why government support for businesses could harm the economy in the long run

The UK government is hoping to protect businesses and public sector organizations from rising energy costs with a package that runs in tandem with the price cap and support payments recently promised to households. However, these significant interventions come with a high and inaccurate price tag, which raises serious doubts about the government’s future finances.

By lowering retail electricity and gas prices, the new strategy aims to share the cost of energy affordability with energy companies. The Bank of England has meanwhile extended £40 billion in credit lines to energy companies that have struggled to cope with volatility in gas prices this year.

The Treasury Department’s total bill from 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 recent escalation of the conflict in Russia.

These figures even exceed the £70 billion spent on supporting businesses and households during the COVID-19 pandemic and the £23 billion made available to banks during the 2007-2008 global financial crisis.

The new chancellor, Kwasi Kwarteng, has tried to allay fears about this fiscal liberality ahead of his Sept. 23 budget update. He argues that the UK is still well below any borrowing limit, with the lowest public debt-to-GDP ratio of the major G7 developed countries.

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Ahead of the September 23 financial report, he announced plans to end the tax increases introduced by his predecessor Rishi Sunak, while pledging enough funding to ease mounting pressure on the NHS, social care and other public services.

rental frenzy

Expansionary budgeting – that is, spending more and taxing less – is the standard response to a recession that most forecasters and business groups are now anticipating. The idea is to bring demand into the flagging economy as households buy less and businesses invest less, to accelerate the return to economic growth.

But the starting point of the recent crisis challenges the usual assumption that governments can find their way out of this mess. Borrowing to fund successive emergency responses has pushed the UK’s public debt to record levels for periods not immediately following a major war. And it now vastly exceeds GDP by measures such as those of the World Bank.

The UK has been in a public debt frenzy since 2008, alongside increased household debt helped by more than a decade of extremely low interest rates. This meant that government (and households) debt-servicing costs relative to their income continued to fall, even as the debt-to-income ratio rose again.

The Bank of England maintained these low borrowing costs by continually buying back government bonds from retail investors, increasing appetite for new debt issuance. The government’s ability to add significant new debt to the central bank’s balance sheet has encouraged the view that it can borrow whatever is needed to shorten the recession.

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And with the UK borrowing mostly in sterling, its finances are unfazed by the falling pound, in contrast to lower-income countries, which mostly seek foreign currency borrowing.

reach credit limit

But this new borrowing comes at a time when the Bank of England is pushing up interest rates and financial markets are increasing the yield (a measure of an investment’s return over time) that the Treasury is paying on its latest bond issuance. The government interest bill in August was 19% higher than a year ago and the highest since 1997.

Debt service costs are also rising because a quarter of outstanding government bonds now have inflation-linked yields as measured by the retail price index (RPI). In this way, the government can reassure investors that inflation will not eat away at their wealth. The RPI inflation rate hit 12.3% in August, well above policy rates based on the consumer price index (CPI), another measure of inflation.

Debt service costs are increasing, including for the state.
William Potter/Shutterstock

All this means that while energy price caps initially dampen inflation, borrowing to fund them could eventually push prices higher by creating additional demand for already tight supplies. Fiscal stimulus on the current scale is usually applied when there are free resources and many people are looking for work.

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For now, however, even on the eve of recession, the UK has historically low unemployment (3.6%) and supply chain disruptions that extend well beyond the energy sector.

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

The Institute for Fiscal Studies concluded on the eve of the mini-budget that the combination of higher spending and tax cuts will put the UK’s public finances on an unsustainable path unless GDP starts growing significantly faster.

Although Prime Minister Liz Truss’ new team is convinced this will happen, Britain’s growth has been unusually lackluster over the past 15 years, spurred by renewed pressures for tax cuts and deregulation. Even in the period between the recessions caused by the financial crash and the pandemic, it averaged just 2%.

Debt sustainability becomes a serious problem once the interest rate on government debt rises above the real growth rate of the economy. If recent moves don’t result in faster GDP growth, the government may run out of fiscal space needed for further attempts to revive the economy.

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