3 min read

Britain's balance sheet recession

Imagine you’re a bank manager.

You have a customer who keeps getting deeper and deeper into debt. You’ve set him targets for spending and borrowing but he has repeatedly missed them.

A few weeks ago it transpired that his annual income had fallen even more than expected and now, today, he is in your office asking for another loan. What do you do?

I imagine one answer that’s not particularly likely is to give him free money.

And yet that is what, in effect, the market has decided in regards to a not dissimilar customer: the Great British Government.

Britain is borrowing more than expected this year.

On the basis of the latest public finance figures, the Government may well borrow more than last year, missing its £120bn borrowing forecast by £30bn, according to Alan Clarke of Scotiabank.

July usually brings a surplus for the Treasury, since it generally receives more in the way of tax receipts than it spends in that particular month. So the fact that it recorded a £0.6bn deficit (£557m to be precise) is particularly damning.

The explanation this time around is that corporation taxes (in particular North Sea oil) didn’t come in as much as expected.

But ignore the statistical noise (including the one-off windfall from when the Government took on the pension fund of the Royal Mail) and the story is a depressing one.

Britain still has one of the worst deficits in the western world, and the picture is hardly improving.

For the Treasury, this is yet more evidence that the last thing the Government should do right now is to remove the restraints on its budget plans and spend more.

For those who disagree with the coalition’s policies it’s evidence that the austerity plans, far from improving Britain’s finances, have actually worsened them.

That latter point gains more and more force every month that the UK remains in recession.

After all, at least some of Britain’s recent negative output is due to the fact that austerity has reduced economic growth (and hence income, and hence tax receipts).

And that’s why even some of those who have been sceptical about the notion of a burst of stimulus spending now argue that a little extra money spent on capital investment might be sensible.

But having said that, the debate may well shift in the coming months when, as seems almost inevitable now, the Q2 GDP figures get revised upwards and the Q3 figures get boosted by the Olympics.

Even so, the next few weeks and months will be nervous ones for the Chancellor as the Autumn Statement approaches.

All of which is why it’s still so intriguing that the markets are willing to lend to the UK government at such a cheap rate.

A mere hour after those nasty public finance figures were released, the Debt Management Office sold £1.25bn of 17-year index-linked (e.g. inflation proof) bonds at a negative real yield: -0.025%.

In other words, investors committed to a guaranteed real-terms annual loss to lend to the UK government for almost two decades.

There are a number of potential explanations: for one thing, investors may fear a big spike in inflation, which they would at least be protected from with these bonds.

There is certainly an element of the safe-haven argument here; Britain is not Spain or Greece, or indeed any member of the euro area.

But the best explanation for these almost unprecedented negative interest rates comes down to the fact that the analogy I’ve given above, comparing Britain to an unreliable bank customer, isn’t really appropriate.

If it were, you would indeed probably expect investors to treat the UK as so many struggling mortgage-holders are being treated at the moment, with higher interest rates and bigger charges.

While it’s tempting to try to compare an indebted country to an indebted person, the comparison is somewhat misleading for one simple reason: unlike Joe Public, a country has the power to raise taxes at will.

In extremis it has the capacity to print money at will.

In fact, those record low interest rates are more likely to mean investors believe in the following: Britain will not default; it will be able to raise taxes and cut spending in order to pay off the debt; however, this will likely stifle the economy for an extended period of time; which in turn will prevent any investment in UK PLC yielding much of a reward; hence those low yields.

That is what happened in Japan during its lost decade.

It has since been dubbed a “balance sheet recession”, where there is so much debt hanging over the public and private sector that it simply weighs down activity for the foreseeable future.

And, on the basis of the latest evidence, that is precisely what is happening in the UK at the moment.

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