The yields on British government bonds have drifted upwards again. As many commentators have pointed out, we are back at the levels experienced during the short-lived premiership of Liz Truss.
An obvious culprit is government debt, now at around 100 per cent of GDP in the UK. This in itself can create anxiety in the financial markets.
But there is no hard and fast rule which connects the debt to GDP ratio with the degree of confidence in a country’s bonds and hence the interest rate required for new issues to be taken up.
Indeed, throughout the Western world governments have run up similarly massive amounts of debt, mainly due to lockdown policies. The markets appear to be taking much of this in their stride. Although yields on 10-year government bonds have risen, to some 2.4 and 3.0 per cent in Germany and France for example, they are still at historically low levels.
But when we look at Germany, everything seems very familiar. The German railway workers are on strike for a 12 per cent increase. The Köln Institute for Economic Research has shown that the worker shortage in Germany has reached an all-time high, with 630,000 unfilled vacancies. Although both the UK and Germany have been teetering on the brink of a recession, Germany is now officially in one.
To some extent, the British government is simply being unlucky. The elusive factor of “confidence” has slipped away from the UK in financial markets, and yields on government bonds have risen as a result.
John Maynard Keynes attached the greatest importance to confidence, although he believed that at any point in time it was often “confused”. Keynes did not mean that confidence was determined in a completely irrational manner; he ruled this out explicitly. Rather, it was not necessarily completely logical.
This makes much more sense than the completely rational expectations which mainstream economists now assume in many of their models. Everyone is assumed to know the true model of the economy and to use it to form expectations. This is a tricky assumption to sustain when economists disagree amongst themselves as to what is the correct model.
But there are some fundamental worries about our government’s financial situation, so even allowing for “confusion” still seems pertinent. Index linked bonds make up over 20 per cent of total UK central government debt, compared to less than 5 per cent in Germany. With inflation being high, this means the Treasury has to pay out huge sums purely in interest on these bonds. In the space of just a few months, the Office for Budget Responsibility has more or less doubled its estimate, now projecting £83bn of interest payments on government debt this year.
A key way of paying off debt is through a growing economy. This generates a stream of extra tax revenues from the higher levels of economic activity. But UK productivity, whether per worker or per hour, is the same as it was before the pandemic: zero growth in over three years.
Imagine an economy in which all government debt was index linked, so that inflation could not erode its value in real terms. Imagine further there was zero growth. In this fantasy world, the only way to repay debt incurred today would be by tax increases in the future.
Although Britain is a long way off this nightmare world, we are much closer to it than Germany is. The economy is stagnating and our ability to repay government debt without massive tax rises is increasingly being called into question. No wonder that financial markets have the jitters on UK bonds.