Government borrowing has fallen. The Office for National Statistics (ONS) is likely to say next week that, thanks to a big budget surplus in January, public sector net borrowing is on course to hit the Office for Budget Responsibility (OBR’s) forecast of £25.5bn this financial year. At 1.2 per cent of GDP this would be the lowest deficit since 2001-02.
And the market’s reaction is likely to be one big yawn. The fact is that there is just no link between government borrowing and bond yields. Longer-dated index-linked gilt yields were much lower in 2009-10, when borrowing reached almost 10 per cent of GDP, than they were in the late 1990s when the government ran a surplus. And real yields haven’t changed much since 2016-17, even though borrowing has almost halved since then.
One reason for this is that bond yields are largely set by global forces. They have trended downwards since the late 1990s because of a combination of high savings rates in Asia and the Middle East and a lack of investment opportunities and growth prospects in the west.
Also, it's because the circumstances in which government borrowing is high are also circumstances in which private sector savings are high – and the latter tends to depress yields. This follows from basic national accounting – that government borrowing equals private saving. The same boom in the late 1990s that caused a budget surplus also tended to raise yields, while the slump of 2009 that raised borrowing also reduced yields.
What this means is that the level of bond yields has not been a reason to reduce government borrowing. In fact, now that yields are significantly negative the government can raise borrowing a lot and still see the debt-GDP ratio fall over time. Even if we assume only moderate trend GDP growth, current yields suggest the government could run a deficit some three percentage points of GDP more than now, and have the debt-GDP ratio fall. That’s equivalent to extra annual spending or tax cuts of £60bn.
Which poses the question: what, then, is stopping governments borrowing more if not yields? The economic answer is: inflation. At some point a big fiscal stimulus would boost demand so much as to cause inflation to rise – although it is uncertain what this point is. Given the inflation target, this would mean higher interest rates.
For many economists, however – such as Jonathan Portes and Simon Wren-Lewis – this is a feature not a bug. Higher rates would give the Bank of England room to respond to the next downturn by cutting rates. This is a good thing because if a recession hits us when rates are as low as they are now, the Bank would have to print money, which has more uncertain effects upon output than do plain interest rate cuts. Looser fiscal policy, therefore, is a way of restoring the effectiveness of monetary policy.
In truth, though, perhaps economic analysis misses the point. The binding constraint upon government borrowing might not be economics at all but politics. High deficits give the impression that borrowing is 'out of control'. And some people – who are disproportionately employed in political journalism – think this a bad thing.
