Is a significant debt crisis on the horizon for Britain?

As of yet, things are not as dire as some reports have suggested

"But they're definitely not rosy either," Julian Jessop says.

Headlines describing a "meltdown" in the bond market and a massive "50 billion" black hole that will require additional tax increases have already dominated the run-up to the November Budget. The UK may soon receive another IMF bailout, according to some conjectures. Fortunately, things might not be as bad as these reports indicate. However, a developing fiscal crisis is consistent with the recent rise in the cost of borrowing by the government. It is becoming more and more difficult for the chancellor to break free from her own fiscal regulations.

The yields on 30-year UK government bonds, or "gilts," have experienced a sharp increase to their highest level since 1998, making the issues most noticeable. Investor apprehension over global public debt increases is partially reflected in this upward trend. In many other nations, particularly France and Japan, similar headlines are being written.

Despite this, the UK now routinely has the highest bond yields among the advanced economies in the G7. In the UK, the cost of new government borrowing for ten years is currently about 4 percent. In the US, France, Italy, Canada, Germany, and Japan, the cost is about 3 percent, 3 percent, 2 percent, and only 1 percent, respectively. This is especially noteworthy because, by global standards, the UK's public debt is not very high. The United Kingdom's debt to national income ratio, which stands at approximately 100 percent, is actually lower than that of Italy (135 percent) and significantly lower than that of Japan (240 percent). Even Greece can borrow at 3 percent, even though its debt still exceeds 150 percent of its GDP.

Why it seems like the UK is in a downward spiral.

There are three primary reasons why the UK has become such an anomaly.

First, a lot of foreign investors are becoming less convinced that the Labour government will make difficult choices to reduce borrowing, particularly in light of its recent inability to reduce welfare spending.

Fears that the UK is caught in a "doom loop" of slow growth and collapsing public finances are only being heightened by the possibility of additional tax increases.

Second, in contrast to other central banks, the Bank of England has been aggressively selling its government bond holdings, reversing the previous policy known as "quantitative easing" (QE).

The new "quantitative tightening" (QT) policy, according to the Bank itself, may have raised 10-year gilt yields by as much as 0 to 25 percentage points. Given that defined-benefit pension funds, which have historically been significant purchasers of longer-dated government bonds, are currently showing less demand, this additional selling is particularly detrimental. Thus, the comparatively significant increase in 30-year gilt yields can be explained.

Third, there are concerns that rising inflation in the UK will raise the cost of inflation-index-linked borrowing, of which the UK has a sizable amount, and keep official interest rates higher for longer. In contrast, relatively low inflation and the comparatively low interest rates set by the Bank of Japan and the European Central Bank serve as the anchors for yields in the euro area and Japan.

This does not imply that a full-scale debt crisis in the UK is unavoidable or even approaching. Only the cost of new borrowing is impacted by the rise in bond yields; the cost of existing debt remains unchanged, giving at least some leeway. With only 16 percent due in the next three years, each conventional gilt has an average of more than 13 years left before it must be refinanced. Index-linked bonds have an even longer average durationmore than 17 years.

It is also important to emphasize that the increase in government bond yields has happened in a fairly orderly fashion, with minimal impact on other markets. There hasn't been a shortage of buyers at the lower prices, but investors have been demanding higher returns to offset the increased risks. The government's Debt Management Office is also selling more gilts with shorter maturities in order to avoid paying the higher interest rates on longer-dated bonds when more money is needed.

This episode thus far differs from the crisis following the mini-Budget in September 2022. Home lending dried up as a result of the panic in the mortgage market that followed the gilt sell-off. Some pension funds also experienced immediate difficulties as a result of the steep declines in gilt prices. Additionally, the pound fell.

Is a debt crisis akin to the one of the 1970s imminent?

Furthermore, the UK is not yet in danger of receiving an IMF bailout. Undoubtedly, a growing number of analysts are predicting a "debt crisis akin to the 1970s" unless the chancellor alters his agenda.

These voices include prominent economists Andrew Sentance, Willem Buiter, and Jagjit Chadhaall of whom are not your typical suspects but whose opinions are worth considering.

The rational argument put forth by Chadha and others is that IMF participation could boost the fiscal framework's legitimacy and regain some market trust, drawing in more private investment that would outweigh the IMF's meager resources.

However, things are also different now than they were in the 1970s. In 1976, the IMF provided a US dollar loan for the bailout. This was primarily used to reimburse other nations that had given the UK government foreign exchange loans in an effort to support the pound. Right now, that is not the issue.

