Last time, we explained what bond markets are and why they matter. Today, we’re discussing what the future looks like. Spoiler alert: not great.
Before we get into that, here’s a quick recap on last week’s piece:
1. Bonds are debts issued to the government, traded by private investors in the form of hedge funds, private pensions and so on;
2. These investors charge an interest on these debts, and that interest is by the likelihood they’ll be paid back, which is in turn determined by an infinity of factors, but mainly government policy and financial forecasts.
3. Britain, by spending too much, is accruing debt at an unsustainable rate - spending too much of its GDP, promising too many public goods - and the bond markets are charging us accordingly.
Alright, now we can get into the many reasons why our indebtedness is a problem.
Firstly, it is worth appreciating the scale and acceleration of our debt. When the Bank of England was founded in 1694 it lent £1.2m to the government and our national debt was born. It took from 1694 to December 2011 for us to reach £1Tr of national debt. This doubled in less than 10 years to reach £2Tr by July 2020. Today it stands at £3Tr. That is correct – we have tripled the national debt inside 15 years. (This ignores inflation but the scale of the increase from 2011 to now is staggering).
Perhaps this is ok if our economy has grown sufficiently alongside this increase in debt? Sadly, UK growth has been anaemic since the financial crash. Our rapidly rising debt load and weak growth record means that our national debt now stands at almost 100% of our GDP. In simple terms, imagine the UK is a company that has as much debt as it achieves in sales in a single year – that’s what debt to GDP really means.
Imagine a company took on large debts to invest in technology and infrastructure with a view that the sales and profits of the business would be massively enhanced. Well, the UK took on the massive debt, but the sales have not really budged.
To put that 100% debt to GDP ratio in context, debt to GDP was around 76% when the Cameron/Osborne/Clegg government was ushered in on a programme of austerity.
The latest government figures show we spent £124.7bn on National Debt Interest, some 10.8% of government expenditure. This is more than we spent on Education (10.3%) and essentially twice as much as we spend on Defence (5.5%).
We are funding current spending (the government throwing us sweeties) out of this debt. Our largesse will be paid back (or not!) by our future generations. Is that something we are morally comfortable with?
Ultimately, we are in hock to the bond markets whether our politicians like it or not. If you don’t want to be dictated to buy bond investors, don’t borrow from them.
Deficit versus debt
It is worth clarifying what the difference is between our debt and our deficit as you often hear these terms thrown around and used interchangeably. They are related but fundamentally different. Let’s try to simplify it as it isn’t actually that complicated – Economists just like to make it sound like it is.
The deficit is simply the difference between what the government earns in taxes and what it spends each year. If we earn £50k from our job but spend £60k that £10k difference must be funded from somewhere – our savings or more likely credit cards and loans. The government is no different – if its spending exceeds what it takes in in taxes, it taps the bond market to cover the difference.
Common perception is that the Cameron/Osborne years were associated with brutal austerity. Perhaps it might shock you to learn that under Cameron/Osborne our national debt actually grew over their time in office. How can this be true? Cameron continually spoke of his aim to cut the deficit, which gave the public the impression his government was tackling our indebtedness.
This is him in 2012: “My message today is clear and unequivocal. Be in no doubt: we will go in and finish the job. We will deal with the deficit.“
Why was this misleading? In our example above where we spent £60k after our earning just £50k, we created a deficit of £10k. Assuming we have no savings to fall back on, we must have borrowed the £10k from credit cards or loans. So, after year 1 we have a total debt of £10k. Then in year 2, we decide to get our act together and ‘cut the deficit’. This year we still earn £50k from our job, but we cut our annual spending compared to last year’s £60k to £55k. We then proudly tell our mates we just halved our deficit – from £10k to £5k.
But the reality is that £5k overspend also needs to be borrowed. So, our total debt has in fact risen to £15k despite our brutal austerity programme which halved our deficit.
For governments, the deficits incurred each year just get added to the total debt pile we have to service. It might shock you to learn that the last time the UK government spent less than it earned was way back in 2001, under Gordon Brown.
Therefore, think of the National Debt as the accumulation of all our annual deficits, added to the debts we’ve incurred over time for major expenditure programmes like wars, Covid, big infrastructure projects like HS2, road networks and nuclear power stations.
Is the UK alone in being a spendthrift like Brian?
No, other major countries are facing similar headwinds. Debt levels are very high, and bond yields are rising, in the US, France and Japan. The US has been able to get away with profligacy and printing dollars because of the importance of the dollar to the rest of the world – much of world trade is conducted in dollars, most commodities are priced in dollars, many emerging countries borrow in dollars and the dollar forms one side of circa 90% of FX transactions. The world demands dollars.
The situation for the UK and France is more concerning. Unlike the US, the world sadly doesn’t need Pounds in the way it needs the Dollar. We don’t run the world anymore even if some of our politicians delude themselves that we do. Encouraging international investors to lend to us will require us to pay higher yields than our peers.
France on the other hand faces the problem that it owes its debts in a currency it doesn’t directly control – the euro. This is what did for countries like Argentina – incurring large debts payable in US dollars they can’t service.
Thanks to Gordon Brown we aren’t in the euro, so we do at least control our currency, meaning we can always print it to honour our debts. However, this is a mixed blessing as the end result of money printing is usually inflation and a weakening of your currency.
Why are our rising bond yields a problem?
