Tuesday, October 26, 2010

Debt and Bonds in the UK


From: What Debt Crisis

UK public sector debt is currently around 70%, we are told the necessity of cutting the deficit immediately. But, just imagine if the government said, we are going to embark on a huge expansion of the welfare state, build 500,000 homes a year and spend a lot more on the National Health Care. We will keep spending until we have a public sector debt of 200% of GDP.

There would be incredulity and we of course, we would hear the bond market would never lend the government money so much. Surely borrowing over 200% of GDP would lead to higher interest rates, inflation, and economic decline?

Well, the interesting thing is that is exactly what we did in the 1940s and 1950s. UK public sector debt did rise to over 200% of GDP, but, bond yields barely battered an eyelid, and remained as low as 2-3%.

Why Could Government Borrow So Much and Could They do The Same Again?

Inflation expectations. The 1920s and 30s were a period of deflation. In the 1940s and 50s, people expected low inflation. Therefore a government bond yielding 2% seemed a relatively good deal. These days, there is a greater fear of potential inflation. Inflation reduces the value of holding bonds, leading to higher interest rates. In the 1960s and 1970s, moderate inflation, was a factor in reducing real value of government debt. Bond markets are more wary of government inflating debt and making bonds less attractive. (though there is still greater risk of deflationary pressures than hyper inflation at moment.

Patriotic Feeling.

The Second World War was all encompassing. If you couldn't physically fight Hitler, you could at least buy government bonds. It was an easy action for those who wanted to help war effort from a financial point of view. I can't see the same patriotism and deference to government today. Never could I image David Cameron launching a campaign - buy government bonds to help our 5 million UK adults living off benefits and an ageing population. It just doesn't have the same ring as defending democracy.

Military Cuts.

Obviously a key component of UK debt in 40s and 50s was military spending. Bond markets knew this could be cut back when the war was over. This was a relatively easy aspect of government spending to cut back. It is harder to find a similar area of government spending that can be cut today.

Less Competition.

In the 1940s and 1950s, the bond market had greater prominence, it took a bigger % of investment funds and private sector saving. These days, there is greater interest in the stock market and other financial instruments.
  • However, the credit crunch did create greater interest in the perceived relative security of government bonds. Despite examples of Iceland, Greece and Spain, bonds are currently in vogue. Banks are also not lending to private business / individuals so are buying government bonds as an alternative.
High Growth

The post war trade boom helped increase economic growth. The rise in GDP helped improve tax revenues. The high growth also enabled a long period of full employment. (Beveridge always said full employment was essential to make Welfare state manageable)
US spending its way out of recession (source: Krugman)

Though UK in 1940s and 1950s declined relatively, the strong global growth helped increase UK GDP and thus helped to reduce debt as a % of GDP. Prospects for global growth in 2010 are more uncertain.

Private Sector Saving

Private sector saving was higher in the 1940s, these household funds were used to buy government bonds.

Borrow From US

In the 1940s, with onset of cold war, the UK secured a significant loan from the US, which was essential to avoiding debt default. Obviously the US is unable to start lending to any other country now.


In the 1940s, most UK bonds were held by UK individuals. Globalisation has given UK access to global bond investors. This is good so long as foreign investors have confidence in value of Sterling. It can make UK more vulnerable to capital flight if Sterling devalues too quickly.


This example shows that higher government borrowing doesn't necessarily lead to higher interest rates, inflation and economic damage.

But, nor does it prove that the government could borrow anything like the same amount today, without causing a different result. There are so many factors that determine levels of government borrowing, you can't easily make comparisons with other years and situations.


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