It is often insufficiently appreciated how much has changed in economics since the 1990s. One of the biggest changes is that the bond market vigilantes have long since disbanded.
Once upon a time, governments that saw big increases in borrowing would be punished by a sell-off in bonds and hence higher borrowing costs. This led James Carville, an adviser to President Clinton, to quip: “I would like to come back as the bond market. You can intimidate everybody.” Today, though, they intimidate nobody. Official figures next week could show that UK public sector net borrowing is on course to overshoot March’s forecast of £29.3bn by perhaps more than £20bn, albeit due in part to a statistical change. And yet bond yields – both real and nominal – are now lower than a year ago and close to record lows.
Government borrowing, then, does not raise bond yields. The story of the past 25 years has been one of a long decline in yields, whether government borrowing has hit record highs – as it did in the financial crisis – or has fallen. One reason why both main parties since the 1990s have had some sort of fiscal rules is that bond markets impose no meaningful constraint on borrowing so they need a self-imposed constraint instead.
In truth, there are good reasons why government borrowing has so little impact on yields.
One is that the price of any asset depends not on the flow of new supply and demand, but on investors’ willingness to hold the stock of the asset. And the flow of new gilt issues is small relative to the stock. The government is likely to issue around £60bn (net) of gilts next year, but this would be less than 4 per cent of the total stock.
Also, demand for gilts is global. The latest figures show that foreign investors own £580bn of them. That’s 28.2 per cent of all gilts, and more than the Bank of England holds. Many of these investors are looking for safeish assets they cannot find in their own country, or ones with above-zero yields that are not available in much of Europe. A year of UK government borrowing is a minuscule fraction of the stock of global savings looking for a home.
But there’s something else. Government borrowing rises in bad times; one reason for this year’s overshoot is that the economy has flatlined for much of it. And the same bad times that add to borrowing also create extra demand for safe assets. This extra demand exceeds the extra supply, causing yields to fall even as borrowing rises.
This is not to say that the government can borrow with impunity. The constraint it faces is not a loss of market confidence but rather inflation. Big borrowing would, at some point, boost aggregate demand so much as to add to inflation. But with CPI inflation well below its target, and next week’s figures likely to show that producer prices and wage inflation are falling, this constraint is some way off. And even when we approach it, there is no great problem. Quite the opposite. Rising official interest rates – which would tend to raise bond yields – would be a good thing, insofar as they would give the Bank of England more room to cut rates when the next downturn comes.
What gilt investors have to worry about, therefore, is not government borrowing. Rather, it is that we might – at least when the coronavirus is contained – see signs of an upturn in the world economy that would reduce demand for safer assets.
