The cost of UK government borrowing is higher than it has been since just before the global financial crisis of 2008. The yield on 10-year gilts – the interest rate the government is paying on the £4.25bn it borrowed today to finance the deficit – is about 4.5%, nearly five times what it was a decade ago, and higher than at any time during the Liz Truss meltdown.
So have the so-called bond vigilantes come after Rachel Reeves, selling off their holdings of government bonds en masse as they did after Truss and Kwasi Kwarteng’s budget? Not really. The Truss debacle was the consequence of a toxic cocktail of irresponsible tax cuts, institutional vandalism and a near-death spiral in an obscure part of the pensions market, all of which were UK-specific. By contrast, since the start of 2023, UK long-term interest rates have broadly followed US ones upwards. While part of this reflects the fact that UK inflation has been somewhat more persistent than the Bank of England hoped, it is mostly driven by global developments, and especially those in the US, where growth and inflation are somewhat higher than expected. It’s this, far more than anything the new UK government has done, that has driven the rise in borrowing costs.
And while most of the attention here has focused on Donald Trump’s plan to increase tariffs, arguably an even bigger risk to the UK and global economy is what he will do on taxes and spending. Higher US budget deficits usually mean higher US interest rates and a stronger dollar, and that appears to be precisely what markets are expecting. That in turn will mean higher UK rates, pushing up the deficit and hitting growth at the same time. So things may well get worse before they get better – and there is little or nothing we can do about that.
Unfortunately, all this means that our room for manoeuvre is limited. In October 2022, reversing the Truss budget was enough to restore confidence in fairly short order. That option is not available now.
Most immediately, the rise in the cost of borrowing further constrains what was already shaping up to be an extremely difficult spending review, given the pressures on public services. While Reeves’s sensible decision to change the debt rule has given the government welcome space to increase public investment, spending on interest payments hits her other rule – that current spending should be covered by tax revenues. And this rule, which has a long history and is grounded in economic theory, is not one that can sensibly be fudged or tweaked.
So how should the government respond? First, don’t panic. The government’s overall fiscal strategy – shoring up public services in the short term by putting up taxes, and then looking over the longer term to improve public sector productivity – is the right one. Nothing about what is happening in markets now changes that. Higher taxes or spending cuts in the short term would be bad economics and bad politics – and there is no reason to believe that the markets would react well to either.
Second, look to the longer term. Structural pressures on public finances are driven by an ageing population and the resulting pressures on health spending, social care and pensions, as well as the consequences of state failure on issues such as the special educational needs system in schools and the rise in the number of people out of work for health reasons. The UK’s fiscal credibility will ultimately be determined by how it addresses these issues.
Third, focus on delivery. If, for example, the extra spending allocated to the NHS over the next two years, coupled with the reforms announced last week, genuinely helps to reduce pressures on GPs and hospitals and get waiting lists down, that will mean less need for more spending in the later years of this parliament, when the fiscal constraints really begin to bite.
Fourth, remember that it is growth that really matters from an economic and a fiscal perspective. If the economy stagnates, we will remain in the economic doom loop of the past 15 years. There is a huge agenda here, on everything from planning and infrastructure reform to the “modern industrial strategy” we have been promised, to repairing our economic and trading relationship with the EU. This also means not doing stupid things that make matters worse. Immigration is now falling sharply, as forecast by the OBR. Imposing numerical caps or further restrictive policy changes would be bad for economic growth and the fiscal position.
None of this is easy. Ten years ago, the markets were saying loudly “borrow and spend”. George Osborne and David Cameron ignored them, and we are still paying the price for that catastrophic failure. Today’s risks and opportunities are quite different, but Reeves and Keir Starmer, if they hold their nerve, can still avoid another lost decade.