What Would it Take to Stabilize UK Debt?

The UK, like a number of other developed economies, is facing a difficult fiscal outlook. Public debt, at 101% of GDP and climbing, is historically high outside of major wars.

At the same time, the deficit was 5.7% of GDP in 2024—the third-highest among European countries.

And borrowing costs are high, particularly when compared to growth, while elevated inflation makes it harder for the Bank of England to reduce rates. 

“The combination of those factors suggests there is a challenging fiscal outlook, and significant consolidation steps will be needed to make sure that the debt outlook remains sustainable,” says Jari Stehn, Goldman Sachs Research’s chief European economist. 

But there are factors playing in the UK’s favor, including strong fiscal institutions, a track record of successful fiscal consolidation, and monetary sovereignty. 

We spoke to Stehn about why UK debt and deficits are so high, how markets are responding, and what it would take to stabilize the fiscal situation.

You estimate that the UK needs to attain a primary surplus of 1% of GDP to stabilize debt, requiring a large fiscal consolidation of around 3% of GDP. Is that realistic?

It's ambitious when you look at the UK's own history of fiscal adjustment. And it's been a while since the UK last ran a primary surplus of 1% in the early 2000s. It's also pretty sizable when you compare the required adjustment to what other countries have achieved over time. So it’s a tall order.

At the same time, the UK has an encouraging track record of achieving consolidation. When you look back over time—and you can do this with very long-run data in the UK, going back to the 1700s—you see that the government has typically responded to rising debt by raising the primary balance. 

What experience have other countries had in fiscal consolidation?

When you look at historical fiscal consolidations across countries, what you see is that spending-based fiscal consolidations tend to be more successful than tax-based ones. They generally lead to a more sustained improvement in public finances at a lower cost to growth. 

There are quite a number of studies that have shown this. I think the rationale for this result is that it's harder to cut spending than to raise taxes politically, so markets typically reward spending-based consolidations. 

Interestingly, central banks tend to cut policy rates in response to spending-based adjustments, whereas they typically raise interest rates in response to tax-based adjustments, because there can be inflationary consequences. I think that's an important insight: Fiscal consolidations that focus on cutting spending tend to be more successful and lead to better growth outcomes than revenue-based ones. 

Typically, when it comes to tax increases, the best way to do that is to raise taxes on broad bases rather than focusing on very narrow tax bases to improve the fiscal outlook. 

How does the structure of UK debt affect borrowing costs?

The UK stands out relative to other countries for having a large share of inflation-linked debt. Given high inflation, that’s been an unfavorable characteristic of the debt structure recently. 

The ownership structure of gilts has also changed in recent decades. The proportion of debt held by domestic pension and insurance companies has declined significantly, and the share held by foreign investors has risen.

The Office for Budget Responsibility (OBR) has argued that overseas investors are less likely to have a structural desire for sterling assets, and so small shifts in the outlook can lead to relatively large shifts in gilt holdings and amplify volatility. So I think these shifts in the ownership structure of gilts have been an important part of the challenge that the UK has faced in recent years.

Ten-year gilt yields are the highest in the G7. Why are they so high?

First of all, you have to distinguish between the rate expectations component of long-term yields and the term premium (the risk premium that investors demand on top of expected short-term rates). When you look at the UK, not only are ten-year yields the highest across advanced economies, but the term premium component is also the highest.

We estimated a model to try to explain why the term premium is so high. Usually, variables like the unemployment rate, public debt, inflation volatility, and also a measure of the global term premium help to explain the ups and downs of the UK term premium over the last 25 years. But you also see that the UK term premium, particularly over the last year or so, has risen quite a bit more sharply than implied by the model. 

So there's an unexplained part which accounts for almost 100 basis points in this model, which corresponds to how much we think markets are over-penalizing gilt yields given the fundamentals of the UK economy. 

Our view is that we will get a contractionary budget in November coupled with some improvement in inflation in the coming months, and therefore more Bank of England cuts. We expect that to be a catalyst for long-term gilt yields to continue to decline. 

What factors are in the UK’s favor?

The first is that the UK has strong fiscal institutions—in particular the OBR scores very well compared to fiscal institutions in other countries. It’s very independent, it has an important role to play, and there's a lot of evidence that fiscal institutions like this help to achieve better fiscal outcomes. 

The second is the UK’s track record of fiscal consolidation. When debt goes up, the government tends to adjust the primary balance. You don't see that in all countries—in France, for example, that stabilizing response is much weaker. 

The third point I would mention is that the UK still has capacity to increase tax revenues. Government revenue levels in the UK are in the middle of the range compared to other countries. Revenues are higher than in the US, but significantly lower than in France or Italy. So from an economic perspective, I think there's still some room to consolidate. 

And lastly, the UK has monetary sovereignty—in contrast to France or Italy. That’s important, because the Bank of England can support the economy when the government consolidates. It’s also much easier for central banks to respond to periods of fiscal stress when they have monetary sovereignty. 

Take the example of the 2022 ‘mini-budget’, where the Bank of England quickly stepped in to stabilize the debt market. That was much quicker than the response of the European Central Bank during the Greek crisis. And that's quite natural when it's a single country and a single central bank issue rather than a monetary union.

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