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OPINION

The cost of rising yields

The cost of rising yields
June 17, 2013
The cost of rising yields

For the next few years, the answer is: not much. The OBR's forecasts assume that gilt yields will rise by two percentage points between 2012-13 and 2017-18. Even on this basis, government spending on debt interest will rise only slightly, from three per cent of GDP last year to 3.8 per cent by 2017-18. This would leave the interest "burden" lower than it was in 1997, when the government spent over four per cent of GDP on interest.

There are two reasons why the increase will be so modest. One is that, thanks to quantitative easing, the Bank of England owns 29.4 per cent of the stock of gilts. A chunk of government spending on debt interest is therefore, in effect, the right hand paying the left hand. Also, UK government debt has a long maturity - an average of over 15 years. This means that the government has locked in low borrowing costs, so that a rise in interest rates will have little immediate impact. The OBR estimates that a percentage point rise in gilt yields would add only £2.6bn to public spending by 2014-15. That's a fraction of a forecast error.

However, both of these are only shortish-term comforts. Eventually - that is, after very many years - QE will be reversed so that debt returns to the private sector, and the government will have to refinance its debt at higher rates.

This would have two implications. Most obviously, it would add to debt servicing costs. If gilt yields rise to six per cent - their mid-90s level - then a debt-GDP ratio that's stable at 85 per cent (the OBR's forecast for 2017-18) implies that government spending on debt interest would rise to over five per cent of GDP. That's two percentage points more than now.

Secondly, higher interest rates require a tighter fiscal policy to prevent the debt-GDP ratio from rising explosively. Simple maths tells us that a real gilt yield of three per cent would require a surplus on the primary budget (which excludes debt interest payments) of 0.8 per cent of GDP. This year, the OBR expects a deficit of 4.8 per cent of GDP.

Historically speaking, these are not great problems. The government spent more than five per cent of GDP on debt interest in the early 1980s and late 1940s. And a primary surplus of 0.8 per cent of GDP would only be the average balance the government ran between 1948 and 2012.

Two other things, though, suggest they would be tricky. One is that this is not the only long-term pressure on the public finances. An ageing population will also increase spending on health and pensions. The other is that the tax base is weak. Google and Amazon have reminded us that multinational companies can escape corporation tax, whilst there's little public appetite for higher personal taxes - an aversion which might not diminish even if the squeeze on incomes ends.

In this sense, the return of gilt yields to normal levels would be a problem for the public finances. Not a catastrophic problem, and certainly not a short-term one, but a problem nonetheless.

It's not obvious that the solution to this is greater fiscal austerity now; insofar as austerity hurts the economy it does little to improve the public finances. Instead, there are three possible solutions. One would be higher inflation, which would transfer real resources away from holders of (conventional) gilts. Another would be what Carmen Reinhart of the Petersen Institute for International Economics calls "financial repression." For example, forcing banks or pension funds to hold lots of gilts - purely for prudential reasons of course - would help hold down government borrowing costs. And a third possibility, once the economy has recovered, is a combination of higher taxes and lower public spending on other items. Come the next economic boom - remember, we're talking long-term here! - counter-cyclical policy might have to be more fiscal than monetary.

We shouldn't, however, panic about this. Remember that for very many of us, higher gilt yields would be a good thing insofar as they raise annuity rates and hence retirement income. The public finances aren't the only thing that matter.