How to deal with a debt pile
We have had several conversations with very smart investors who have asked: “Does the debt position in the UK mean that the country will end up like Greece in 2010? Greece, a member of the Euro area, by 2010 had borrowed too much and was forced to drastically cut benefits and reduce government services. Despite these measures, it ultimately defaulted on its debt.
The UK’s debt position is poor, but that does not mean that the UK will end up like Greece as the former has more flexibility. The UK government controls its own currency – it can print as many pounds as it likes and can inflate its way out of its dire debt situation. Greece, on the other hand, is in the Euro and did not control its currency and could not inflate its way out of debt. Many investors understand the Greek situation, but do not understand how a country like the UK, with its own currency, can inflate its way out of debt.
There are a few features of government debt that not every investor may appreciate. When the UK government needs to borrow, it raises money by selling certificates or bonds, called gilts, to investors. The government gets the investor’s money and, in return, agrees to pay out a fixed rate of interest over the life of the gilt, typically up to 30 years. At the end of the 30 years the investor gets her money back.
Investors like the gilts because they get a steady, reliable income from their gilts and because they can sell their gilts to other investors if they need to cash out of their investment. The key point, though, is that gilts are long term and pay a fixed rate of interest for the life of the gilt; the interest rate does not change with base rates. There are also index-linked gilts, which we will come back to later.
At the present time there are £2,700,000,000,000 outstanding gilts or £2.7 trillion. About £2 trillion are gilts that pay a fixed interest rate, and the balance are index-linked gilts. Today the average life of fixed-rate gilts is 13 years and the average fixed-interest payment is about 4%. Let’s say a typical investor in UK gilts invests £10,000 in her SIPP in 13-year gilts and receives an income of 4% a year. If inflation is 4% over the next year, then the spending power of her £10,000 will shrink to £9,600. This is entirely offset by her interest income on the gilt of £400 (0% tax rate on SIPPs). Our investor is neither better off nor worse off economically.
If, though, inflation had risen to 14%, the same investor with the same portfolio of gilts would still be getting an income of £400 (remember the interest rate is fixed for the life of the gilt) but the spending power of her £10,000 would shrink to £8,600, a net loss in spending power of £1,000, or 10%. Furthermore, should our investor want to sell her loss-making portfolio of gilts, she will almost certainly find that the prices of the gilts will have fallen considerably.
The real-terms loss of 10% in spending power is, in effect, a transfer of her wealth to the government. You can look at this as a hidden tax on savers or a betrayal of trust in the government’s promise to repay its debt holders. For this reason, in the 1970s, when inflation was touching 27%, gilts become known as “certificates of confiscation”. It got so bad that in 1976 there was a gilt “buyers’ strike”, which meant that the government could no longer borrow money from investors, and was forced to turn to the IMF to bail the UK out.
There is £2 trillion of fixed-maturity and fixed-interest-rate gilts outstanding. If inflation hits 14%, then the spending power of the money invested in gilts drops by £280bn. As mentioned, this is a kind of tax on investors. In this hypothetical case, the tax is very large when you consider that in 2023/24 the government raised £268bn from regular income tax and £162bn from VAT.
Another way of looking at government debt is to consider that UK GDP today is about £2 trillion (actually slightly higher), and the stock of fixed-rate gilts is £2 trillion (ignoring index-linked gilts) – then on this simplified example government debt to GDP is 100%. If inflation is 14% over the next year, all else being equal, then UK GDP will be £2.28 trillion, and if government debt remains at £2 trillion, then debt to GDP would fall to about 88%; an apparent real improvement in the government financial position thanks to the hidden tax of inflation.
Debt built up during the 18th Century, largely thanks to war, was paid off in the relatively peaceful 19th Century, before climbing once again during the 20th Century’s World Wars. Debt was not paid off in the 1950s, 60s or 70s; it was inflated away, assisted also by rapid GDP growth. Now, 21st Century debt is growing thanks to COVID and financial mismanagement – it has reached a peacetime high.
One crucial difference between then and now is the Bank of England enjoys independence from the government, and has done since the late 1990s. Before Gordon Brown ‘set the Old Lady free’, politics and interest rates were closely linked. Governments could tailor interest rates to boost growth pre-election, or, inflate away debt. Now, decisions on interest rates, and how inflation is controlled, are made by the nine members of the Monetary Policy Committee. It is subjective, and the MPC makes any decision with its 2.0% inflation target in mind.
The independence of the Bank of England is not under threat. However this is not the case in the US. President Donald Trump has continually and publicly criticised the US Federal Reserve, specifically Chair Jerome Powell, over their refusal to cut interest rates at the pace that Trump wants. Trump’s motives are twofold: one, to boost what he deems to be slowing US growth, and two, to reduce the interest costs on the US’ giant and growing debt pile. Just like the UK did in the 1970s, Trump wants to inflate this debt away. It may also tie into Trump’s desire to reduce the value of the US dollar. Higher inflation in the domestic currency versus a foreign currency will reduce the purchasing power of the former.
So, how do you protect yourself against inflation as an investor? One can retain purchasing power through index-linked gilts. About 20% of gilts outstanding are index-linked, that is gilts that increase in line with inflation plus a little bit. “Linkers” represent a way to protect against inflation in the long term, provided the government does not alter the way inflation is measured, something it did as recently as 2020. The financial commentator James Grant said that “debt is always repaid, either by the borrower or the lender.” With governments all over the world getting deeper into debt and continuing to run large deficits, and continuing to make promises to spend money, investors must be wary of the hidden tax of inflation.
Please be aware that the value of investments may go up or down and you may receive back less than you invested originally. Past performance is not a guide to the future.
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