UK bond markets have become a political trap that stifles public spending. But there is a way out Sahil Dutta
MMore than three decades ago, James Carville, a political adviser to Bill Clinton, made what became a famous quip about the power of bond markets to “scare everyone.” Clinton took office promising to transform America’s infrastructure, then was told that huge public spending would scare off investors, raise borrowing costs, and sink his presidency.
Today, if there is one thing that Clinton’s Britain and the United States have in common, it is that bond markets once again loom large in policy debates. Clinton has postponed large-scale investment plans and welfare cuts because he believes that doing so will prove his economic credibility with investors. Likewise, in Britain, since Liz Truss’s failed mini-budget, politicians have consistently pointed to the risk of a bond market revolution as the reason behind the unaffordability of public investment.
Bond markets are undoubtedly important. Governments and central banks support public spending by selling bonds to investors in financial markets. When these investors lose confidence, demand for bonds declines, and governments feel forced to pay higher interest rates to keep investors on side. When the cost of borrowing rose globally after the pandemic, this particularly affected Britain. Having borrowed heavily for rescue Banking sector in 2008 and again during Covid, the country’s national debt is now 101% of GDP. This imposes real constraints on public spending. But the idea of a financing crisis is exaggerated.
On the one hand, investor demand for government debt remains resilient, and yields – the rates the government pays to borrow money when it issues bonds – are lower than they were during most of the New Labor era. If the government wanted to improve living standards, it could raise taxes and borrow to invest in local government, public housing, and public transportation. In an attempt to limit the impact of negative bond market reactions, the supportive Bank of England can use its balance sheet to buy government debt itself. By increasing demand for government bonds, yields can generally be contained.
All of this means that governments have choices about how they respond to bond markets, and that these choices are guided by policy, not cold economic necessity. If the bank is still forced to raise interest rates and hit leveraged investors and mortgaged homeowners with higher costs, other interventions – such as adjusting utility rate caps and imposing rent controls – could mitigate the broader impact. Whatever path the government and the World Bank take, there are winners and losers. The important point here is that the beneficiary is a political choice, not market dictates.
At this moment Labor and the Bank appear to have made up their minds: contain public investment, control the growth of disposable income, and hope for lower interest rates. Ironically, this approach may intensify pressure on the bond market. Take Labour’s fiscal base. While Labor believes this is a way to reassure investors, it actually creates uncertainty for them. Twice a year, the government must prove that it is on track to deliver on its promise that current spending will be matched by tax revenues, and debt as a share of GDP will decline, which forces the government to make knee-jerk changes to taxes and spending when expectations change.
It’s a similar story with taxes. The stronger a country’s tax base, the safer and more desirable its bonds are for investors. Since publishing its manifesto, Labor has hidden behind a fantasy that growth would naturally lead to higher tax revenues, and so redistributive taxes would not be needed. The government now faces a reality where GDP grew just 0.7% over the past year. This is an opportunity to comprehensively overhaul the tax system, reducing the government’s need to borrow from the bond market and providing the basis for repayment when it does.
The other fundamental problem is that we have come to view central banks as institutions isolated from democracy or people’s daily needs. Instead, we view them as institutions that exist primarily to keep financial markets happy. This is inherent in the bank’s design. Shortly after the bank was granted formal independence to set interest rates in 1997, it became independent Debt Management Office It began to deal with the issuance of the national debt. This has been justified, once again, in the name of bond markets. It established the idea that governments have the power to levy taxes, but not the power to formulate the terms under which public spending is financed.
It is worth noting that this was not always the case. From the 1930s to the 1950s, the Bank worked with the government to restructure the national debt and reduce the interest payments the government faced on war debt. The national debt was much higher than it is now, but the so-called cheap money policy designed by the Bank and the Treasury supported the war, and helped Labor rebuild the country once the war was over. This approach continued until the 1970s. More recently, the bank bought huge holdings of government debt to support Covid-19 bailouts, once again demonstrating how closely debt management is linked to government policy.
Recognizing that public spending is a political choice made by governments, rather than one dictated remotely by financial investors, is especially important now. The poorest 40% of UK households are set to see their living standards rise Fall dramatically Through this Parliament. Public investment is an urgent part of reversing this trend, but it will be much more difficult to implement without reforming the foundations of public finances.
After promoting the newsletter
There is nothing preventing the government and the World Bank from working together in the service of national renewal, and there are many places where this could start. At present, the bank costs the government approx 20 billion pounds annually In its handling of public debt, this is partly because of the interest it pays private banks on reserves created during QE, and partly because it is now selling those government bonds back into the market at a loss (these sales also threaten to push yields higher).
The government could change the rule that makes it responsible for losses incurred by a bank due to interest payments and bond sales, or it could recover some of these costs by imposing a tax on banks’ windfall gains. At the same time, the bank can stop bond sales when they incur losses. Carville had another infamous phrase: “It’s the economy, stupid!” A real healthy economy will come from government taking responsibility for creating real change, not conjuring up bond markets to avoid that change.