Scare stories about UK fiscal policy seem a regular occurrence nowadays. The latest is the idea that the UK might have to go to the IMF for money. It’s nonsense of course. The UK government cannot run out of money because it can create reserves, just as it did when the world’s bond markets dried up at the start of the pandemic. Current levels of debt to GDP rose a lot because of the Global Financial Crisis, austerity and the pandemic, but it is still below levels between 1917 and 1960.
But, as is often the case, there is a grain of truth in the recent concern. Inflation is coming down slower in the UK than in the US and Europe (although tariffs and deportations mean inflation is likely to rise again in the US.) That is one reason why interest rates on government debt remain pretty high in the UK.
While current (end August) rates on UK 10 year government bonds are 4.7%, for the US they are 4.2%, France 3.5% and Germany 2.7%.
This matters partly because it means the government has to pay these higher rates on the debt it issues, and higher debt interest payments mean either higher taxes or less money for public spending. (My own view is that it should be higher taxes, because most of those higher interest payments are going to UK individuals or institutions.) It also matters because other long term interest rates in the economy are influenced by bond rates, so higher bond rates mean higher mortgage rates, a higher cost of firm borrowing and so on.
The rates shown above are for 10 year government bonds. (If you buy them now, you get what you paid back in 10 year’s time.) One interesting feature of UK government debt at the moment is that interest rates rise the longer the maturity of the debt. The current interest rate on UK 30 year government debt is almost a full percentage point above the 10 year rate. Now that is not completely unexpected. Investors normally need something a bit extra to lock their money away for a long period, or risk having to sell in a volatile bond market.
However, the additional interest on a 30 year bond compared to a 10 or 3 year bond has been increasing recently. There are a number of possible reasons for this. One is global uncertainty, caused in particular by the antics of Donald Trump. In times of uncertainty people like to stay flexible, which in financial terms means staying liquid and avoiding long term commitments. The rise in 30 year bond rates relative to 10 (or less) year bond rates appears to be a global phenomenon.
Other specifically UK factors could involve supply and demand factors, plus some reason why arbitrage breaks down (such as the long time frame to make any profit.) One of these is the Bank of England selling off its stock of government debt built up under the Quantitative Easing programme. (Whether the Bank should be unwinding QE right now is another matter: see Carsten Jung of the IPPR here, for example.)
But there is yet another potential factor that should be raising bond rates in the UK beyond the short term, and that is the threat of a populist government. There are three reasons why the prospect of a populist government should lead to higher interest rates on longer term government debt. The first is central bank independence. Populists (by definition in the way I use the term) don’t like institutions that are independent from them yet that can take decisions that influence them. Populists also often (but not always) take stupid economic decisions, like cutting interest rates when inflation is likely to rise.
That matters a lot for anyone thinking about buying a government bond whose value is fixed in nominal terms (as most are). A period of inflation will reduce the real value of that bond, so anyone buying that bond will require a higher interest rate to compensate for that risk. Trump is a good example here. He has explicitly said that he thinks interest rates should be lower because the economy is booming (in his view), which is an idea that would help you fail a first year undergraduate economics exam. At the moment an independent central bank controls US interest rates, but Trump would like to replace the current decision makers with people who would do his bidding (effectively ending US central bank independence).
When Trump attempted to fire Lisa Cook, a central bank governor, under some fabricated pretext, this was seen as him stepping up his attempt to take control of the US central bank. The reaction of markets followed the analysis above. Rates on short term government debt fell, because Trump wants lower rates. However interest rates on longer term US government debt rose because of the prospects of higher inflation (coupled with the fact that someone at some point would raise interest rates to bring that inflation under control.)
The second reason bond markets should really worry about a populist government is default. A normal government in the UK or US would never choose to default, because the political costs of doing so far exceed the cost of servicing the debt. In addition, as noted above, a UK or US government cannot be forced to default. A populist government is, however, another matter. It is much more conceivable that a populist in power might choose to default on the government’s debt, although reducing real debt through higher inflation is still more probable. Even a very small chance of default would require significantly higher interest rates on government debt to compensate, as we saw in the Euro crisis.
The third reason why populist governments are likely to lead to higher interest rates on government debt is that they tend to make economic promises that can only be reconciled by higher budget deficits. Higher deficits will tend to raise interest rates not because they raise the chances of default (although see above) but because they add demand into the economy, which requires higher rates to offset its impact on inflation.
The example of Trump does raise an issue, however. Given his clear threats to central bank independence, the fact that he has flirted with the idea of partial default in the past, and that he has increased the deficit by giving tax breaks to the rich, why are interest rates on US government debt not even higher? One answer is to say the US is special, and there will always be an international demand for US government debt. Paul Krugman has a different answer, which is that markets typically discount the chances of a crisis until it is almost upon us.
In what is now the constant drip of scare stories about UK fiscal policy, there are two types. The first is pure wishful thinking by the (far) right. Here is Allister Heath of the Telegraph, thinking an impending debt crisis will force an early General Election. These are often the same people who thought Truss’s budget was wonderful.
The second and more interesting group involves more reputable and well intentioned economists, who sometimes raise legitimate issues. But there is always a danger for economists, which is that they focus on the economic details while ignoring the big political elephants in the room. If you are worried about levels of debt or debt interest in the UK and want to see debt to GDP falling, then focusing on fiscal rules or institutional fixes is not going to achieve very much as long as two big political hurdles remain in place.
The first elephant, as I have already mentioned, is the possibility, perhaps probability of a right wing populist government taking power in the next decade or so. Not only will this government probably ignore or cast aside any fiscal rules or institutions, they are also likely to greatly increase deficit finance simply for their own political gain. Under a right wing populist government, current worries about UK fiscal sustainability will look rather ridiculous.
The second, which is related to the first, is that in the UK any alternative to a populist government seems unable to raise taxes on income. Calling this cowardice by these governments misses the key point, which is that there is a general political belief that not pledging to keep current tax rates on income constant has a significant electoral cost. There are two possibilities. The first is that this belief is wrong. The second is that we have a political/media system that allows enough voters to believe that they can have both lower taxes and higher public spending. More needs to be done to show that if we want a level of public services similar to our Western European neighbours, we need to stop having a lower level of taxes than our Western European neighbours.
