Despite having increased substantially since the financial crisis, the face value of UK government debt is currently below its average value for the period of over 300 years since the late 17th century. At the same time, the market value of UK government debt is more than 30% higher than its face value, a differential last seen in the early 1700s – and a result of the substantial appreciation of bond prices in the face of lower interest rates following the financial crisis.
These are among the findings of research by Professors Martin Ellison (Oxford University) and Andrew Scott (London Business School), to be presented at the Royal Economic Society''s annual conference at the University of Bristol in April 2017. Their study constructs a new historical database, built up bond-by-bond, that calculates the market and face value of UK government debt from 1694 to 2016; and corrects the National Accounts so that the government''s fiscal deficit includes not just interest payments but also changes in the value of outstanding government bonds.
The researchers use this long-run database to examine how the UK government has controlled its debt over time. And they use their bond-by-bond dataset to examine whether alternative debt management strategies would have achieved better outcomes than the actual policies pursued.
Summary
• We construct a new historical database, built up bond-by-bond, that calculates the market and face value of UK government debt from 1694 to 2016.
• We correct the National Accounts so the government''s fiscal deficit includes not just interest payments but also changes in the value of outstanding government bonds.
• We use this long-run database to examine how the UK government has controlled its debt over time.
• We use our bond-by-bond dataset to examine whether alternative debt management strategies would have achieved better outcomes than actual policies pursued.
Results
• As of 2016, the face value of government debt, despite having increased substantially since the financial crisis, is below its average value for the period 1694-2016.
• As of 2016, the market value of government debt is more than 30% higher than its face value, a differential last seen in the early 1700s. This is due to the substantial appreciation of bond prices in the face of lower interest rates in the wake of the financial crisis.
• Until the 20th century, governments used primary surpluses to reduce debt. In the 20th century, inflation and poor returns for bond holders were used to reduce debt even in the face of primary surpluses
• The return to bond holders – for example, the cost of borrowing to the government – comes from coupon payments and capital gains. The actual government deficit series only includes cash payments, for example, coupons, and not the capital gains. Including capital gains boosts the fiscal deficit by an average of 1.5% of GDP since the financial crisis.
• The period since 1997 has seen the highest real return (3.8%) to bond holders across our sample. Long bond holders have particularly benefited from this increase in bond prices. It is this that makes long bonds expensive to issue.
• UK government debt is distinguished by a high average maturity of around 10 years. Given the low level of interest rates on current long-term debt, there are repeated claims that the government should issue even longer-term debt.
• But we find that had the government since 1890 issued just three-year bonds every year, then the level of government debt today (the market value of outstanding bonds) would be approximately 20% of GDP lower than it is. Had the government since 2007 issued only short-term debt, the level of debt would similarly be about 20% of GDP lower.
• Comparing issuing three-year bonds with ten-year bonds since 1914, long bonds would have produced a lower level of debt in only 10% of occasions.
• The period since the financial crisis is historically unusual in terms of the rates of return achieved by long bond holders – the highest for 300 years. This high rate of return has played a substantial role in pushing up the market value of debt to GDP ratio to its current level.
