The UK bond markets have become a political trap that strangles public spending. But there’s a way out | Sahil Dutta

More than three decades ago, James Carville, political adviser to Bill Clinton, made what became a famous quip about the power of bond markets to “intimidate everybody”. Clinton had entered office promising to transform the US’s infrastructure, only to be told that big public spending would spook investors, drive up borrowing costs, and sink his presidency. Today, if there is one thing that Britain has in common with Clinton’s US, it’s that the bond markets loom large again in political discussion. Clinton shelved large-scale investment plans and slashed welfare in the belief that doing so would prove his economic credibility with investors. Likewise, in Britain, ever since Liz Truss’s botched mini-budget, politicians have continually pointed to the risk of bond market revolt as the reason why public investment can’t be afforded. The bond markets are inarguably important. Governments and central banks support public spending by selling bonds to investors on financial markets. When those investors lose confidence, demand for bonds falls, and governments feel compelled to pay higher rates to keep investors on side. When the cost of borrowing shot up globally after the pandemic, it hit Britain particularly hard. Having borrowed significantly to bail out the banking sector in 2008 and again during Covid, the country’s national debt now stands at 101% of its GDP. This imposes real constraints on public spending. But the idea of a funding crisis is overblown. For one thing, investor demand for government debt remains resilient, and the yields – the rates government pays to borrow money when issuing bonds – are less than they were through most of the New Labour era. If the government wanted to improve living standards, it could increase taxes and borrow to invest in local government, public housing and public transport. To try to limit the impact of an adverse bond market reaction, a supportive Bank of England could use its own balance sheet to buy up government debt itself. By increasing the demand for government bonds, yields overall could be contained. This is all to say that governments have choices about how they respond to the bond markets, and these choices are guided by politics, rather than cold economic necessity. If the Bank still had to raise interest rates and hit leveraged investors and mortgaged homeowners with higher costs, other interventions – such as adjusting price caps on utilities and introducing rent controls – could mitigate the broader impact. Whatever path the government and the Bank take, there are winners and losers. The point is that who benefits is a political choice – not market diktat. At the moment, Labour and the Bank seem to have made their choice: contain public investment, keep growth of disposable income in check, and hope to lower interest rates. Ironically, this approach may be intensifying bond market pressure. Take Labour’s fiscal rule. While Labour believes this is a means of reassuring investors, it actually creates uncertainty for them. Twice a year, the government has to show it is on track to keep its promise that current spending will be matched by tax revenues, and debt will be falling as a proportion of GDP, which leaves the government having to make kneejerk changes to tax and spending when forecasts change. It’s a similar story with tax. The stronger a country’s tax base, the more secure and desirable its bonds are to investors. Since publishing its manifesto, Labour hid behind the fanciful idea that growth would naturally increase tax revenues, so that redistributive taxes wouldn’t be needed. The government is now facing up to a reality where GDP has grown just 0.7% over the last year. This is an opportunity to substantially overhaul the tax system, reducing the government’s need to borrow on the bond market and providing the basis to repay when it does. Another underlying problem is that we’ve come to see central banks as institutions that are insulated from democracy or people’s everyday needs. Instead, we think of them as institutions that exist primarily to keep financial markets happy. This is inherent to the design of the Bank. Shortly after the Bank was given formal independence to set interest rates in 1997, an independent Debt Management Office started to handle the issuing of national debt. This was justified, again, in the name of the bond markets. It embedded the idea that governments had the power to tax, but not the power to shape the terms on which public spending is financed. It’s worth remembering that this wasn’t always the case. From the 1930s into the 1950s, the Bank worked with the government to restructure the national debt and lower the interest payments the government faced on its war debts. The national debt was far higher than it is now, but a so-called cheap-money policy engineered by the Bank and the Treasury supported the war, and helped Labour rebuild the country once it was over. This approach continued well into the 1970s. More recently, the Bank bought up vast holdings of government debt to support Covid bailouts, again demonstrating how closely debt management is tied to government policy. Acknowledging that public spending is a political choice taken by governments, rather than one dictated by remote financial investors, is especially important now. The poorer 40% of households in the UK are set to see their living standards fall substantially through this parliament. Public investment is one urgent part of reversing that trend, but it will be far harder to do without fixing the foundations of public finance. There’s nothing to stop the government and the Bank from working together in the service of national renewal, and there are plenty of places where this could start. At present, the Bank is costing the government around £20bn a year in its handling of public debt, partly because of the interest it pays to private banks on the reserves created during quantitative easing, and partly because it is now selling those government bonds back into the market at a loss (these sales also risk pushing up yields). The government could change the rule that leaves it liable for losses the Bank makes on interest payments and bond sales, or it could claw back some of these costs with a tax on banks’ windfalls. The Bank, meanwhile, could pause bond sales when they are loss-making. Carville had another notorious line: “It’s the economy, stupid!” A truly healthy economy will come from a government taking responsibility for delivering meaningful change, not evoking the bond markets to avoid it. Sahil Dutta is a lecturer in political economy and co-author of Unprecedented: How Covid-19 Revealed the Politics of Our Economy