Merlin Weekly Macro: Debt addiction poses far-reaching risks

“Everyone has a plan until they get punched in the mouth”. So, pithily through broken teeth, said Mike Tyson. The more sober military version is “no plan survives first contact with the enemy”. Both epithets assume that there was a plan in the first place. With the Labour government’s economic programme, the plan, such as it is or was, has been a serving of thin gruel lacking either nourishment or substance; less generously, after 11 months in office, who knew the plan involved Labour punching itself in the mouth.

The Third Reckoning

On 11 June, Rachel Reeves faces her third formal fiscal event in her capacity as Chancellor of the Exchequer: she will present the multi-year spending review for public services. Since the first event, her Budget last October, she has been continually on the defensive. Hailing it as an economic reset ‘after years of Tory chaos’, her budget assumptions (and it was most definitively ‘her’ budget, so often did she drum home to all and sundry when presenting it that ‘these are my choices’) if not in tatters are already distinctly frayed at the edges. Only five months later, her formal March Statement revealed the extent to which the fiscal headroom she thought she had created for the duration of the parliament, had already evaporated.

As to surviving first contact with the ‘enemy’, she is dealing with stakeholders who if not outright foes, are hardly friendly and at best are neutral; whatever their perspectives all have an active interest and express it in their own ways. She has a multi-faceted problem: to raise more revenue from the electorate to whom she and Keir Starmer vowed not to change the rates of Income Tax and VAT, and the employee’s National Insurance rate; with a posse of vociferous but vulnerable back-benchers who have forced U-turns on benefits savings (winter fuel allowances, potentially the two-child benefit cap etc); with the public sector unions demanding further significant real-terms pay awards on top of the ones already given last July while insisting on more departmental funding and fiercely resisting budget cuts and changes to entrenched working practices; with the Office of Budget Responsibility which prescribes her limits of fiscal freedom; and finally, the bond markets who are marking her homework and are so far unimpressed with her grip on the situation. Further, Donald Trump’s likely insistence next month at the annual NATO summit that every member spends 5% of GDP on defence leaves Reeves scratching around trying to find a spare 2.5% to persuade Trump we are committed, onside players worthy of rescue if the Russians come marching in.

Storm’s a’comin’!

As barometers of sentiment and therefore political susceptibility to changing tack (or blowing in the wind), consider the following: Labour was elected with a majority of 174, already reduced to 165 through a resignation, an arrest, a by-election loss and suspensions for defying the whip, and while less than a fifth of the way through its mandate already Deputy Prime Minister Angela Rayner is surmised to be ‘on manoeuvres’ for the top job;  in the aggregate of polls over the last month, Reform is averaging a seven point lead over Labour whose share has fallen 11.7pts since the election; in a case of financial backwardation, on Budget Day on October 30th 2024 the UK 10 Year Government bond carried a yield of 4.36% (and six weeks previously it was 3.75%) against a UK base rate of 5.0% but today the 10 Year Gilt yield is 4.72% while the base rate has been reduced to 4.25%. At 5.4%, the government has found issuing strategic 30 Year debt to be too financially onerous and has had to resort to shorter-dated offerings which need refinancing more frequently. The markets’ preoccupation is less with future inflation than it is with an increased perception of financial risk.

Reeves was on shaky ground from the off: as we pointed out last autumn, after assuming office her sudden identification of a mysterious ‘inherited £22 billion black hole’ which rapidly doubled to £40 billion immediately ahead of the Budget simply told the markets that Reeves’s grip on the numbers was limited and her department’s due diligence had been dilatory. These are very big sums to have missed, not ones that are buried deep in the notes of the accounts or bills written on scraps of paper stuffed in the tea caddy hidden at the back of the cupboard. That she and Starmer then spun the obvious non-sequitur that a big rise in employers’ NI was in no way a tax on employment only added to the perception that Labour was either taking everyone for fools or was divorced from reality. By March, such was the pressure to balance the books when against her assumptions GDP growth had stalled but government borrowing costs had risen, she had to find £14 billion of emergency savings to stay within the red lines of her fiscal rules. Today, with further upward pressure on borrowing costs and headroom once more running out but new money-saving policies already in danger of being reversed or moderated, the suggestion by the economic thinktank the National Institute for Economic and Social Research is that she will already be needing to find another £30 billion a year by the time of the Budget in October to keep the books straight. This is tantamount to perpetual fiscal firefighting; it is no way to run the world’s sixth biggest economy.

As Reeves walks the tightrope of balancing the fiscally credible with the politically possible, adding to her preoccupations this week has been the International Monetary Fund and its annual assessment of the UK economy. Emphasising our caveat that in the current conditions of fluidity with Trump’s tariffs (the latest twist being the contradictory court rulings that most of his tariffs are illegal and the President exceeded his authority), economic forecasts should be taken with a significant pinch of salt, having downgraded its estimate of 2025 UK GDP from 1.6% to 1.1% only a month ago, it has now revised the projection upwards again to 1.2%, rising to 1.4% in 2026. But it is the IMF which is suggesting that the UK’s preoccupation with always staying within the bounds of the fiscal rules is itself contributing to the erratic and short-term nature of our fiscal management. The IMF proposes that assessment against the rules should only be made once a year, at the Budget, rather than watchers keeping a constant eye on any transgression and inflicting real-time penalties through increased borrowing costs.

The clash between technocracy and politics: ‘trust’

The IMF has a point (though it was unforgiving with Liz Truss): strategic perspective and micromanagement are uneasy bedfellows. So what if there are minor deviations along the way, so long as the end goal is reached satisfactorily? Surely that is the superior target: the end justifies the means.

