Jeremy Warner: Watch out for bond yields as public debt spirals out of control

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The Independent Online

Outlook So maybe bumper City bonuses weren't such a bad idea after all. City bonuses, together with the soaraway profits that their sponsoring organisations once used to make, have been helping sustain the public finances for years. Now they are largely gone, and the public finances are looking sicker than at any time since the immediate aftermath of the Second World War.

But it is not just City bonuses and banking profits that have gone down the Swanee. Income, corporation, spending and property taxes are all suffering under the weight of deepening recession. The public borrowing rate is now notably worse than forecast at the time of the pre-Budget report (PBR) last November, and makes the forecasts contained in last spring's Budget look like cloud cuckoo land.

Nor could anyone say the outlook is at least brightening. In fact, it is darkening all the time. The only comfort to be drawn from yesterday's numbers is that the cost of bringing the liabilities of Royal Bank of Scotland and Lloyds Banking Group on to the Government's books doesn't seem to be quite as big as the combined size of their balance sheets would suggest.

According to the ONS, the liabilit-ies will add between £1trillion and £1.5trillion to public sector net debt, equivalent to between 70 and 100 per cent of GDP. Either these balance sheets have been shrinking faster than thought, or the liquid assets, which are netted off, are bigger than imagined. Whatever the explanation, the numbers are quite scary enough, and would be larger still were it not for the fact that categorising these two banks as publicly controlled bizarrely allows the Government to treat the £37bn spent recapitalising the banks with new shares as a payment to itself and therefore cancel it out. We won't get to know what the true cost to the taxpayer of propping up the banking system is until the banks are fully re-privatised.

As it is, the PBR forecast of public sector net debt rising to a maximum of 57.4 per cent of GDP over the next five years is toast. Even ignoring the banking liabilities, which because they are balanced by "assets" arguably shouldn't count, net debt now looks likely to rise to something closer to 80 per cent of GDP, and possibly higher still. This puts Britain up there with the worst in Europe.

It's anyone's guess how quickly these debts can be brought down again, but certainly there is no chance of even starting to address them for at least the next two years. When the new Budget forecasts are announced next April, they will again, with the predictability of figures made up to fit the Government's wishes, show a marked recovery in subsequent years. Is this in any way credible?

Not without steep cuts in spending and/or sharp rises in taxation well in excess of anything suggested to date. The public finances are in a terrible mess, and it's going to take years to dig us out again. The only consolation is that, for the time being, the markets seem perfectly happy to carry on funding it all. There is little sign of gilt yields rising to penalty levels. That's in part because investors have become so risk averse that Government debt is the only thing they want to buy right now.

Yet it may not ever be thus. Governments throughout the world are queuing up to borrow in unprecedented quantities. It surely cannot be long before investors start to make a distinction between the good, the bad and the ugly. Many developing countries are already finding it impossible to access the required finance. Unless Alistair Darling can demonstrate a clear road-map back to the principles of sound money, he may find himself in much the same boat.

The politics of this downturn are a good deal easier to predict than the economics. As John Major discovered after the recession of the early 1990s, voters are not going to thank the incumbent for the necessary squeeze on tax and spend. And this recession, it scarcely needs saying, looks as if it will be a lot deeper, and therefore inflict far greater damage on the public finances, than the last one. Mr Darling will be desperately hoping to delay the squeeze until after the next election. But will the markets let him?

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