Merlin Weekly Macro: Rachel through the Looking Glass

Rachel Reeves is a Chancellor under pressure. She is being pulled in all different directions about the ambitions for future government expenditure, how best to raise taxes to meet the cost, and whether to break the fiscal borrowing rules.

In this week’s musing we are going to look specifically at government deficits, debt and fiscal probity.

UK financial health report: “superficially satisfactory but co-morbidities increasing”

But first, a reality check on the health of the UK’s finances. UK government debt stands at £2.77 trillion, up from £2.59 trillion a year ago. The UK economy is calculated to be worth roughly £2.28 trillion. Through enduring annual budget deficits going back in an unbroken record for quarter of a century (in 2023/4 a deficit of 4.6% of GDP), debt has been steadily accumulating. Currently it is growing faster than the economy. Depending on whose numbers you use to calculate GDP the debt is already as great as the economy, perhaps bigger. This year, the cost of servicing the government debt will be an estimated £90bn (the net interest bill is approximately half that amount because the government owns other countries’ government bonds as collateral against other financial instruments on which it also earns interest).

In 2023/24, the government had total revenues (tax income, interest receipts etc) of £1.057 trillion; it spent £1.216 trillion in total on public services, including the cost of servicing its own debt. The difference between income and expenditure is a deficit in cash terms of £159 billion. Even removing interest charges and receipts from both sides of the equation, after considering all the government’s committed departmental and capital expenditures, there is still a yawning deficit and therefore insufficient left to cover the net interest cost, let alone the gross interest payment. Congenitally incontinent, the UK government is permanently leaking cash.

Rationally, it should be the case (as has been partially tested in the past 18 months in the US when the government broke the debt ceiling limit mandated by Congress) that the UK government is presented with a gun-to-the-head alternative: suspend public services or default on its loans. Of course, in the real world, the second is financial Armageddon and the first is social revolution: in a game of bluff between the government and its creditors, the government holds most of the cards in what would otherwise be the ultimate game of financial mutually assured destruction.

That notwithstanding, however, if this were a company, the UK would be close to bust. It would have broken its loan covenants. With no intention to curb its excesses it would be knowingly trading insolvently. In the US it might be placed into administration (known as ‘Chapter 11’), required to get its house in order through a radical reorganisation of its costs in return for keeping its creditors at bay; if it failed to do so after a reasonable period, it would be declared bankrupt and the vultures would strip what was left of the carcass clean. The sovereign equivalent of Chapter 11 for countries in the ‘Good Old Days’ before the advent of quantitative easing as the solution to containing the global financial crisis in 2007-10, was rescue by the International Monetary Fund. We should know: Labour Chancellor Denis Healy landed us there in 1976. It was possible to go from being the global superpower to an economic basket case in a mere four decades; we did it.

Yet here we are, the world’s sixth biggest economy, we remain firmly open for business, the ‘Gilt’ in gilt-edged securities (UK government bonds) maintains its lustre. Despite our seeming weakness, investors both at home and abroad still want to lend us money. Why? And on what basis?

It’s all a great big con

The modern monetary and financial system is in its literal sense one great big confidence trick. Virtually all monetary systems today are known as ‘fiat’: they are completely based on trust rather than transactions and liabilities being fully backed by tangible reserves, for example gold. In its simplest terms think of a £5, £10, or £50 bank note: a bill of exchange, each is no more than a Bank of England ‘promise to pay on demand’ given by the Bank’s Chief Treasurer, printed on an intrinsically worthless film of plastic regardless of the denomination of that note. But that ‘promise’ is also built on trust: there are insufficient gold and other precious metal assets mined and above ground to cover the outstanding aggregate liabilities of all the world’s governments and their central banks. Liquidity is the financial system’s life-blood but ephemeral, intangible, invisible trust is its foundation.

We are still trusted to honour our debts

It is in that context that lenders to the UK government have faith that it is almost unthinkable that it would default on its loans, whether such a default were skipping the coupons (the regular periodic interest payments) or failing to repay the principal sum, in full, on time when redemption is due. The nuance of the risk that one of these events might happen is reflected in the bond yield: sovereign bond yields broadly correlate with interest rate expectations but the extent to which they deviate from the benchmark, or spreads between our own and other countries’ bond yields widen or narrow, reflects the perceived relative risk.

