When Nigel Lawson became Chancellor in 1983, Margaret Thatcher told him that he needed to get a haircut because apparently he looked ‘scruffy’. This may seem unduly harsh but by his own admission he recognised that it was a reasonable request as investors would have more respect for and confidence in a clean-cut Chancellor. He was right. Markets – especially the bond market – are easily spooked. As such, it was hardly surprising that the Truss/Kwarteng Budget sent the markets into meltdown when they announced their massive unfunded spending splurge and tax cuts without any real assessment from the unfairly maligned OBR. It also obviously didn’t help that apparently in the days following the Budget, Kwarteng ended a call to the heads of major banks by saying ‘Nobody really cares about the debt these days’, much to the horror of HM Treasury officials and advisers.
I say all this because, unless you missed it, the current Chancellor was in tears on Wednesday during Prime Minister’s Questions. This was not just distressing to see but it also moved financial markets with the value of Sterling and UK Government bonds falling while gilt yields spiked.
People have been quick to interpret this as the markets thinking that Reeves is incompetent and out of her depth. While this may be true, it is not the reason why the markets got so spooked. In reality they had assumed that it meant that Reeves had been told that she had to leave or that she was going to quit. The markets feared that she would be replaced by someone with less of a commitment to fiscal discipline. This is hardly surprising given that a significant proportion of the Parliamentary Labour Party have clocked that they will probably only be an MP for one term and so are going to pursue their own agendas rather than making the tough decisions in the interests of the country. While there are some very clever and sensible Labour MPs who could be good picks for Chancellor, the markets know that they would have an even harder time than Reeves at making the necessary cuts to public spending and so would have to further increase borrowing or increase growth crushing taxes. I wrote more about this for Policy Exchange, which you can read here. Anyway, I think it all strengthens Reeves’ hand as it will be difficult to fire her and will allow her to call for more cuts and to (sadly) increase taxes in order to not increase borrowing.
We talk a lot about why increasing borrowing isn’t ideal for governments but I do not think that we appreciate enough that this is a uniquely bad time for the UK to increase borrowing. The world has shifted from a global ‘savings glut’ to, in the words of the ECB’s Isabel Schnabel, a global ‘bond glut’. Persistently large deficits and the winding down of Quantitative Easing have made government bonds (including UK Gilts) less attractive to investors.
The ECB is not the only institution that has picked up on this. For example, the Bank for International Settlements in its most recent Annual Economic Report of June this year highlighted this ‘bond glut’ (see the chart below).
This glut and a lack of interest (pun unfortunately intended) in government bonds from investors means that borrowing is now simply much more expensive for countries right now. The abundant supply of bonds and the fact that they are looking increasingly less stable than in the past means that investors want more bang for their buck and so governments have to pay higher interest rates in order to entice them. If we were to have increased borrowing (and I’m not necessarily suggesting that it would have been the right thing to do) it would have been in 2010 when borrowing was historically cheap. This is no longer the case.
Remember, this is a global bond glut and so commentators (including those who should know better) should do well to remember that when we see an increase in gilt yields and not necessarily blame the UK government.
However, I do think that the UK is in a more precarious position than many other countries and so is more likely to find itself at the mercy of the bond vigilantes. As discussed above, the markets were spooked when they thought that Reeves was going to be forced out and replaced by somebody else. The markets are beginning to suspect that the government has no credible plan to sustainably fund public spending. Who can blame them? They have seen a government with a massive majority fail to make even modest reforms to its unsustainable welfare bill and has been forced into a number of U-turns as its MPs would rather raise economically damaging taxes in order to give bungs to wealthy pensioners and public sector workers. While Reeves and Starmer may be committed to fiscal discipline, the majority of the Parliamentary Labour Party clearly is not and the markets can see this.
I do not think it’s fair for Labour to shoulder all of the blame here though. Although the Conservative governments from 2010 did face a series of unprecedented challenges (aftermath of the Great Recession, Brexit, Covid, and Russia’s invasion of Ukraine), they did very little to repair the state of the public finances and practically nothing to boost economic growth.
Governments like to go on about the need for growth (and this one is no exception) but the sad truth is we’ve had so little of it. If the economy had continued on its Global Financial Crisis trend then it would have been significantly higher than it is today and so would profits and real wages. This would have given HM Treasury much more revenue to fund public spending without having to resort to higher levels of borrowing. Starmer and Reeves have pledged to go for growth by taking on the blockers and pushing through planning reform to make it easier to build energy and transport infrastructure and new homes. All of this, coupled with tax reform, would have the potential to significantly increase productivity and economic growth. Sadly, there is little appetite for serious tax reform with this government, and an unruly Parliamentary Party means that Starmer will struggle to push through the necessary supply side reforms. Investors see all this and rightly suspect that the country won’t be seeing health levels of growth anytime soon.
It is an obvious point but it does need to be made. Government borrowing is not free money and it has to be paid back. Public borrowing and the national debt are already at historically high levels. Financing the National Debt is already one of the largest areas of government expenditure, costing over £100 billion a year which is more than the budgets for Defence, Education, and the Criminal Justice System. This is simply unsustainable and represents a significant opportunity cost as every pound spent on servicing the National Debt is money not being spent on other more socially beneficial areas or on helping to boost the economy and lower the burden on households and firms by lowering taxes. Increasing borrowing would mean that an even greater proportion of government expenditure will go towards servicing the National Debt which will not only tie our hands but also those of future generations. It is not only unsustainable, it is also deeply unfair.
All of this means that the UK is now in a very precarious place should the country face another major crisis. We assume that events on the scale of the Global Financial Crisis and the Covid Pandemic are once in a century type events. However, this is not guaranteed and, as we have seen with the war in Ukraine, the world is now much more uncertain and unstable and so we would be foolish to assume that something equally or more catastrophic won’t happen again in the short to medium term. Moreover, there was a genuine fear during the GFC and the start of the Pandemic that the DMO’s gilt auctions would fail to raise enough money to keep things going and in both instances the Bank of England had to extend the government’s Ways and Means Facility in order to fund public spending. If a similar crisis were to happen within the next few years then the government wouldn’t be able to raise anywhere near as much on the markets and so would be limited in what it could do to support firms and households. There will be no furlough, for example.
Now is the worst time in modern history for the UK to increase borrowing. While I don’t agree with most of her policies, Starmer would be a fool to get rid of Reeves. She should stick to her guns and Starmer should back her. Now is not the time for even higher taxes and it is definitely not the time to increase borrowing which would be both reckless and unfair to future generations. Instead the government must urgently pursue economic growth by pushing through supply side reforms while also bringing public spending down to more sustainable levels.
Thanks as ever for reading. Enjoy your weekend!