The UK is risking a debt, tax and austerity doom-loop
By Simon French, Chief Economist and Head of Research
The cost for the UK government to borrow continues to cause headaches in Whitehall. Despite four interest rate cuts from the Bank of England, the interest rate on ten-year UK Gilts has risen from 4.2% to 4.6% since last year’s General Election. Push that debt out to thirty years and the interest rate for the UK government has gone from 4.7% to 5.4%. This is adding to annual debt servicing costs of £105bn – not far short of the entire public sector investment budget set to shortly be unveiled by the Chancellor, Rachel Reeves, in her first Spending Review.
Whilst the rising costs of public sector debt are troubling, almost as problematic is how to interpret these interest rate changes. That interpretation is heavily contested by economists, bond investors, and politicians alike. The conclusion will shape policy decisions on health care, defence, education, pensions and, of course, tax for years to come. The idiom often used to refer to such deliberations is the “sixty-four thousand dollar question”. Inflation and a rapid accrual of debt over the last two decades has made this a two and half trillion pound question for the UK.
For some observers we are living through a period of healthy normalisation of interest rates after a seventeen year hiatus. A combination of £36 trillion of purchases of debt by central banks, allied to strong demand by pension funds for debt to cover their defined benefit liabilities, and a rebuilding of financial sector balance sheets after the Global Financial Crisis in 2008 created a unique period - at least in modern times - of low interest rates. Government debt was highly sought after. The result was that a wide range of UK and international interest rates hovered around zero. All these factors have now stabilised, or gone into reverse. This has meant that interest rates have reverted to levels last seen in the late 1990s. Indeed many investors are surprised interest rates are not even higher given much more elevated levels of indebtedness – totalling £325 trillion globally. If this relatively benign interpretation – often referred to as normalisation - holds then this is a healthy development that should introduce more disciplined balance sheets, fewer inflated asset bubbles - including in housing - and less incentive for investors to go hunting for returns using obscure and highly leveraged investment products.
However this Goldilocks scenario is perhaps at odds with economic history. The celebrated economist, Hyman Minsky, noted that extended periods of stability in financial markets create their own instability. A “Minsky Moment” was a fitting description of the leveraged Liability Driven Investment (LDI) crisis that brought down Liz Truss’ government in 2022. The pension funds that experienced stress in the aftermath of that Budget were encouraged to pursue leveraged LDI strategies by the low interest rates that had been previously available. It would be naïve to think that other, slower-to-reveal-themselves Minsky Moments, wont emerge. Arguably the US hedge fund industry came close to mirroring LDI back in April in the aftermath of President Trump’s “Liberation Day”.
A more troubling interpretation therefore is that investors simply don’t believe there is a political path to more sustainable debt levels - at least not without some combination of durably higher inflation and/ or a debt default. One of the more frustrating elements of watching UK economic discourse is the focus on relatively short-term horizons for the UK debt and deficit profile. Whilst the UK public sector debt is currently equal to 100% of GDP this is projected to grow to an eyewatering 270% of GDP by 2075 under the Office for Budget Responsibility’s latest forecast. Anyone lending to the government for decades at a time therefore doesn’t really concern themselves with whether Winter Fuel Payments will be means tested, or whether there is a two child benefit cap. They question the affordability of the Triple Lock State Pension, defined benefit public sector pensions, an NHS that is free at the point of use, and a social care system with no apparent long term funding plan. Maintaining all these over a period of time when the number of Britons aged over 80 is set to double to seven million looks unsustainable.
When bond investors look on at a social care review kicked, again, into the long grass, ambitious defence spending commitment for 3% of GDP with no detail on how it will be funded, and a political party - in Reform UK - now leading strongly in the opinion polls but with tens of billions of uncosted commitments in their plans, the only possible conclusion is that interest rates deserve to be higher to compensate for the sheer volume of debt issuance that will be required.
There is of course an international component to all of this. UK assets – and government debt is no different - have to compete with those from the Rest of the World . As I noted in these pages two weeks ago, Japan is now offering interest rates unseen in decades, the Trump administration is making capital repatriation to the US a key foreign policy objective and tying that to security guarantees. Last week’s announcement of UK pension reforms to strong-arm asset managers into greater ownership of UK private assets was a tacit admission that the UK economy has been too costly a venue for deploying capital for too long.
And this ultimately provides the best clue on how to interpret the signals from the bond market. It continues to see the UK as a fundamentally attractive, but expensive place to invest capital. An energy policy that has led to the UK having the priciest energy in the industrialised world is part of this, but so are costs for building high speed rail, nuclear power, approval times for residential and commercial property development when benchmarked with comparable countries. These all look like the result of regulatory and policy decisions taken in an era of low interest rates – and only remain affordable by taking the tax take even higher from its already 75-year peak.
If UK government debt doesn’t want to be the ugly duckling in the global bond market - and pay interest rates accordingly - it needs to convince investors that the default answer to the builders, the innovators, the entrepreneurs is “Yes, you can”. Not “No, you can’t”. So far the Cabinet has only done this with a whisper. To avoid a debt, tax and austerity doom-loop they need to say it far more full-throatedly.