UK bond yields have been volatile again after dipping earlier this year in anticipation of the Bank beginning to reduce interest rates. So too have those of our competitors, for example the US, Germany, France etc. This reflects the battle of wills between the markets and the central banks about the future trajectory of interest rates now that the peak has passed with inflation abating. However, the spreads between them have not been uniform: at the time of the UK election the German 10-Year government bond had a yield of 2.44% while our equivalent was 4.03%, a difference of 1.69 percentage points (or in market lingo, 169 basis points); at the beginning of October, the German yield was 2.05% and ours was 3.94% (189 basis points apart); at the time of writing, Germany’s has jumped to 2.25% and the UK’s is 4.21%, now a difference of 196bp or close to two percentage points. In round terms, since July, investors’ perceived risk outlook for the UK relative to Germany has increased by almost half a percentage point.

Part of the reason UK yields are higher in any case than the German equivalent is simple: the UK base interest rate is 5.0% while the eurozone’s is 3.5%, a differential of 150 basis points which also reflects a perceived more benign inflation outlook in the eurozone compared with the UK. But much of the rest of the difference is down to the two countries’ very different approaches to deficits: other than in emergencies, in Germany in the normal course of business it is illegal for the government to present a budget for parliamentary approval that includes a planned deficit of more than 0.3% of GDP. Here, our last reported deficit is 4.4% of GDP. The UK’s Office for Budget Responsibility (OBR) lays down constraints but the substance for chancellors to adhere to is that there must be a commitment to reducing deficits and debt as a percentage of GDP by the fifth year of the fiscal plan. But being a rolling timetable, the fifth year never comes; it becomes impossible to hold any chancellor to account for missing the target because the time series has already moved on. The OBR has no legal powers to enforce compliance.

A considered exercise in smoke and mirrors fiscal planning

But it is this expanding spread between British and German bond yields which reflects investors’ growing jitters about the forthcoming Budget. In particular the rumours that Reeves is planning to mess about with the Office of Budget Responsibility guidelines about deficit management and borrowing limits in order to be able to borrow even more, possibly another £50 billion more, but without spooking the markets.

Elements under consideration include redefining the Public Sector Net Worth (PSNW, essentially the public sector balance sheet which quantifies the assets against which borrowings can be raised). Reeves sensibly wants to ensure that there is a clear distinction between operational expenditure (e.g. paying wages etc funded by tax income) and capital expenditure (to pay for buildings and infrastructure funded by borrowings). To do that she is exploring how to reflect that spending on hospitals, roads, railways, or any infrastructure which is publicly owned, is shown as a tangible asset on the government balance sheet.

It is not an unreasonable accounting proposition in theory. Indeed, it is normal corporate accounting practice. Where it runs into trouble for the government is a) determining what can legitimately be included and b) arriving at an agreed, independently audited valuation of every asset involved. What is the value of a hospital? Is it how much it cost to build? It has no market value, after all, because it is never going to be sold to another operator as a going concern; if the hospital became redundant and the land was sold to a developer, that would be different but the value of the buildings would be worthless. How do you value the rail network? Re-nationalised, it has no commercial value and the rail system needs a public subsidy of over £13bn a year to keep it viable. Question: is it even an asset or is it a liability? A final problem with this approach, identified by the OBR itself, is the difficulty all governments have spending capex according to schedule; when capital budgets slip, the tendency is to re-allocate in-year capital expenditure (investment) across to day-to-day operational expenditure (a revenue cost). It confuses the two, destroys budget discipline and in the long-term adds to the overall accumulation of debt. You see the problem here.

Other areas being considered are variations on the theme of Private Financing Initiatives (PFI). Gordon Brown was the chief proponent of these schemes, partly because they ostensibly shared the financing costs between government and the private sector, but principally because the accounting treatment allowed him to get the government debt liability off its own balance sheet. In the event many of these PFI contracts proved ruinously expensive.

If all this smacks of smoke and mirrors, it’s because that is precisely what it is. Another piece of monetary jiggery pokery disguised as internal housekeeping was also agreed last month: the Treasury will indemnify the Bank of England against any losses incurred on the sale of bonds acquired by the Bank under the old quantitative easing regime. As monetary policy loosens and the Bank sells bonds back to the market it is likely that they will be at lower prices than when purchased. As Simon Jack, the BBC business editor said glibly on Radio 4, “you can’t have the Bank of England going bust”. It wouldn’t go bust but the losses would eat into its reserves and as we discussed above, those reserves are accounting concepts much more than they are backed by real assets such as gold bars. But in making the indemnity while having no cash surpluses, the Treasury can only make good the difference by issuing more debt when the obligation crystallises. This is Alice in Wonderland stuff, a financial circular argument (it also undermines the principle that the Bank does not directly fund the government: if the Treasury is indemnifying the Bank’s losses on bonds issued by the Treasury in the first place, it is effectively an inducement for the Bank to facilitate more government borrowing however circuitous the mechanism).

