323 years of UK national debt

Martin Ellison, Andrew Scott

A new dataset for the market value of British government debt makes a long-run analysis of fiscal sustainability and debt management possible. It shows that the 20th century saw a shift to financing debt by inflation and low bondholder returns, rather than through fiscal surpluses. This column uses a counterfactual analysis to show that long bonds have been an expensive way of financing debt, especially after a financial crisis. Had the government issued only three-year bonds since 1914, the level of debt in 2017 would have been lower by 28% of GDP.

The Bank of England was founded in 1694, and so this date marks the beginning of UK debt management. Based on a new dataset that has been assembled from the price and outstanding quantity of each bond issued, we have been able to determine the behaviour of the national debt over the 323 years since then (Ellison and Scott 2017). The dataset means we could focus on variations in the market value of government debt over this period, through more than 60 business cycles, six major wars, and six large financial crises.

The market value matters

The market value of debt is important. It is the relevant variable if we want to think about the intertemporal budget constraint, and makes it possible to examine the success of debt management after adverse fiscal shocks. Angeletos (2002) and Buera and Nicolini (2004) argued that if the market value of debt declines then, through the logic of the intertemporal budget constraint, this reduces the required magnitude of tax changes following a fiscal shock. With this data, we can therefore assess different debt management strategies by their ability to stabilise the level of debt.

Figure 1 Market value of debt in UK since 1694

Long-run trends in the par and market value of debt are closely linked (Figure 1), but the two are rarely equal, and the fluctuations between them are substantial. In the 18th and 19th centuries, uncertainty over the outcome of major conflicts would cause the market value to fall sharply, and then rise again afterwards. By 2017, it is noticeable that the market value of debt is at its highest historical value relative to par. The 30-year bull market in bonds has produced elevated market levels of debt.

Figure 2 Outstanding UK gilts (government bonds) since 1694

For most of our period, the UK government made use exclusively of consols – coupon paying bonds without a maturity date. It wasn’t until 1914 that the government issued its first finite maturity bond. During the 20th century, the government issued more distinct bonds, and then started to issue short- and medium-term maturities in large quantities. UK debt, however, is still characterised by long maturity – in July 2017, the weighted average maturity was 15.4 years, more than 10 years longer than in the US. In the 20th century, there has been a sharp increase in the number of different bonds that the government issues and manages. This has been achieved by substantially reducing the average size of each bond issued (relative to GDP), as in Figure 2.

Following the method of Hall and Sargent (2011), it is possible to analyse what has driven the market value of debt over these 323 years. The market value of debt is pushed up because every year coupons are payable on issued debt, may go up or down depending on whether bond prices rise or fall, and is reduced by inflation and GDP growth (because we are examining changes in the debt-to-GDP ratio). The market value may also rise or fall, depending on whether the government is running a fiscal surplus or a fiscal deficit.

Figure 3 Cumulative decomposition of change in debt to different factors

Debt has tended to reverting to the mean over the 323-year sample. Even though debt shows long-run swings, it eventually converges back to a stable level.

The means of achieving this sustainability have changed substantially. Before the 20th century, bondholders received a good real rate of return and debt was repaid through financial surpluses. In the 20th century, bondholders have on average received poor real rates of return, as the government has made greater use of inflation and has not used financial surpluses to control the debt. This shift in how debt has been financed coincided with the UK’s expansion of the electoral franchise in the 1920s (Crafts 2016).

As well as focusing on different centuries, we have also used our data to investigate how the UK financed wars and periods of financial crisis. Wartime expenditures were financed by deficits and declines in long-bond prices, with surpluses during peacetime. The government achieved debt sustainability after major financial crises (of which there are six in our sample, including the 2007-9 crisis) in intriguing ways. Government debt increased substantially during financial crises, and all the usual mechanisms of sustainability operated in the wrong way. Lower growth and lower inflation meant that debt-to-GDP rose faster than normal and, in particular, there was a large upward revaluation in the value of bonds. Long bonds were especially expensive after a financial crisis.

Figure 4 Government debt during crises

Counterfactuals of debt management

Using the bond-by-bond nature of the dataset it has been possible to run counterfactuals, to see how UK debt would have differed if the government had issued different types of debt. These counterfactuals require yield curve estimates and, as the first finite maturity bond was issued only in 1914, our sample for these counterfactuals is restricted to 1914-2016 (Figure 5).

Figure 5 Level of debt/GDP (%) in 2016 under different debt management policies, 1914-2016

We compare three counterfactual debt management policies with observed policy. In one case, the government would only have issued three-year bonds, in another only five-year bonds, and finally only ten-year bonds. The best-performing policy would have been to issue only three-year bonds. Under this policy, nominal marketable debt at the end of the period would have been 54% of GDP – 28% of GDP less than the actual outturn.

Comparing every possible sub-period between 1914 and 2016 shows this result is robust. In 98% of cases, a policy of issuing only three-year bonds would have produced better outcomes than alternative policies. The rationale for this result is simple: the yield curve usually slopes up, and so short bonds are cheaper to issue than long bonds.

This result even holds in the most recent period. In a period of historically low interest rates, there has been a tendency to view long bonds as the best way of financing large post-crisis deficits. Our analysis, however, implies this is incorrect. Issuing three-year bonds would have produced a much lower level of debt-to-GDP.

Rather than focus on cash flow, the government’s cost of funding should be based on one-year holding returns. Because of the sharp increase in the price of long bonds over this period, they have offered a high rate of return and a large increase in the value of debt compared with an issuance policy based on three-year bonds.

By issuing three-year bonds throughout this period, the government would have benefited from rising bond prices and would not have left these large gains to be accumulated by investors. Financial crises are followed by declining interest rates and rising bond prices, and this makes long bonds an expensive way to finance rising debt.

The advantages of short-term debt

Focusing issuance on just one maturity, as in our counterfactuals, may concern debt managers. We find, however, that – even allowing for liquidity effects, rollover and refinancing risks and taking into account the possibilities of leverage and buyback –over the last 100 years the government would repeatedly have been better off had it issued three-year debt. An upward-sloping yield curve makes short bonds cheap. The price of long bonds is more volatile, and often triggers increases in debt when adverse fiscal shocks occur. These properties of the yield curve over the last 100 years point strongly to the fiscal advantages of issuing short-term debt. There may be market microstructure issues that require long bonds, but our analysis suggests that the cost of this is a substantially higher level of debt.

References

Angeletos, G-M (2002), “Fiscal policy with non-contingent debt and optimal maturity structure”, Quarterly Journal of Economics 117: 1105-1131.

Buera, F and J P Nicolini (2004), “Optimal Maturity of Government Debt with Incomplete Markets”, Journal of Monetary Economics 51: 531-554.

Crafts, N (2016), “Reducing High Public Debt Ratios: Lessons from UK Experience”, Fiscal Studies 37(2): 201-223.

Ellison, M and A Scott (2017), “Managing the UK National Debt 1694-2017”, Centre for Macroeconomics Working Paper 2017-27.

Hall, G and T Sargent (2011), “Interest Rate Risk and Other Determinants of Post WW-II US Government Debt/GDP Dynamics”, American Economic Journal: Macroeconomics 3: 192-214.