Contrary to popular opinion, the UK gilt market – the market in government IOUs – has not yet collapsed, despite the ongoing increase in national debt. Nevertheless, following Alistair Darling's pre-Budget report, the gilt market has had a rather unpleasant wobble.
A few months ago, investors were mostly worried about the solvency of banks; today, their concerns have shifted to the solvency of governments. Reflecting this, gilt yields have risen, alongside yields on, for example, the Greek Government's bonds.
The pre-Budget report offered absolute clarity in only one respect: despite all the headlines about bonuses and bingo, the main decision was simply to postpone the really tough fiscal decisions until after next year's general election. A case of paradise lost, austerity postponed.
There is very little change in the underlying fiscal story compared with the Budget earlier this year. In particular, the ratio of government debt to national income continues to rise over the entire forecast period (miraculously, it falls thereafter, but it is not obvious why anyone should believe this claim).
There is a simple reason for rising debt. The Government is not managing to save any money (either through higher revenues or spending cuts) to finance the rising interest payments on its ever-increasing liabilities. In other words, the Government is borrowing merely to pay interest on earlier borrowings, using the Bernie Madoff approach to fiscal affairs.
For the longer-term health of the UK economy, and its institutional arrangements, this instability creates a big problem. This is the relationship between the Government and the Bank of England and, in particular, the future of the quantitative easing (QE) programme. Back in February, Mervyn King, the Governor of the Bank of England, signalled the beginnings of QE. The actual programme began in March but, by then, gilt yields had already fallen a long way in anticipation of the purchases to come. Given that the Bank was intending to buy gilts with newly created money, it was fairly obvious to investors that gilt prices would rise and, hence, that yields would fall.
At the time, the Bank asked the Government for assurances that there would be no additional borrowing as a result of the QE programme. The Bank did not want to find itself accused of printing money merely to fund the Government's borrowing on the cheap. Ultimately, the aim of QE was to provide additional monetary stimulus at a time when interest rates had dropped more or less to zero. The most important objective was to prevent anyone from thinking that deflation might be just around the corner. With nominal interest rates at zero, falling prices would have increased the real cost of borrowing, thereby threatening the start of a downward deflationary spiral. Printing money offered an antidote.
Whether or not QE is working is still a matter of some debate. The pick-up in money supply which the Governor hoped to see has not really transpired. Although sterling softened earlier in the year, supposedly helping to rebalance the economy away from consumption and towards exports, it has more recently staged a modest recovery. Meanwhile, even allowing for the vagaries of the official estimates of national income, the UK struggled to recover in the third quarter when other nations were, seemingly, doing a lot better.
Yet there is still plenty of good news. There is no obvious sign of deflation and asset prices have, for the most part, moved higher. With so much money sloshing around, investors have been happy to take on risk. For large firms with access to the equity and corporate-bond markets, the gain in asset prices has made it a lot easier to raise funds than seemed likely earlier in the year.
There is, however, a bit of a problem. At the end of last week, the rise in gilt yields proved sufficient to take them back up to the level seen before Mr King announced intention to pursue QE back in February. If, now, gilt yields are no lower than they were before the QE programme began, is it credible to argue that the QE policy is still working? Is the rise in yields a sign of improving economic fortunes? Or, instead, is the rise a threat to economic recovery and, perhaps, to the independence of the Bank of England? The answer ultimately depends on the reasons behind the rise in gilt yields. Bond markets around the world are closely correlated. In recent days, increases in long-term UK interest rates have tracked gains in equivalent US Treasury yields, reflecting encouraging signs of heightened economic activity on the other side of the Atlantic. Maybe, then, the rise in yields simply reflects a return to global economic good health after the misery seen earlier in the year.
However, the so-called "default risk" associated with gilts has also risen. Investors in financial markets who supposedly know about such things appear to believe that the risk of sovereign default in the UK has risen so much in recent days that gilts are more dangerous than the Portuguese Government's paper and only slightly less risky that the paper issued by either the Spanish or the Italians. Investors appear to believe that there is much greater safety in the German, US or Belgian Governments' paper.
In effect, they fear that UK gilts are in danger of being downgraded by the various ratings agencies. That would force some investors to sell their holdings of gilts, driving the price down and the yield up. What should the Bank of England do in these circumstances? Because QE is focused on the quantity of credit, rather than its price, an easy answer is to do nothing. The Bank could reasonably argue that higher gilt yields are market-determined and, thus, have no bearing on its own QE policies. Nevertheless, should yields rise above 4 per cent, say, thereby triggering a fall in the stock market, what could then be said about the success of QE? After all, having failed to deliver much of a boost to money supply growth, the Bank now argues that QE operates primarily through asset markets. If these markets soften, what is left?
The problem is simple. Gilt yields are determined partly by the Bank's decisions on QE but also by the amount of money the Government intends to borrow. If the Government's borrowing plans lack credibility, the danger is that gilt yields rise. If that increase threatens recovery, the Bank may feel obliged to pursue QE to an even greater extent. By doing so, however, it could stand accused of printing money to bail out fiscal excess.
In these circumstances, the most likely safety valve is the exchange rate. If investors begin to believe that, despite the Government's extravagance, gilt yields are being sat on by a nervous central bank, the chances are that sterling will drop. It will drop because foreign investors will begin to believe that UK economic policy is lacking coherency, leading to a fire sale of UK assets. QE was never going to be easy. But its success is now being compromised.
Despite its much-vaunted independence, the Bank is beginning to discover that its policies are increasingly being tied to the electoral cycle. Without a forthcoming general election, Mr Darling would presumably have been a lot tougher. And, had he been tougher, the gilt market would have reacted much more favourably than it has done over the last few days, thereby allowing the Bank of England to maintain its independence without being forced into a politically motivated compromise.Reuse content