Government Debt

The headlines have been filled with articles about the exorbitant levels of government borrowing which reached over 99% of GDP through the month of February while many publications discuss the level of debt, it is rarely disclosed what the actual impact of this debt is. Below, we cover some of the potential repercussions that continued high levels of government debt could have on the UK.

Higher Taxes

The government has three main sources of revenue in the form of Taxes, the Creation of Money and Borrowing. A deficit occurs when levels of government borrowing are greater than the amount the government is able to earn in taxes and naturally one way to reduce the deficit is to increase taxes. It has already been revealed in the Chancellor’s Spring Budget that corporation tax is set to rise to 25% which will make the UK economy less hospitable to businesses which in turn can lead to slower growth of the economy.

Lower Growth in the Economy

Working papers released by the European Central Bank featured research that concluded that a “higher public debt-to-GDP ratio is associated, on average, with lower long-term growth rates at debt levels above the range of 90-100% of GDP.” Given that government borrowing in the month of February reached over 99% of the UK GDP we are well within this range meaning that the UK economy is likely to see stunted long-term growth.

Less Favourable Exchange Rates

High levels of government debt can lead to the value of the Pound Sterling being limited. This can have a wide-ranging series of effects not just limited to Forex traders; poor exchange rates can impact the costs of imports and exports to and from the UK, they can lead to fluctuation in the value of your investment portfolio and a weak currency will likely lead to a rise in inflation.

Increased Inflation

Higher levels of government debt can lead to increased inflation in a number of ways, as mentioned before, a weak currency caused by debt can in turn cause inflation to rise. More directly, the government have a limited number of ways to fund the interest incurred by higher levels of national debt; the two best options for the Government to get these funds are austerity measures and ‘printing money’. Austerity measures include raising taxes and reducing the expenditure of government benefits which often leads to increased inflation as those with higher taxes and lower benefits seek higher salaries to make up the difference. Alternatively, if the government opts to ‘print more money’ the value of currency reduces significantly meaning the cost of imported goods rises and the value of exported goods depreciates.

Inflation

Reports revealed this week that UK inflation hit 10.4% through February, doubling expert projections, reversing the drop in rates experienced at the start of 2023 and growing closer to the 11% peak late last year. This unexpected rise exemplifies the extreme turbulence gripping the global economy. More astounding still, it was reported that Food and Beverage prices were up 18.2%, adding yet more petrol to the slowly smouldering cost of living crisis. With UK Inflation sitting at significantly higher rates than the US and the Eurozone, British investors must seek assets that can serve as strong inflation hedges.

“Falling inflation isn’t inevitable” – Jeremy Hunt

As the Chancellor states, we cannot just expect inflation to drop, so investors must uncover opportunities that permit them to reliably hedge against inflation. The issue lies in discovering which investments are likely to earn their investors a growth rate greater than the ever-rising rate of inflation.

Interest Rates

As a result of climbing inflation, the Bank of England was forced to raise interest rates to 4.25%, a move that may benefit savings account holders but will serve as yet another of many blows suffered by buy-to-let investors who have faced ever-burgeoning pressure since George Osbourne announced cuts to buy-to-let tax relief in 2015. Increased interest rates also lead back to the issue of government debt, when interest rates are hiked, the cost of government borrowing increases. This in turn creates a necessity for the government to increase their revenue via the avenues discussed earlier in this article.

Higher interest rates may also lead to a drop in consumer spending and investment which can cause lower economic growth or potentially even negative growth which equates to a recession. Higher interest rates are also related to a rise in unemployment; as consumption falls there is less demand and with less demand, companies are forced to reduce their output and as a result, must reduce their staff to remain profitable.

Only 4 of the 10 strongest performing alternative investments; art, cars, watches and handbags experienced growth of matching or exceeding that of inflation last year with art topping the list, bearing a phenomenal 12-month growth rate of 29% in 2022. The Times reported earlier this year that “art is the most rapidly appreciating luxury asset in the world,” surpassing many more prominent alternative investments such as equities and gold. Art investments have seen a meteoric rise in value for a number of reasons, most notably the growing popularity from Asian markets, Phillips auction house reported a 77% increase in art sales from Hong Kong in 2022 exemplifying the boom in demand from Asian consumers which drives demand globally.

With the value of art growing at such a significantly higher rate than that of inflation, it is clear that art investments can serve as a valid hedge against inflation. Art’s annual growth of 29% outperforms even the highest level of inflation experienced in the UK since 1960 which reached 24.21% in 1975 which should exhibit just how reliable art is as a hedge against inflation.