First published in the Telegraph on 17 December 2009
Something important happened this week: for the first time since the start of the financial crisis, investors demanded a bigger premium in return for holding British debt than Spanish. Indeed, the cost of our government borrowing – as measured by the interest rate – is rising so quickly that within a month it could be higher than Italy’s.
The fact that Britain is such a risky proposition in the market’s eyes has hardly gone unnoticed in the Treasury. Since last week’s pre-Budget report, the mood there has been a cocktail of misery and resentment. Misery because civil servants know full well that if they lose the faith of international investors, the resulting crisis will consign the country to an even more hideous decade than they are projecting. And resentment because, fearing precisely this reaction, they recommended more ambitious plans to reduce the eye-watering deficit, only to have them nixed by No 10.
Much of the worry has been over whether Britain will have its credit rating cut, but this is actually something of a sideshow. The credit ratings agencies are charged only with working out the likelihood that Britain will default on its debt – something that has never happened since the UK started issuing bonds in the 17th century, save for a fiddle with a loan from the First World War in the 1930s.
What is far more likely, or so investors fear, is that Britain will inflate the deficit away by debauching the currency: as inflation rises alongside the money supply, every pound we owe will be worth that little bit less. This is what we did in the 1970s – and most other times we have faced a debt crisis. So suspicions that a repeat performance is on the cards are not difficult to understand: the pound has already fallen by around a quarter since the start of the crisis; the Bank of England has embarked on a quantitative easing scheme that involves printing enough money to buy the annual economic output of Denmark; and inflation is threatening to leap well above the Bank’s 2 per cent target.
Might history repeat itself? You can understand why the market thinks so: we are facing not only the debts from the current crisis (equivalent to those incurred in the Second World War) but a looming bill of almost double the size from the ballooning health and pension costs of an ageing population. Plus, one of the peculiarities of the British debt market – that the Treasury issues bonds that take far longer to mature than most other countries’ – has historically made it easy for profligate governments to create the odd burst of inflation without being punished as badly as the Italians or French, whose bonds are short-term, and so need to be rolled over more often.
Yet however much today’s politicians may be tempted to try to inflate away their debts, this avenue is in fact far more difficult than it was in the 1970s. First, it would mean throwing away the 2 per cent inflation target that the Bank of England has kept to for more than a decade. Second, investors are far more mobile than 30 years ago: one of the by-products of globalisation is the speed with which capital can be withdrawn from a country. That means, according to the International Monetary Fund, that inflation in single digits – say 6 per cent – would “not make much of a dent in the real value of the debt”, because investors would charge the governments higher interest rates if they got even a sniff of impending inflation. Which implies that only inflation in the high double digits – 1970s style – would do the trick.
Third – and perhaps most importantly – governments have, largely unwittingly, sewn safeguards into the debt market which make an inflation strategy pointless. Since the 1970s, we have issued an increasing amount of debt in the form of index-linked bonds, which now account for a quarter of the debt market. These are inflation-proof: the debts increase automatically alongside inflation. Then there are the country’s other liabilities: public sector pensions (circa pounds 800 billion), the state pension ( pounds 1.4 trillion) and the costs of private finance initiatives ( pounds 140 billion), all of which are tied to inflation.
In fact, around four fifths of the state’s debt bill is inflation-proof. The only way ministers and mandarins could inflate their way out of the crisis would be to rip up all the contracts that tie these debts to inflation: possible in the case of the state pension (which is one reason why Gordon Brown’s pledge to link it to earnings is probably doomed), difficult for all the rest.
And a good thing, too. As tempting as it is for profligate governments, permitting double-digit levels of inflation inflicts a baleful cost on households and companies. If we have forgotten this lesson from the 1970s – where the cost of the strategy was economic chaos and an IMF bail-out – it is just as well that these restrictions ought to prevent, or at least impede, the Government from taking that approach. No, the solution to today’s fiscal crisis is the same as it has always been: to cut spending, reduce the deficit and learn to live within our means.