Why we need a bond market crisis

December 29, 2009

copelandLaurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

The spirit of Britain’s Christmas is looking disconsolate this morning. Santa Claus has failed to deliver what our democracy most needed. No, not a deal to let the French have the 2012 Olympics in exchange for a bottle of Beaujolais Nouveau.  Nor the nomination of Tony Blair for the Nobel Peace Prize. Number one on this year’s wish list was something more realistic, and maybe far closer:  a gilt market crisis.

To see the consequences of Santa’s negligence, consider the outlook for 2010. At present, the two main parties have adopted wait-and-see policies for dealing with a budget deficit approaching £200 billion or about an eighth of our GDP.

Neither is proposing to do anything serious until after the election, due no later than May. At most, we have had government promises about what spending would be sacrosanct, leaving us to imagine for ourselves the devastation that will have to be inflicted on whatever is not ring-fenced.

In the face of Labour’s trust-us-till-after-the-election stance, the Tories have felt little pressure to say what they themselves will do if they form the next government.

If no outside force intervenes, the  electorate will be faced with a choice between two parties neither of which is offering any programme for dealing with the biggest economic problem the country has faced since 1945, so that whoever wins the election will have no clear mandate for restoring fiscal balance.

In the unlikely but not impossible event that Labour wins, its supporters will interpret the victory as a vote against substantial cuts, so they are bound to feel aggrieved when the new government proceeds to slaughter their most sacred cattle.

On the other hand, if the Tories win, they will be in an impossible situation, having spent the previous four months denying Labour claims that a Conservative victory will mean cuts in health, welfare and defence.

Of course, the prospect of a hung parliament – a distinct possibility if current opinion polls are to be believed – is even more frightening, since it would involve months of wrangling while the parties negotiate so as to find the lowest common denominator, with the ever-present threat of having to rerun the election as soon as the opinion polls showed an advantage for one side or the other.

The only thing that can extricate us from this impasse is a pre-election gilt market crisis — and the sooner the better. To understand the implications, consider how governments usually operate. In normal times, the government satisfies its borrowing requirements by issuing gilts – IOU’s promising buyers repayment in 10, 20 or 30 years in return for an extra payoff (a “yield”) determined at regular auctions.

The prospective lenders bidding for the gilts are a range of British and foreign financial institutions (insurers, pension funds, sovereign debt funds etc), and the keener they are to lend, the less incentive they need to be offered and hence the lower the yield the Government needs to pay in order to borrow.

At the moment, however, things are very far from normal. The UK gilt market is currently a three-ring circus, because, lined up alongside the usual lenders is none other than the Bank of England itself, buying gilts as part of its quantitative easing program.

So any misgivings the genuine bond market participants may have about the ability of the government to repay its debts has been submerged by the buying power of the Bank, which simply prints money to buy gilts. No wonder the cost of long term borrowing has stayed at only about 4-4.5 percent!

However, if at some point the financial institutions (possibly prompted by a fall in our credit rating) despair of the government’s resolve to make the cuts needed to repay the debt, they may refuse to carry on lending without a significant rise in yields.  In the short run, this would be a calamity for Britain. But it would force the government’s hand, requiring immediate cuts to restore fiscal credibility.

This scenario, unappealing though it may be, is more attractive than the status quo. As things stand, the closer we get to the election and the less likely a Labour victory looks, the less compunction Gordon Brown has about emptying the kitty.

Labour’s logic is cynical, but not necessarily incorrect: if parsimony results in a Tory victory, the beneficiaries will ultimately be the opposition. It follows that, as long as the bond market continues to give the UK the benefit of the doubt while counting on the post-election administration to clear up the mess, the current government will push spending to the absolute limit.

Some innocent people may wonder where the interests of the nation figure in this electoral calculus. Alas, it seems that nobody can succeed in modern politics unless they can effortlessly convince themselves that what is best for them personally is ipso facto best for the country.


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