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.
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