HSBC: The government is about to spend big - but it could lead to an 'unsustainable debt spiral'
The bank's chief UK economist Simon Wells and his team say in a note sent to clients this week that: "The Bank of England has done what it can, all eyes are now on the government."
HSBC says in the note, titled "When uncertainty reigns, look to Keynes:"
"In the current environment, the case for public investment is compelling. Interest rates can't go any lower, uncertainty is extreme and borrowing is cheap. Moreover there is evidence that fiscal multipliers (i.e. the GDP impact of fiscal stimulus) are larger when the economy is in a slump."
The underlying assumption here is that the UK is going to take a big economic hit from Brexit as corporations hold off from investing or expanding here until the EU exit is sorted out. Almost all major economists and banks believe the UK is heading for a slowdown after the referendum result.
The Bank of England has more or less exhausted its arsenal of monetary weapons to try and stave off a slowdown, cutting interest rates to a historic low of 0.25% and introducing a multi-billion pound bond buying programme.
Wells and his team believe that it is now time for the government to step up and do all it can to boost the economy. But what will it do?
HSBC says (emphasis ours):
"We argue that increasing public sector investment may be the most effective form of stimulus and that there is no shortage of infrastructure investment opportunities, notably in transport and housebuilding. That said, the government may be attracted to the immediate boost from a temporary VAT cut, which would offset some of the rise in inflation resulting from sterling depreciation."
Wells and team note that the UK railways, for example, have been historically under invested in by international standards and the country is suffering from a chronic housing shortage caused by years of declining building rates.
Pouring billions into projects like housebuilding and doing up the railways would create more jobs and boost GDP - at least that is the idea.
'Unsustainable debt spiral'
But there is a downside.
Theresa May "faces a choice between enacting near-term economic stimulus at the possible cost of storing up problems for future governments or taking near-term economic pain and the potential for higher future prosperity."
Yes, investing today may boost GDP and stave off a sharp rise in unemployment, but it will also involve borrowing more, which will increase the country's debt burden. It is cheap to borrow right now, with gilt yields at record lows, but future governments will still have to content with a debt mountain, which currently stands at 84% of GDP.
The country is not set up to deal with more debt either because of our ageing population. Wells and team say: "Long term, demographics and, in turn, rising healthcare and pension spending mean that, without future policy tightening, the UK is heading into an unsustainable debt spiral."
People are dropping out of the workforce faster than they are joining, meaning more elderly people are sucking up fewer tax pounds through healthcare and pension costs. To fund healthcare and pensions the government will therefore have to borrow more to make up the shortfall between taxes and costs. The last thing it then needs is a bigger debt pile to begin with. (You can read more on the country's pension crisis here and here.)
Here is what that "unsustainable debt spiral" looks like:
Worse still, even if the government does take the risk and spend to boost the economy, there is a chance it will simply be a short-term balm that fails to tackle underlying issues. Or as HSBC puts it:
"The government borrowing more to pay people to dig holes and then paying others to fill them in again does not sound like a recipe for long-term prosperity."
Still, on balance HSBC thinks boosting public spending is a risk worth taking. The bank says: "Our view is that an increase in public sector investment would be the best type of fiscal response. It may be better to risk building 'bridges to nowhere', than have a collapse in investment. And there seems to be little shortage of infrastructure opportunities."
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