The government would be justified in allowing the pound to decline if the UK were experiencing a sterling crisis, which it is not yet. Significant cuts in public spending would be among the harsh terms of any IMF bailout that would make it politically unacceptable.

In other words, we wouldn't require the IMF at all if the UK government were prepared to make these difficult choices. With Jeremy Corbyn's new far-left party posing a threat, an IMF-imposed austerity program would undoubtedly spell disaster for both Rachel Reeves and Keir Starmer. Markets wouldn't necessarily feel more at ease.

On a more optimistic note, the UK's prospects remain better than they were in the 1970s. Both inflation (which peaked at 24 percent in 1975) and interest rates (the Bank rate hit 15 percent in 1976) were significantly higher, the economy shrank by roughly 4 percent overall in 1974 and 1975, and unemployment increased dramatically (from a low of 3 percent in 1974 to a peak of 11 percent ten years later).

To avoid a debt crisis, start with stopgap measures.

Last but not least, the authorities may attempt other measures before contacting the IMF. The Bank of England's "Ways and Means" (WandM) overdraft facility could be used by the government to borrow short-term funds in an emergency.

There is a recent precedent: although it was never really required, an agreement reached in April 2020 permitted increased use of the W&M during COVID.

The Bank of England could also intervene and temporarily buy gilts again if the bond markets did become chaotic, as it did in September 2022 with remarkable success.

This is only partially comforting, though. These stopgap measures might backfire if they are perceived as highlighting the dire state of the public finances and if the government fails to take advantage of the breathing room to address the root causes. On the down side, the state of the public finances has gotten worse since the 1970s.

While the stock of debt was much lower (roughly 48 percent of GDP, as opposed to 96 percent today), the annual budget deficit was comparable (averaging 6 percent of GDP in 1974 and 1975). The fact that about 25% of the nation's debt is now correlated with inflation is another new risk.

Regardless, the most recent tremors in the bond market couldn't have happened at a worse moment. The Office for Budget Responsibility (OBR) will begin analyzing the budget's financial data in a few weeks.

Significantly, the OBR's projections will be predicated on whatever assumptions the markets have regarding the direction of interest rates over the ensuing five years. Therefore, these assumptions may further reduce any remaining leeway against the government's fiscal regulations or, more likely, increase the current deficit.

This could then lead Reeves to declare even more significant tax hikes, which would have a direct effect on economic activity and severely damage business and consumer confidence.

Also, there is still a chance that bond investors' anxiety will affect other markets, like stocks. It already looks as though the real estate market has stalled once more.

If the decline in global confidence turns into a rout, sterling is particularly vulnerable as well. This could have an immediate effect on inflation, the real economy, and the prices of other assets.

The fact that other nations are currently experiencing difficulties also reduces the likelihood of a sterling crisis. However, if the UK were perceived as an even greater anomaly, that could quickly change.

Perhaps the government has time on its side.

Right now, the main hope is that things will get better before the actual budget is announced on November 26. There are concerns that a longer period of conjecture and uncertainty will further erode confidence because of the comparatively late timing. However, there might also be some benefits.

Primarily, the postponement gives the world's bond markets more time to settle, which relieves some of the strain on UK borrowing costs.

Additionally, this could backfire if there is more negative news from other countries, such as the US (for instance, higher tariffs might finally cause consumer price inflation, escalating tensions between Donald Trump and the Federal Reserve), France, or half a dozen other nations where fiscal sustainability concerns are also growing.

Thankfully, the potential benefits of a late budget go beyond a boost in world sentiment. The second benefit is that the UK government would have more time to find additional welfare bill savings to make up for the £6 billion that was lost due to the working-age benefit and winter fuel payment U-turns. Labour MPs would still need to approve of these savings, but the government would have more time to correct the political situation.

Additionally, the government will have more time to convince the OBR that the supply-side reforms and anticipated increases in public investment will increase the economy's potential for productivity.

Indeed, the growth assumptions will be even more significant than the interest rate and inflation assumptions. The shortfall that must be made up by tax increases or spending cuts may increase by roughly £5 billion due to the rise in gilt yields since the OBR's forecast for the Spring Statement. However, if the OBR uses the same gloomy growth and productivity projections as the National Institute of Economic and Social Research (NIESR) recently, this deficit could increase to 50 billion.

Thankfully, NIESR 50 billion is an anomaly. Without raising taxes, the chancellor may still be able to keep the new pain down to about 20 billion, with at least 5 billion coming from welfare savings.

That might be the least undesirable result, and some people might even find it relieving. Nonetheless, there is no denying that the UK is in the early phases of a crisis that could develop in a variety of ways, with or without the IMF's assistance.

Julian Jessop is an economist who works for himself.