It would be an entirely pragmatic route if governments and treasuries had a demonstrable track record of achievement and could be trusted to deliver. But that is precisely the problem: the history of the last 25 years says that across the western world, virtually none of the major democracies can be trusted to manage their finances without accruing significant debt. For the fact is that while most are predisposed to Keynesian economic orthodoxy by political choice, the urge to spend is pre-programmed. By whatever route they choose, running enduring budget deficits is a habit that is very difficult to kick. Whether they describe themselves as conservatives, social democrats or socialists makes very little difference: essentially they are merely variations on the path to penury rather than offering radically different economic and political choices as to how to avoid it.

A good case in point is Trump’s spending bill which was passed in the House of Representatives last week and now goes to the Senate: while it includes spending cuts to areas such as Medicaid and other benefits, there is also the inevitable increase in defence spending and the strategic plan to invest in infrastructure to support the AI revolution; taken alongside tax cuts, the net effect is an estimated $600bn a year increase in the government’s planned deficit in 2025/6. Ultimately it is estimated that more than $5 trillion is potentially added to US government debt by the end of the decade. That will take total projected debt to over $41 trillion from $36 trillion now; today, the US economy is worth $27.7 trillion, the debt exceeds the economic capacity to support it by 30%. Here is the question: will Trump’s new lower tax but higher spending combination create an economic multiplier effect that expands the growth rate and in the longer-term helps reduce the debt? Or will frictional factors and inefficiencies erode the benefit and simply reinforce the embeddedness of the debt resulting in the key deficit/GDP and debt/GDP ratios continuing to deteriorate? Moody’s, the rating agency, was decisive: the last of the major agencies crediting US government debt with the accolade of an Aaa rating, it promptly downgraded: down went the credit rating, up went the cost of capital reflected in a higher bond yield; a higher cost of capital attached to a rising debt pile becomes more burdensome to the economy. Investors have not lost confidence in the US to honour its financial obligations to repay its borrowings, but they are more thoughtful that it might not, on time and unconditionally.

Enduring debt and persistent deficits

The UK’s OBR, the International Monetary Fund and plenty of respected economic institutions are warning about the dangers posed by the growing mountains of debt across the west. Debt is no longer the elephant in the room; it is being called out as a significant financial risk potentially with systemic consequences (heaven knows, we’ve been droning on ad nauseam in these columns about it for years). Yet the collective body politic refuses to tackle the situation head on, or where it does, those who understand either do not have the numbers to make their voice matter or are unable to make a strong enough case. France’s government suffers debt paralysis; having had a government implode on what defines the bounds of a deficit in an emergency, markets worry about the increased financial risk of Germany’s new relaxation of the debt brake law to fund defence; Italy remains grossly over-borrowed but has made some progress reducing the deficit but is unable to eliminate it. Europe is a mere beginner in comparison to Japan: 236% geared and with a deficit of 5.5% of GDP, nobody stresses too much because most of the debt is owned by the Japanese central bank, ostensibly a self-contained problem; until it isn’t. Elsewhere, China’s economic data remains enigmatic: is its debt/GDP 88% as reported by the authorities, or 300% as calculated by seasoned western watchers who include all the hidden, off-balance sheet liabilities; you can drive a coach and horses sideways through the gap.

Here in the UK, successive administrations since 2010 and the Global Financial Crisis have tinkered at the edges and deluded themselves that they are addressing the issue (e.g. Tory Austerity, 2010-2018) without ever getting get to the meat. The consequence is that we now spend over £100 billion a year on debt interest, more than double the sum in 2019. The difference between the two is the equivalent of the current defence budget.

Bond Vigilantes 

It is currently popular to say that bond markets are fulfilling the fiscal policing role abrogated by national parliaments. There is an element of truth to that. But only to the extent that markets as providers of capital determine its cost: they can only deal with what is presented to them; they do not formulate policy even if they influence its limits.

But while bond markets might be tempted to bask in the reflected glory of being hailed as ‘vigilantes’, their overpowering motive is making money (or not losing it); heads down relentlessly in pursuit of gain (that’s the whole point, of course!), they too can lose sight of reality and become unwitting or blind participants in undermining the foundations of economic resilience. As accessories caught red-handed at the scene of the crime, the evidence is all there, m’lud.

In the prolonged period between the Global Financial Crisis (GFC) and the aftermath of the pandemic and Putin’s invasion of Ukraine, bond markets were the active, willing agents of the central banks’ policy of quantitative easing and ultra-low interest rates, indeed negative rates in the Eurozone (on the basis that most governments cannot issue bonds direct to the central bank, those bonds must be issued to the market from which the central bank then purchases them). A one-way bet, it created excess demand for bonds, driving yields down and prices further up. It increasingly relied on the Law of The Greater Fool to keep going. It became so irrational that at its peak, a third of all government debt globally was on a negative yield: governments were being actively paid by investors to borrow money. In Germany, for a brief period, even its 30-Year bonds were so priced, implying a completely implausible less-than-zero risk on a thirty year outlook. It seems incredible (we said as much at the time), but however mad, it was it was accepted orthodoxy. It ill-behoves such players now to be holier than thou.

With instant access to the never-never from willing markets and central bankers mired in flawed thinking, it is hardly surprising that governments became the financial equivalent of drug addicts, hooked on the monetary methadone. Now that the market tariff has gone up many fold, the era of cold turkey is proving painful, but one in which many governments remain in denial. Rehab has barely begun. But as dealers, markets must recognise their share of the blame for fiscal probity sliding off the rails.

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