The UK’s public finances are deep in the red. Next week’s figures will show that net borrowing in the first three months of this financial year was around £150bn. At 30 per cent of gross domestic product (GDP), this is comparable to the deficits the government ran during the second world war. This will push the ratio of government debt to GDP up to around 110 per cent, the highest since the late 1950s.
And the gilt market couldn’t care less. Short-term yields are negative even in nominal terms. And even longer-term yields are negative in real terms. The market is so keen to lend to the government that, over 15 years, it is happy to accept a repayment of only £66 for every £100 it lends.
To understand why yields should be so low, we must know why borrowing is so high. Standard explanations say it is because tax revenues have slumped because of the lockdown while government spending has soared, thanks in large part to the furlough scheme.
This is true, but incomplete. Instead, we must start from a very basic fact – that every pound borrowed by someone is a pound lent by somebody else. When the government is borrowing, therefore, it’s a sign that somebody else is saving. Right now, that somebody is households. Bank of England data show that in the last two months we have reduced our debt by £12bn as we’ve paid off consumer loans and not taken out mortgages and added £41bn to our bank deposits. Closing shops forces us to save: who’d have guessed?
If one sector – households in this case – is a net saver, somebody else must be a net borrower.
In this sense, the same thing that causes government borrowing also creates demand for gilts. Sure, households themselves aren’t buying gilts in any significant quantity. But the same recession and uncertainty that is forcing us to save is also increasing investors’ demand for safer assets. Hence the low yields.
Although today’s numbers for both borrowing and yields are mostly unprecedented, the story is certainly not. In the last three significant recessions – the early 1980s, early 1990s and 2008-09 – we saw the same thing: increased government borrowing and falling yields. And we saw them for the same reason. The same recession caused by increased private sector savings creates sufficient demand for gilts to drive yields down even though the government is supplying more of them. The price of assets depends not on the flow of new supply and demand, but on investors’ willingness to hold the stock of assets. And the willingness to hold the stock of gilts increases in the same bad times that cause the supply of them to rise.
This does not mean that all increases in government borrowing must be benign. If the government were to choose to borrow more when the economy was operating near full capacity, the prospect of increased inflation might well trigger a sell-off of gilts. It is inflation that constrains government borrowing, not a lack of finance. For now, though, the threat of inflation is a distant one.
Now, you might think that everything I’ve said here is modern monetary theory, of the sort described in Stephanie Kelton’s new book The Deficit Myth. But there’s nothing modern about it. Economists have long known all this. “Look after the unemployment, and the Budget will look after itself,” said Maynard Keynes in 1933. In the 1940s, Abba Lerner argued that public finances should be directed towards ensuring prosperity rather than fretting about government debt. And in the 1980s, Mrs Thatcher’s talk of cutting borrowing being like good housekeeping caused winces of pain in economics department everywhere. Talk of modern monetary theory makes me feel like Monsieur Jourdain in Moliere’s play, the Bourgeois Gentleman, who was surprised to learn that he had been speaking prose all his life.
