Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 27 February 2024

Detoxifying government debt, part 3. The Truss crisis has no relevance for Labour borrowing to invest


Over the last fifteen years the UK has experienced or witnessed three crises stemming from financial markets, the Global Financial Crisis, the Eurozone crisis and Truss’s ill-fated ‘fiscal event’, all of which have led to a view that government debt is in some way toxic, and therefore public investment needs to be curtailed. Because it is more recent I will focus on the last, but it is worth just repeating why the other two have no relevance whatsoever.

The Global Financial Crisis occurred in large part because banks started treating risky assets issued by the private sector (US subprime mortgages) as safe assets. US, UK or Japanese government debt, by contrast, really is a safe asset. There is a literature that argues that one of the reasons for the GFC was a global shortage of genuinely safe assets, or in other words that there was too little government debt. The big increase in government debt that occurred after the GFC can be seen as a correction to that problem, rather than the problem it is usually portrayed as in the media. When Conservative politicians tried to link the Global Financial Crisis to UK government debt or deficits, they were at best ignorant or at worst lying,

The Eurozone crisis was all about financial markets refusing to buy the government debt of certain Eurozone countries. The media and political narrative was all about how these governments needed to borrow less. But the reality, hardly ever described in the media, was that the crisis arose because the European Central Bank (ECB) initially made it clear they would not be a last resort buyer of national government debt, which meant that governments could be forced to default if no one bought their debt. Once markets knew that, they were perfectly right to worry about whether they would get their money back if they bought government debt, and once that concern became significant it was almost inevitable that a crisis would unfold, and governments could be forced to default.

The moment the ECB policy changed (‘we will do whatever it takes’), and agreed to become a last resort buyer of most Eurozone government debt, then the Eurozone crisis ended. The implication, which again the media hardly ever draws, is that the Eurozone crisis has zero relevance to advanced countries with their own central bank like the US, UK or Japan.

So of the three crises, the only one relevant to the market for UK government debt is what happened before and after Liz Truss’s disastrous fiscal event. This can be thought about in three stages [1], using my simple guide to the bond market outlined in part 2 last week.

Stage one was happening before the fiscal event itself, once it became clear the event would involve tax cuts without any announcement of specific spending cuts. That put money into an economy that already had an inflation problem, so meant the Bank of England was likely to increase interest rates as a result of the fiscal event. As explained above, that means interest rates on government debt will rise. The bond markets were acting as a pricing mechanism.

Stage 2 involves uncertainty. Because spending cuts were not announced, we had no idea how plausible they would be, or even if they would happen at all, given that public services have already been cut to the bone. The uncertainty about cuts to public spending mattered to the markets because any cuts would influence aggregate demand and therefore Bank decisions on interest rates. Greatly increased uncertainty about future interest rates made markets more reluctant to hold sterling assets in general, which is why sterling depreciated despite higher expected interest rates. It made traders reluctant to buy government debt, pushing interest rates on that debt up further. (This was sometimes called the ‘moron premium’.)

Stage 3 involved UK pension funds needing to sell a lot of government debt because of a combination of their Liability Driven Investment (high leveraging) strategy and higher interest rates. Supply increased, but demand had fallen because of much higher uncertainty. We had an unusual example where supply and demand in the market for government debt influenced its price, but as we noted last week that is also when central bank intervention is likely to happen. Sure enough, It was at this point that the Bank of England stepped in as the buyer of last resort for UK government debt. However the Bank made it clear their role was to only allow pension funds time to sort themselves out, and not to reverse the impact of stages 1 and 2. [2]

The key point to note is that none of this has anything to do with ‘borrowing too much’, in the sense that an individual borrows too much and cannot pay the money back. Instead it has everything to do with trying to guess future interest rates set by the Bank of England, during a period in which further cuts to public spending were no longer politically credible. At the only point where it looked possible that a funding crisis could emerge because there were not enough people in the market willing to buy UK government debt, the Bank acted as the buyer of last resort, just as it did at the start of the pandemic.

What relevance does the Truss episode have for a future Labour government wanting to borrow to invest? It tells us that if the economy is at full capacity, and the UK government increases public investment by more than expected, paid for by borrowing rather than higher taxes, then the central bank is likely to raise short term interest rates because investment and aggregate demand will be higher. As the bond market acts as a pricing mechanism, that will raise interest rates on government debt, although by less than the increase in short term rates. [3]

In economic terms this is exactly what needs to happen. If the government wants to pay for many more people insulating homes, it needs to create the extra workforce to do that, which means reducing the demand for workers in other areas of the economy. Higher interest rates is one way the government can shift resources from the private to public sector. Note crucially that interest rates are increasing because of pressure on aggregate demand, not because government borrowing is higher. If government borrowing rose because the economy moved into recession, interest rates on government debt would follow short term rates down, not up.

Critically, however, interest rates would not rise by nearly as much as they did under Truss, because there would be no uncertainty involving possible cuts to public spending. Truss helped create a crisis because of two mistakes. The first, generally recognised, was to announce tax cuts without announcing cuts to public spending at the same time, and refusing to publish an OBR forecast that would have had to pencil in numbers for cuts. The second was to imply possible spending cuts in an environment where further cuts to spending were almost politically impossible to implement. In that sense it was a disaster created by the small state obsession of the Conservative party hitting the rocks of the political reality that you couldn’t make a state in charge of health, education and much more any smaller. It was this combination of lack of information and credibility that created the large increase in uncertainty that led sterling to fall despite higher expected interest rates.

As higher public investment should be paid for by additional borrowing, there is just no scope for the kind of shift up in uncertainty that led to stage 2 of the Truss crisis, which in turn precipitated stage 3. In that sense, the Truss crisis has no relevance to a future Labour government wanting to increase public investment.

So why is Labour acting as if the opposite is true? They may have trimmed their public investment plans on greening the economy to diminish a potential attack line from the Conservatives at the next election, but they didn’t need to justify doing so by implying the economy could no longer afford additional public investment. As I noted in part 1, saying the economy can no longer afford to borrow to invest makes no sense in economic terms, and indeed additional much needed public investment is a key way the UK gets out of its current stagnation. Starmer even talked about this government maxing out its credit card, which is a terrible analogy to use and is indicative of basic macroeconomic muddled thinking.

Next week, in the final part of this series, I will look at why there are so many myths surrounding government debt, and why it is so important that a new Labour government does not succumb to these myths.

[1] Use of the term ‘stage’ is not meant to imply a strictly sequential process, as the stages undoubtedly overlapped

[2] The Bank was undoubtedly right not to try and counteract the increase in bond rates generated by market expectations about its own future decisions on short term rates (stage 1). They were also right to intervene to provide a buyer for the government debt pension funds needed to sell (stage 3). Others can debate whether they were right or wrong not to intervene to try and offset the additional uncertainty (the ‘moron premium’) created by the government’s actions.

[3] Long term interest rates depend on expected short term rates over the period until the maturity of the long term asset. Central banks are not normally expected to keep short rates high for prolonged periods, so the interest rate on long term assets will rise by less than short term rates. 

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