October Budget 6: Thanks to Truss, bond market scare stories are back

 

In truth they never went away, but after Truss there is a danger that they will be taken more seriously. The FT recently published a classic of its kind, entitled “Gilt investors urge Reeves to keep investment ambitions in check”. The subheading read “Markets on edge ahead of overhaul of fiscal rules that could result in tens of billions of pounds of extra borrowing capacity”. Sounds scary, but worse is to come.

The article warns that Reeves may “bump up against tight constraints in the bond market as investors warn they have a limited appetite for fresh UK debt”. One trader suggested that anything more than £10bn to £20bn in additional borrowing could “push gilts over the edge”. The language of ‘constraints’, ’on edge’ or ‘over the edge’, and ’limited appetite’ all suggest the potential of a crisis where the government can no longer sell its debt.

As a result of this and other similar articles, I have seen plenty of pieces from political commentators warning that the budget might ‘spook the bond market’. This suggestion, along with the accompanying language, is complete and utter nonsense. The idea that if Reeves wanted to borrow an extra £30 billion, say, the markets would refuse to lend that to the UK government is just ludicrous. Reeves will not bump up against any constraints from the bond market for anything she is realistically likely to do.

What is possible is that a lot of extra borrowing might lead lenders to the UK government requiring a better interest rate. But this has little to do with supply and demand for UK government debt, and instead reflects expectations about what the Bank of England might do in the future (‘arbitrage’). If additional borrowing is associated with additional aggregate demand for UK goods, this will increase inflationary pressure, which in turn will mean the Bank keeps interest rates higher than they might otherwise have been. I discussed the mechanism for this in more detail here. At the end if this post I briefly discuss what the inflationary impact of additional public investment might be. 

This is exactly what happened initially with the Truss fiscal event. With inflation high and rising, the Bank of England were raising interest rates because they thought that strong labour demand coupled with weak supply could make the impact of the energy and commodity price shock more persistent. A fiscal event that cut taxes would only add to aggregate demand, meaning that the Bank would have to raise short term interest even further. If short term interest rates are expected to rise, so will the longer term interest rates in the market for government debt. Markets didn’t stop buying government debt, but they made it clear they wanted a higher interest rate on this debt because short term interest rates were expected to be higher as a result of the fiscal event.

With Truss, two factors turned normal market behaviour into a crisis. The first was peculiar to what Truss was doing. By announcing tax cuts without an accompanying OBR forecast, and with no clear indication of whether these would be followed at a later date by spending cuts (and if so, by how much and how credible were such cuts with public services already in crisis), accompanied with suggestions more tax cuts were to come and maybe Truss and others thought these tax cuts would ‘pay for themselves’ by boosting growth (which most people in the markets knew was false), the overall direction of fiscal policy suddenly became much more uncertain. [1]

By throwing a well established fiscal framework out of the window, Truss greatly increased the amount of uncertainty in the markets. If the return on an asset suddenly becomes much more uncertain, then other things being equal most would feel less inclined to buy that asset. The demand for Sterling assets fell, which is why Sterling depreciated when an appreciation would normally have been expected.

This increase in uncertainty led to interest rates in the market for government debt rising further still. That produced a second peculiar event, which was that pension funds suddenly had to sell a lot of their government debt (more details here). With few buyers and many sellers, the market for government debt became too thin for arbitrage to work, leading the Bank of England to step in as buyer of last resort (just as they did during the early stages of the pandemic).

These two factors, Truss’s departure from the OBR monitored method of fiscal policy making and the pension fund crisis that caused, were what turned what might have been a normal and relatively modest upward movement in interest rates into a crisis. Nothing Rachel Reeves will do in her budget is comparable with this. She has not sacked the most senior Treasury civil servant, she has not dispensed with the services of the OBR, and it is the OBR not Reeves that is making the reasonable case that additional public investment will almost pay for itself.

Which makes all talk of markets going ‘over the edge’ if Reeves increases borrowing to fund that investment just ludicrous. So why do we see that kind of nonsense written in otherwise sensible newspapers like the FT, alongside similar scaremongering from more predictable sources. A lot is simply political. Do you remember all the articles warning that the Truss fiscal event would spook the bond markets in the weeks before it happened? I don't.

Scaremongering works because of an absence of understanding, with most people having little idea of how financial markets work. Two things follow. First, articles warning of a crisis will be read rather than dismissed, which is good for the journalists that write them. Second, the words of market participants are given far too much weight, because they are seen as people who do know how markets work. That means all too often that financial markets are treated like a capricious god, and City economists like high priests. 

The reality is that it is not hard for any journalist to find market participants willing to say that extra borrowing will lead to a crisis, but the market also contains analysts who are much more sensible. As an example here is a piece by Will Dunn, which first quotes a City economist warning of a buyers strike if borrowing rises, but then quotes another giving a much more reasonable analysis along the lines outlined above.

The lesson is to ignore any article or any City economist that predicts a bond market crisis as a result of any normal budget where borrowing might be higher than previously planned. Higher public investment financed by additional borrowing might add to inflationary pressures, which might mean the Bank cuts interest rates more slowly than it otherwise might have done leading to moderately higher interest rates on government debt, but that ain’t no crisis and in my view is a price worth paying for much needed investment and improving economic growth.

But will additional public investment add to inflationary pressure? I ask because I read this, where Dan Davies discusses a brief interchange between himself and NIESR head Jagjit Chadha. Jagjit suggests that because public investment supports future supply, and because inflation setters are forward looking, any short term pressure on aggregate demand might not find its way into inflation.

I don’t buy this argument, even on its own terms. Yes, public investment will directly or indirectly improve the future capacity of the economy to supply goods and services, but there is no reason to think that aggregate demand will not expand to fill that capacity of its own accord. For example, if public investment helps improve future productivity, wages are likely to rise in line with that as they normally do, leading to higher consumption and aggregate demand.

What the Treasury can do is be aware of any inflationary dangers in choosing what investment to prioritise (as well as ensuring that projects are worthwhile in standard cost benefit terms). For example, as I have mentioned before, projects that involve buying stuff from abroad (e.g. MRI scanners) put less pressure on aggregate demand than projects that are entirely home produced. The US experience suggests it is possible to substantially increase investment without creating significant persistent inflationary pressure, and with sensible planning it may be possible to do the same in the UK. 

[1] If these tax cuts were quickly followed by credible spending cuts, the overall impact on aggregate demand would be negative, because some of the tax cuts would be saved. This would mean the Bank would lower, not increase, interest rates. In contrast, if those in charge really did think these tax rises would pay for themselves, and intended to do more of them, then the Bank would have to increase interest rates by a lot.