Outlook Last week, I expressed the view that the recession should prove just about affordable for the UK assuming nothing further by way of fiscal stimulus. Now I'm not so sure. With the failure of yesterday's long-dated gilt auction – the first such failure in seven years – we may be seeing the beginnings of a buyers' strike that will make the fiscal deficit increasingly difficult to fund.
This was always the nightmare for government and at the Bank of England, and it may be coming true. To those of a cynical disposition, it was also the surrogate purpose behind the policy of "quantitative easing" (QE). If you are struggling to persuade investors to fund the deficit, it kind of helps if you can fund it yourself by printing money and expanding the money supply.
In any case, growing concern about the size of the deficit, Monday's unexpected uptick in inflation, and the continued absence of any credible medium-term plan for getting the public finances back on the straight and narrow are threatening to undermine much of the work done by QE in depressing gilt yields and helping to reopen credit markets. Yields are once more on the rise. Yesterday's gilt was of a maturity – 2049 – which falls outside the range being bought up by the Bank of England in its QE programme.
On the other hand, the issue should have been highly attractive to pension funds attempting to match long-term liabilities, yet it turned out they weren't interested. It's not a good outcome if the only gilts investors are willing to buy are those they can immediately sell back to the Bank of England through QE.
The Debt Management Office is under instructions to undertake its funding at different maturities to the ones used by the Bank of England for asset purchases. This is partly to avoid the aforementioned suspicion of underfunding the deficit, but also because it is illegal under the Maastricht rules for the Bank to purchase gilts directly from the Government. Unfortunately, it seems the only gilts investors want are those whose prices they know are being artificially supported by Bank of England purchases.
QE was always a high-risk strategy. Some of those risks are already crystallising in the law of unintended consequences. The Debt Management Office has said it needs to raise nearly £150bn in 2009/10, and some analysts are pencilling in something similar for the year after. The IMF is forecasting the UK budget deficit will spiral to 11 per cent of GDP next year, higher than anywhere else in the developed world and many parts of the developing world too. This looks like borrowing beyond our means and is in the ball-park that can eventually prompt an emergency flight to the IMF.
I'm not saying this is yet a likely outcome, but it is easy to see how the UK could end up in such a parlous situation. Britain exited the Second World War with crippling debts worth around 260 per cent of GDP. The consequences of this millstone were still being felt as late as the 1970s. The figures this time around don't look nearly as bad. Thankfully, banking crises are not as expensive to prosecute as world wars. Even so, total national debt could rise as high as 80 per cent of GDP. Add in the liabilities being assumed of semi-nationalised and nationalised banks, and the numbers become much more alarming – something over 400 per cent.
This too is helping to unnerve gilts markets. A bit like Iceland, relative to the size of its economy, Britain has a massively outsized, and now state- supported, banking sector. Much of this risk has been assumed by taxpayers. Small wonder that Mervyn King, Governor of the Bank of England is warning the Government off any further fiscal stimulus. The Treasury may struggle to bankroll even what we already know about.
What used in economic theory to be called the "Treasury view", after the Treasury officials who in the 1930s dismissed Keynesian thinking as dangerous twaddle, is about to be tested. One possible effect of excessive Government debt issuance is that it may cause interest rates to rise. In these circumstances, desperately needed business credit get's "crowded out", thereby undermining much of the stimulus that a big fiscal deficit is supposed to deliver.
Rising bond yields and a fast sinking currency are worrying harbingers of just such a nightmare scenario, though it ought to be added that, despite the uptick of the past few days, right along the yield curve rates are still incredibly low by historic standards. Whatever the outcome, a miserable and thankless task faces whoever forms the next government. Steeply rising taxes and deep cuts in public spending will be the hair-shirted order of the day. What a hole we've dug for ourselves.Reuse content