Who is pulling the wool over whose eyes?

The obvious question is why, if all this is so obvious, does the system not fail? The answer is very simple: it is in nobody’s interest to allow it to happen. Domestically, there is a large, steady appetite for UK government bonds thanks to the needs of the pension and life insurance industries: they need copious quantities of cash-generating assets to meet their immediate cash-outflows; in any case the Pensions Regulator stipulates what percentage of pension assets must be held in fixed income as a means of ‘de-risking’ the schemes, the specific value of UK government bonds being to match long-term sterling liabilities with sterling assets.

Much more sensitive are overseas investors: they have far greater choice of investments and they do not need to own UK government bonds. Theirs is a more hard-headed approach about risk and value. But again, with sterling being a world reserve currency, it is not in anyone’s interest arbitrarily to pull the plug by refusing to lend. Finally, as was seen in the global financial crisis, during the pandemic and over the course of the car-crash Truss/Kwarteng budget in 2022, there is the implicit assumption that the moment the system is put under stress, the Bank of England will automatically step in to stabilise it (through massive purchases of government bonds).

Too clever by half?

But stand back and look at what is going on here. We all know that government debt is the elephant in the room. And yet markets have been complicit funding egregious and enduring deficits, allowing fiscally incontinent governments including the US, the UK, France and Italy to continue spending almost uncontrolled. In each case the result has pushed up not only the nominal debt, but also the debt/GDP ratios and increased the financial burden of servicing the debt. In the US, were debt interest a spending department, it would have the second biggest budget in the Federal fiscal system, second only to welfare.

In the UK, the position is compounded by the new government inheriting the highest debt and tax burdens outside wartime. Yet it is determined to spend even more, particularly as we embark with unconstrained gusto on the path to carbon net-zero. It requires blunt instruments with which to raise more tax, and ever-more creative ways of borrowing even more by stretching the boundaries of belief as to what constitutes sound money and a stable financial system.

No government sets out deliberately to wreck an economy, not even this new one under Starmer. But over the quarter of a century in which the concept of fiscal probity has been eroded since the end of Thatcherism and Reaganomics, there has been no shortage of very bright people armed to the teeth with first class degrees in economics, finance and PPE from prestigious universities working in government who have invented seemingly rational policies which have led us to the heavily indebted position in which we find ourselves today.

There is little point banging on like a broken record (as we do frequently in these ramblings) about the pre-requisites for a sustainable, match-fit, competitive economy, one that is capable of maintaining its own momentum without constant stimulus from a central government living on the never-never. Nobody is listening. With Labour’s thumping majority and an Opposition composed of parties which are either dysfunctional and distracted (the Tories) or not only supine but wanting Labour to go even further (apart from Reform, just about everyone else), the forthcoming economic experiment will play out.

The markets are gradually waking up to the potential implications. It is interesting that the UK 30-Year government bond today at 4.84% has exactly the same yield as in October 2022 at the height of the Truss budget hysteria: then inflation was peaking at 11% against 2.2% today, and at 2.25% interest rates were barely halfway to the 5.25% summit whereas now they are falling. But unlike in 2022, there are no signs of anything approaching panic. In 2022, a debt-crunch crisis was created by a £2bn increase in borrowings to cut 5p off the top rate of tax being deemed a reckless step too far; today, Reeves is potentially putting the UK on the hook for multiples of the sum that summarily brought down Liz Truss, yet markets are relaxed that all will be well. It’s all about trust. And the assumption that if the wheels do eventually fall off, the Bank of England will be on hand to pick up the pieces before we proceed again as if nothing had happened.

Parting shot: when the pigeons come home to roost 

Markets have a relatively short term outlook but the insidious effects of financial decline have much longer duration. If the threat is imperceptible it is out of sight and out of mind. Governments are on a short-term electoral cycle. What should really concentrate the mind is the legacy for our children and grandchildren. The latest OBR projections show the possibility of UK debt/GDP being 275% of GDP in fifty years’ time, and the cost of servicing the debt is estimated to be 12% of GDP. We can reduce ourselves to penury almost by accident, as in 1976 become an economic basket case. Even the government’s official fiscal watchdog says so! These are the casually careless delinquent policies of the deluded.

At what point does trust in the UK evaporate? More importantly, at what point does everyone (the electorate, government, the establishment, the markets) take the bold step to draw a line in the sand, declare “ENOUGH!” and put our house in order?

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.