Andreas Whittam Smith: A reality check bursts the bubble of optimism

Reducing debt could well become a virility test in the election

Very early in the day, financial markets are playing a role in the general election due to take place within a year. They have sent a warning. If the winning party fails to reduce the level of government debt more sharply than is currently planned, then the cost of borrowing would rise. That means that either taxes would have to go up or government spending would have to be cut to pay the higher-interest bills.

The message comes from the global bond market where government debt is traded. Participants base their prices on comparisons between countries' financial standing. Always at the back of dealers' minds is the risk of default. The occasion was a statement by Standard & Poor's, one of the agencies that give credit ratings to borrowers of all kinds. It told investors yesterday that it had revised its outlook on the UK from stable to negative. This is a way of saying that it might reduce the country's current triple "A" ratings on its debt.

Hang on a minute, you might reasonably ask, aren't these credit-rating agencies the very ones that made innumerable mistakes in how they assessed mortgage loans during the wild days that preceded the credit crunch? Weren't they partly responsible for the financial crisis in which we now find ourselves? "Yes" and "yes" are the answers. Nonetheless, these agencies are still widely trusted when assessing the standing of big borrowers such as sovereign states.

Standard & Poor's had previously taken a close look at the UK accounts in January. It assumed then that the country's net debt burden could rise from about 49 per cent of national output in 2008 to 83 per cent in 2013. At the time it maintained our AAA rating without qualification. What it was really saying last January was that while the trend looked pretty horrific, we think you will be able to deal with the problem.

Not any longer. Following Alastair Darling's Budget statement last month, Standard & Poor's is less confident. The cost of supporting the banking system has risen to a colossal £100-145 billion, or 7 per cent to 10 per cent of national output this year. So, looking out again to 2013, the agency sees the government debt burden reaching 100 per cent of national output and staying there. "A government debt burden of that level, if sustained, would in Standard & Poor's view, be incompatible with an AAA rating." The key phrase here is "if sustained".

Then comes the warning to the political parties. The meaning is clear enough despite the stilted nature of rating-agency speak: "The rating could be lowered if we conclude that, following the election, the next government's fiscal consolidation plans are unlikely to put the UK debt burden on a secure downward trajectory over the medium term. Conversely, the outlook could be revised back to stable if comprehensive measures are implemented to place the public finances on a sustainable footing, or if fiscal outturns are more benign that we currently anticipate."

This could easily become a sort of virility test for the political parties as they go into the election. Were Labour to maintain its current plans, then the opposition parties would be able to say that a rise in Britain's borrowing costs would be the inevitable result. The démarche from the financial markets would also have the effect of forcing the political parties to come clean about their spending and tax plans. Anything too vague would bring the charge that the party concerned was risking a downgrading of Britain's financial standing.

That was the most important reality check of the week, but there were two others from across the Atlantic. Two days ago, the American central bank lowered its outlook for this year and 2010, saying that the American economy would contract more sharply than it had originally projected in January. The final reality check came from the US housing market where on Tuesday we learnt that building activity has plunged to its lowest level on record.

In face of these negative developments stock markets have naturally retreated. Had it not been for the Standard & Poor's announcement, I was going to have written about the reappearance of bubbles in commodity markets, with oil up from $40 a barrel to over $60 in the space of a few weeks, and in stock markets with shares rising more than 20 per cent since March. But the actual news of the week has made the argument much better than I could have done.