Friday, December 31, 2010

Waiting for the great default

What is the true meaning of this chart?

As the red line illustrates, the yield on a UK twenty-year government bond is around four percent. This means that private investors are prepared to accept a promise that the government will repay a loan in 20 years time in exchange for a four percent return a year.

At the same time, the government promised to pay generous pensions to the public sector. It will also maintain a comprehensive pension system for the rest of us. It has agreed to sustain a social safety net for the unemployed and those suffering from long-term illnesses.

It insists that it will keep a fully comprehensive and free National Health Service. It has also committed to honouring a mountain of PFI agreements under which the private sector built public sector infrastructure in return for long-term service contracts.

I could go on, but the key point is that previous governments have promised away decades of tax revenues.

It's impossible to see how all these commitments can be honoured at the same time. The yield on government bonds reveals no such doubts. The UK bond market doesn't appear to be worried by all those years of extravagant promises.

There can be only one way of reconciling that contradiction. Bondholders are convinced that they will be repaid, which means they also believes that the government will renege on all those other commitments. For future generations, there will be no generous pensions, unemployment benefits, or free health services.

The government is going to default, but it won't be on its outstanding stock of bonds. It is going to default on the commitments it gave to us.


  1. "There can be only one way of reconciling that contradiction."

    There is another way: there simply is no contradiction.

    Your argument that "It's impossible to see how all these commitments can be honoured at the same time" is essentially unsupported.

    The UK can easily sustain a higher public debt:GDP ration, just look at Japan.

  2. A higher debt ratio can only buy a few years; it is not going to solve this conflict in the long term. Economic growth might, but I suspect Alice's prediction is correct: policy promises have a lower status than nominal debt promises, and will be broken first.

    However, I'd add two caveats.

    First, I suggest that everyone knows policy commitments are neither firm nor forever. People, by and large, do not plan as if policies will never change. I think this applies to your recent post on pension promises too. Even the pension commitment within an employment contract is not expected to last forever; provided employees are given fair notice, I think it's reasonable that employers (private or public) can change their terms of employment when conditions change. After all, employees can terminate an employment contract whenever they like; although the relationship isn't symmetrical, employers need to be able to make some changes too.

    Second, the debt promise can also be broken, or bent, by inflation. We have seen 3% inflation for about a year now in the UK, and probably for another year to come due to tomorrow's VAT increase. I think we'll either get decent growth or continuing inflation - or both - over the coming years. The Bank of England is effectively following a nominal GDP growth target. Honestly, I'm unsure why bond investors are willing to lend for 20 years at 4% - but perhaps it reflects a perceived lack of alternatives.

    After all, when these bonds were sold, investors hadn't yet seen the Sunday Telegraph's revelations about the amazing returns available in the property market.