The £100bn problem haunting the election

Any mortgage borrower can tell you the shock of the surge in interest rates over the past two years.

After 15 years of cheap money that encouraged households to take on more debt, homeowners were left exposed when the Bank of England began ramping up borrowing costs.

It is a painful wake-up call for mortgage borrowers whose cheap fixed-rate deals are coming up for renewal, with households already being forced to cut back spending, stretch out the terms of their loans, and look for new jobs or promotions to cover the cost.

No debtor in the country is bigger than the British Government, so its problem, and thus the wider population’s too, is on a commensurately different scale.

More than a decade of rock-bottom interest rates lulled ministers into assuming that money was somewhere close to free, and might well remain so forever.

This was used to justify decisions to borrow extraordinary sums of money. The debt soared from just over a third of GDP on the eve of the credit crunch to almost 100pc now, or £2.6 trillion in cash terms.

The magic of low interest rates initially meant that interest payments barely budged.

In 2009-10, around £5.50 of every £100 raised by the Government went on debt interest. That fell below £3 in the pandemic, despite surging debts.

Now it stands at £10, with one-tenth of Exchequer receipts swallowed up in interest payments.

The Government is on track to spend around £100bn on debt interest this year. The Office for Budget Responsibility expects a brief reprieve as inflation falls back before a renewed rise later this decade. The UK is unique in linking a quarter of its debt to the cost of living.

There is an irony to this situation, says Robert Colvile, an author of the Conservatives’ 2019 manifesto and director of the Centre for Policy Studies (CPS), the think tank co-founded by Margaret Thatcher.

“Rishi Sunak, when he was Chancellor, was absolutely red hot on this,” he says.

“He kept on saying ‘we cannot keep piling up debt, if interest rates go up we will be absolutely screwed’.”

It has been a long-running issue for the Conservatives. Nicky Morgan, former Treasury minister and later education secretary, recalls many such warnings from Chancellors over the years.

“It was always talked about,” she says. “I remember Sajid Javid talking about it in Cabinet – ‘if we have got this debt, you have got to think that someday interest rates could go up and it will become more expensive’.

“But of course, at the time, there is always a reason to spend money.”

Philip Hammond, who was chancellor from 2016 to 2019, says Britain has “deluded” itself in thinking the debt could rise inexorably without consequence.

“Imagine you are running your household on the basis that you took a credit card with £500 of debt on it and you run it up to £5,000 but nobody ever says ‘what are we going to do about this’?” he says.

“I don’t want to sound like some sort of Victorian moralist, but I do worry that the public has lost sight of some basic facts that you can’t spend more than you earn. And the ultimate disaster for anybody to get into, either an individual or a country, is you end up borrowing to pay the interest on your borrowings.

“We’re not in a sustainable position.”

Demands to spend money are vast, particularly when it comes to the NHS, pensions, and net zero.

But the £100bn annual cost of debt is unavoidable, and is forcing hard choices on both the Tories and Labour as they plan their election campaigns.

At the March Budget, the Office for Budget Responsibility (OBR) ruled the Chancellor had just £6.5bn of headroom to hit his key target of getting debt falling in five years’ time. Given the scale of the national debt, it means very small changes in borrowing costs can have dramatic effects on room to spend, or requirements for higher taxes.

When it comes to Labour’s plans, it has been forced to cut back its flagship proposal for £28bn of green investment per year. It is a chunky sum, but is dwarfed by the almost £60bn rise in debt interest costs between 2019 and 2022.

Though unappealing to voters, tax rises and spending cuts are the most obvious options for Jeremy Hunt and Rachel Reeves as they wrangle with this dire financial predicament.

So far, higher taxes are doing much of the heavy lifting for the Chancellor. Tax receipts are set to rise to almost 38pc of GDP, the biggest tax burden on records dating back to 1948.

In cash terms, the Government’s current receipts are on track to rise to more than £1.2 trillion in 2027-28, up by one-third from 2021-22’s levels.

Much of this comes from income tax and national insurance, as the Chancellor has frozen the thresholds at which these are charged at a time of high inflation. So much money has flooded in from these freezes that Hunt may have room to allow thresholds to rise once more.

But Colvile suspects the flow of extra tax receipts will prove too valuable given the interest bills, despite the pain for workers and businesses.

“They probably don’t feel able to stop doing that, even though they wish they could, because they just need an awful lot of extra money,” he says.

