The impact of government debt on investors

I have in recent weeks increasingly been asked by clients: “What impact could the government debt have on our assets?”

The co-ordinated response of governments across the world to the pandemic-induced collapse in economic activity has been to inject hundreds of billions of pounds of borrowed money into the system in an effort to plug the gaping holes inflicted upon the economy by the virus.

A particular feature of this policy response is the extent to which policy makers and commentators around the world accepted the need for governments to borrow money and spend it at this time.

One of the negatives that typically arises from higher levels of government borrowing is much higher inflation in the short term. This can happen either because too much cash is pumped into the economy, so demand rises faster than supply, or because the extra currency entering the system leads to a fall in the value of the currency, making imports more expensive.

We are of the opinion the reduction in economic demand has been so severe that inflation will remain low for an extended period.  In addition, the unemployment rate may be relatively high for a prolonged period of time. This is deflationary in an economy as it means individuals have less money to spend.

Government debt never really needs to be paid back. It shouldn’t be forgotten Britain finally repaid its World War Two loans on the 31st December 2006. What will happen with the debt is over time it is refinanced, that is, as the bonds mature and investors get their capital back, the capital is repaid with newly issued bonds. It should be noted that ten year UK government bonds currently have an interest rate of 0.1 per cent.

It is not the case that the UK government will in ten years have to find all of the money to repay bondholders, though the uncertainty comes from what interest rate the government will have to pay on the debt in ten years. If it is much higher than the current rate, that will create future funding problems, however, the government will clearly be motivated to keep interest rates low.

The nature of the recession

While the definition of a recession as two consecutive quarters of negative growth is universal, there are a multitude of different types of recessions. The downturn caused by Covid-19 is what economists call an exogenous shock, that is, caused by an event outside of the financial system.

Such recessions tend to be very sudden, very deep, and over very quickly. They end relatively quickly because if the shock is from outside the system, as the shock subsides, the system is intact and activity can return to previous levels.

This is the thinking behind those who believe the UK economy will recover in a V shape.

However, we do not view this as a typical exogenous shock-induced recession, because the impact of the pandemic may have changed long-term societal trends. For example remote working, will lead to “permanent “ changes in the structure of the economy.

Exogenous shocks do not typically leave permanent changes, but the combination of the Covid crisis and the changes to society are creating “lost growth” which will not be recovered by the economy.

The multiplier effect

The rationale for government’s increasing spending in a downturn was first created by the UK economist John Maynard Keynes, who described a “multiplier effect”. This is the idea that, if the government stimulus is spent properly, it can generate more activity and wealth in the economy than the cost of the original debt.

Some economic activities have a larger, and faster acting, multiplier than others. For example, a pound spent by the government on a construction project tends to move quickly through the economy as such a project employs many people in different trades and requires the purchase of raw materials.

If the multiplier in an economy works, then the pace and rate of Gross Domestic Profit growth should increase rapidly.

Using borrowed money to increase the salaries of already relatively highly paid people may not have the same effect, as the extra salary may not be spent quickly.

We fear that despite the vast sums pumped into the economy, we do not expect the multiplier to be high in the UK. While a lot of money has been pumped into the economy, it has not delivered the traditional benefits of a stimulus. This is because while the money went in, we were told to not go out, we couldn’t spend it, so it didn’t multiply. We also think there are factors in the UK such as the ageing population that were already present and not really conducive to growth.  What we now wait to see is how we come out and spend and this is clearly key to some of Rishi Sunak’s policies, i.e. Eat out to Help out.

We are also concerned that the borrowing and spending now may actually reduce the multiplier of future government spending. By this we mean the cash that has been spent now is to sort out an emergency. It is absolutely the right thing to do, but it also is likely to mean that there is less ability to borrow in future, so there would be less cash for spending on long-term projects in areas such as infrastructure that contribute positively to economic growth. As a result it may be the borrowing now, lowers the longer-term growth rate in a way that is almost permanent.

Other policy decisions taken over the past decade probably mean any multiplier effect will be much slower. The policy of quantitative easing, whereby the Bank of England buys government debt and other bonds helps to keep borrowing costs low, but also reduces the multiplier achieved on that debt. This is because the bond buying programme causes asset prices to rise.

So, for example, in the decade after the global financial crisis, house prices in the UK rose much more quickly than did incomes. This meant people seeking to get onto the housing ladder had to save more of their income and for longer to do this, and that reduces the amount they can spend in the economy.

So, here is the positive with central banks continuing to buy bonds as part of the Covid response, we believe the rise in asset prices is likely to continue. The reality being those with assets will be a beneficiary of the borrowing as a result of increases in asset prices and those that have to save to buy assets will need to save more.

Portfolio impact

It is a central tenet of investment theory that if interest rates are low, then equities will rise in value. This is because many equities are priced relative to the return available on cash on bonds. Low bond yields and low interest rates therefore make equities relatively more attractive.

With interest rates unlikely to rise by very much for many years into the future, this will be supportive of equities and this will be another positive for our clients. Though we will witness lower equity returns in the years ahead, but the returns will be more attractive than those available from other asset classes.


Whatever the climate, we are here to help you to manage your finances and plan for your family’s future. 

If you would like a consultation with one of our Independent Financial Advisers about recent changes in your finances, do not hesitate to contact us by email: info@innesreid.co.uk or on our normal number: 01244 347 583 during office hours.

For further business updates regarding coronavirus, please visit our designated webpage at: www.innesreid.co.uk/coronavirus/


Past performance is not a reliable indicator of future performance. Investors should remember that the value of an investment and the income received from an investment can go down as well as up, and they may not get back the amount they invested.

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