Now government and media are blessed with 20/20 hindsight about the property and commodity price bubbles, they should ask themselves when and how they want to puncture the latest bubble – that in government bonds. Or do they wish to do exactly the same with this as they did with the property and commodity bubbles – supply the cash to fuel them, create the regulatory rules to allow them and sit back and watch until it is really painful to burst them?
The government bond bubble is currently growing large. The government probably wants this to happen, as it knows it has a lot of government debt to sell. But at some point investors and regulators will wake up and see it is not healthy for too many institutions and people to be lending to the government for tiny rates of interest, especially if the government’s aim is to inflate their way out of the crunch in due course. For the moment the government can inflate the bubble more – after all there is still a positive rate of interest on longer bonds, and short term interest rates are still above zero.
So why does the bubble matter? Lending too much to any company or institution, as we have seen in the private sector in recent years is not healthy and at some point has to be corrected. All the time they can get easy credit they are happy and the system looks stable. Once they cannot get the credit any more people are amazed at how much they were allowed to borrow on such good terms in the good times. The private sector went to the borrowing party in 2005-6. The Bank of England supplied the drinks, and the banking regulator organised the tickets and watched as they arrived for the binge. They are all now living with huge hang overs.
Now the government has invited itself to a similar party. The drinks are once again being supplied by the Bank, with help from the other banks and pension funds. The regulator has not merely issued the tickets but has told the banks to bring more booze so the party goes really well. Banking regulations are being changed to make commercial banks lend more to the government (to improve their liquidity). The authorities have dreamt up a new policy called “strengthening the banks” which entails putting taxpayers cash into some of the banks, so they can lend it back to the government at a loss.
The foreign exchange markets currently do not approve. Maybe they have read the detail of the Chancellor’s statement and do understand that this year’s borrowing is not £78 billion as advertised but a massive £157 billion or more than 10% of National Income. Maybe it is just the advertised promise that the government will borrow 8% of National Income next year that worries them. Maybe it is that and the weak performance of the UK economy, though Euroland and the US will not perform well either. Maybe it is thinking ahead to the losses about to be recorded by UK banks, including those that the government has invested in. Whatever it is, something has spooked the currency markets. Sterling hit $1.45, 131 yen and 1.03 Euros yesterday. The slide continues unabated.
So what should the government do about the runaway borrowing, the bond bubble and the collapse of the currency? It should
1. Signal that interest rates have fallen enough.
2. Cancel the regulatory requirement for banks to buy more government bonds – they need to lend more to the private sector instead to start to lift the recession
3. Relax regulatory capital requirements on the banks as they declare write offs and create more realistic balance sheets
4. Get a grip on the nationalised banks costs – they need to make some money to offset the losses
5. Indicate there will be no more share capital for banks – future support for banks will be based around short term loans against proper security
6. Look for ways to get its capital back from the banks it has put share money into – through asset sales, cash sweeps and refinancings
7. Cancel the VAT reduction, and replace it with cheaper better targetted recession busting tax reductions
8. All the usual advice about how to control public spending