Hammond argues that cutting overall spending is unlikely: “With an ageing population, it’s very difficult to see how in practice you do that.”

A government source says restraining growth to inflation plus 1pc is as far as Hunt will go, “so that is keeping a lid on the size of the state”.

Theoretically Labour might have more room for manoeuvre. If it came to power after 14 years in opposition, a new government would not feel bound by its predecessors’ decisions, and could argue it had a mandate for a new approach.

But Keir Starmer’s party has hewn close to the Government’s plans for the finances so far, out of caution and a fear of scaring either voters or financial markets with any talk of higher borrowing and spending.

This time around Labour has promised to go easy on the tax rises, focusing on a few largely symbolic policies such as a VAT raid on private schools, rather than anything which would raise money on the scale of the Conservatives’ freeze on income tax thresholds.

Reeves has set out new borrowing rules to show restraint.

“I set out Labour’s fiscal rules, which are first that we wouldn’t borrow to fund day-to-day expenditure,” she says.

“Second, we would get down debt as a share of GDP and third – subject to the first rules being met – invest in growth potential recognising that lack of growth is the primary driver of high taxes and increasing debt that we’ve seen from this government.”

The shadow chancellor will not be drawn on many specifics: “We don’t know what the picture is that we’re going to inherit yet. And we’ve got at least two more fiscal statements, possibly three, before the election. So I’m not going to put a number on that but we’ll set that out closer to the election,” she says.

But the promised priority is growth.

“We’ve not grown the economy over the past 13 years and as a result we’ve had to borrow and tax more to be able to fund public services,” as she puts it.

Revitalising the Government and boosting growth is not easy without financial wriggle room.

Stephen Timms, a Treasury minister for much of the Labour years, says the Blair government did not feel able to make major financial decisions at first, and so had to find policies that avoided significant spending but still showed voters things had changed.

“Tony Blair managed to persuade people this was different to what was there before,” he says.

“A dramatic change of personnel will make a reality of the change that people, if they vote for it, will have wanted. Different personalities, different ways of speaking about things.”

Boosting growth is certainly vital. But it is also easier said than done.

Hammond praises the Chancellor’s efforts to get more people into work.

“Jeremy Hunt is absolutely right to have latched on to a focus on trying to get as many people as possible into the workforce. We have to stop subsidising people to sit at home doing nothing, if they can possibly be working,” he says.

“Nobody in the UK who is physically able to do a job should be allowed to receive any kind of state support for not doing that.”

The Government’s plans also include boosting public sector productivity, to try to overcome a major drag on growth.

John Glen, the long-serving Treasury minister who was this week appointed Paymaster General and minister for the cabinet office, has been leading the taskforce on the increased use of digital technology and artificial intelligence in the public sector.

Given the lack of cash for spending, Hunt mostly wants to rely on the private sector to do the heavy lifting.

An extension of full expensing to encourage business investment is expected to be announced at next week’s Autumn Statement, while the Chancellor is also seeking ways to encourage pension funds to move more of their money out of bonds and into British businesses.

Labour is also keen on the idea. Liam Byrne, who served as chief secretary to the Treasury in Gordon Brown’s government, proposes consolidating Britain’s fragmented pensions industry into a smaller number of superfunds to more powerfully direct large investment flows.

One risk, however, says Colvile, is that this means taking money out of government bonds, sparking fears in the Treasury that this risks driving up the cost of borrowing further.

Meanwhile Labour’s plan to keep borrowing for public investment also raises concerns.

Extra debt is still extra debt, says Morgan.

“There are those who argue it depends what the debt is incurred for – if it is incurred for investment in infrastructure for example, do you look at it in a different way from debt to cover day to day spending?” she says.

“But the fact is the debt is still there – it still adds up, there is still interest on it.”

The situation could get even worse. After the financial crisis and then the pandemic, the OBR calculated the trajectory of the national debt if another expensive surprise wallops the economy once per decade.

Should this come to pass, the national debt is projected to reach an almost absurd 360pc to 435pc of GDP in 50 years’ time.

All of this adds to worries that it will not be possible to boost growth by anything like the amount required to reduce the burden of the debt without tax rises and spending cuts.

The CPS’s Colvile warns that “we need 2.9pc growth a year just to pay for the current welfare state, and we have come nowhere close.”