts to revive the economy.


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