by Mike Denham, former chairman
The Economist recently asked if Britain is slowly going bust. With public sector debt already approaching 100 per cent of GDP and our floundering government seemingly incapable of getting a grip, many of us are asking the same question. Are we going bust, and if so what will it mean for us?
A country goes bust when its government no longer has the means to service its debts, loses the confidence of investors, suffers a funding crisis, and defaults. Argentina, for example, has gone bust nine times like that. Heavily indebted Greece found itself in a similar position when its access to international credit dried up in the wake of the Great Financial Crash.
Once market credit is cut off, a bust government will have no option but to seek emergency support from an international institution such as the IMF, support that will only be granted subject to a raft of stringent conditions.
The government will typically be forced to slash public spending, hike taxes, tighten monetary conditions, and implement painful economic reforms. Many of these changes will be things that the government should itself have implemented long before, but which it put off for reasons of political expediency or simple incompetence. Now it’s being forced to go cold turkey.
Neither will it be allowed to walk away free from its existing debts, which will simply be restructured to provide a supposedly more deliverable servicing profile.
The pain of all this of course falls on the country’s people. Not only are they screwed for even higher taxes, but wages are frozen or cut. Public services are axed, along with pensions and other welfare support. Unemployment rockets. A country that’s gone bust via defaulting on its debts is a grim place for years afterwards – just ask the Greeks, whose GDP is still way below pre-crisis levels.
Could we soon find ourselves in that position?
As we’ve discussed before, in 1976 an earlier floundering Labour government was forced to apply for a humiliating IMF bailout loan after a collapse in market confidence and the loss of international funding. As usual, the IMF demanded a number of tough policy measures, which the government had no choice but to accept. In particular they insisted on big spending cuts, and the following year spending was slashed by the equivalent of over £50 billion today – the largest outright year-on-year spending cut in post-War history.
So, 50 years later, is history about to repeat itself?
It’s sobering to reflect that in several key respects today’s fiscal mess is actually much worse than it was in 1976.
For one thing, government debt as a percentage of GDP is twice what it was then. Also, while gilt yields – the cost of government borrowing – are now much lower in nominal terms, in real terms, relative to inflation, they’re now positive rather than negative. In other words, government finances no longer benefit from the erosion of the debt burden through inflation. And that turnaround is hugely compounded by the fact that a quarter of outstanding gilts are now index-linked, compared to none in the 1970s.
The fiscal outlook is also dramatically worse. Among other things, today our ageing population is an increasing fiscal burden, whereas in the 1970s that problem wasn’t even on the radar, with the baby boomers just coming into their economically productive prime.
Also back then, we could look forward to North Sea oil which would soon transform government finances with a huge windfall boost to tax revenue. Today, the government’s dogmatic pursuit of its zero carbon ideology has kiboshed any further exploitation of Britain’s carbon energy resources, and it’s instead spending huge amounts on expensive green technologies.
It’s therefore unsurprising that the financial markets worry about our fiscal situation, a worry that’s left us with the highest government bond yields in the G7. And nobody knows if the government is capable of gripping the problem.
Because instead of tackling the poor fiscal position she’d inherited, Chancellor Reeves spent her first year making things even worse. In her first budget she increased already excessive spending plans by a further £370 billion, including huge inflationary pay awards in the public sector. She increased business taxes, further dampening already weak growth prospects. And despite her tax rises, the OBR predicts that debt will increase by £700 billion by the end of this decade (a figure that may well get revised up in Reeves’ second budget).
True, Reeves did try to push through some very modest cuts in Britain’s ballooning welfare bill, but her failure to succeed against opposition from Labour colleagues only underlined the government’s inability to get a grip.
In the face of these and other problems, it would be easy to conclude that a call to the IMF is imminent.
However, although the current fiscal situation is worse than the 1970s, as things stand, a repeat IMF bailout is unlikely. That’s because almost all our public debt today is sterling denominated, and HM Government owns the printing press. Unlike Argentina and Greece which had huge debts denominated in currencies they did not control, we will never be in danger of defaulting on sterling debt because we can always pay creditors by printing more.
What drove us to the IMF in 1976 was not a fiscal funding crisis as such, but the fact that the government had guaranteed the dollar value of various sterling liabilities (the so-called sterling balances) without having the dollar assets to back its guarantees. Thus, when in 1976 market confidence collapsed and sterling plunged by over 20 per cent in just a few months, the government was left unable to honour its dollar guarantees without an IMF loan.
So since the government no longer has such foreign currency liabilities does that mean we can’t go bust?
In the strict sense of the Argentine and Greek busts, the answer as things stand is yes. But unfortunately that doesn’t mean we can avoid the pain inflicted on countries that formally go bust and are forced to call in the IMF.
Because if the bond and currency markets take serious fright at the government’s
continued inability to grip the public finances, they will dump gilts and sell sterling on a scale that will trigger a funding crisis. Then, with gilt yields soaring, and weaker sterling ratcheting up import prices, the government will be confronted with the same urgent and painful decisions it would have faced had it actually gone bust and called in the IMF.
We’re now dangerously close to that point (see previous discussion). We’ve already seen a couple of warning shots, and since foreign investors own one-third of the outstanding stock of gilts – far more than the corresponding proportion in other G7 countries – we’re highly vulnerable to a rush for the exit.
Of course, the government could always try to ride it out. It owns the printing press, so it could simply pay the new higher borrowing costs demanded. But debt interest costs already consume nearly 10 per cent of all the taxes we pay, and relative to national income they’ve already increased by 50 per cent since the turn of the millennium. Forcing yet more gilts on a panicky market would soon get very expensive indeed.
On top of that, higher gilt yields knock on to higher borrowing costs right across the economy, depressing business investment and pushing up the cost of mortgages. Moreover, sharp changes in yields can cause serious problems in the financial system, as we saw during the LDI meltdown following the 2022 Truss/Kwarteng mini-budget (which soon afterwards brought down that entire government).
The best response would be to do the kind of things the IMF would have demanded had it been involved – in particular, to move the public finances onto a sustainable footing as quickly as possible through what's known as fiscal consolidation. And as we’ve discussed before, the most effective way of doing that is through spending cuts rather than tax rises, largely because spending cuts are more likely to restore the market and business confidence that’s been lost.
The worst response would be to duck the difficult choices altogether. We already know that this dysfunctional government faces strong opposition within its own ranks to any spending cuts, and with no IMF enforcement, it might well attempt to square the circle by financing its deficits via the printing press rather than gilt issuance. Or it could issue gilts and then have the Bank of England buy them back via another huge QE programme.
But we’ve seen that film before, many times. Financing government spending via money creation sooner or later results in inflation, just as it did after the covid spending splurge. All of us, especially lower income groups, would suffer from a yet more serious cost of living crisis. And history tells us that inflation is a lot easier to start than it is to end.
The bottom line is that if we do get that funding crisis, whether or not we formally go bust and call in the IMF, we’ll still suffer the pain that comes with it. In fact, avoiding the IMF might well mean worse pain, because it will allow the government to postpone making the necessary tough decisions on spending, thereby compounding the problem. It is to be hoped that Reeves and her colleagues can grasp that in time for November’s budget.