The government borrowing bubble

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


  1. Letters From A Tory
    December 30, 2008

    This time next year, we’re going to look at Alistair Darling’s predictions for the British economy and we are going to hang our heads. He got it completely wrong in March 2008 and he’s going to get it completely wrong with the recent PBR.

    Labour will not be able to escape their own terrible predictions and their inaccuracy will hurt them badly in the run-up to the next election.

  2. Alan Wheatley
    December 30, 2008

    Why are the banks so quiet on these matters that affect them so significantly and affect us all, their customers, so profoundly?

    Does “the banks” mean all banks, or should some differentiation be made between, say, RBS and HSBC?

    Are building societies equally affected?

    Reply: There are important differences between the banks, but they all will have to lend more to the government under the regulators new proposals.The state owned ones were the weakest which is why they accepted state capital.

  3. […] Their faith in Brownian (dis)economics being so strong, we will soon have the indignity of the pound being worth less than ze euro. Worthless, in other words. John Redwood has an excellent post on the borrowing bubble that will eventually burst. […]

  4. T. England
    December 30, 2008

    How many times do we have to watch various governments mess up with Bonds?
    Surely letting a government play with bonds is like giving a child monopoly money!

    What’s going on in the financial markets brain at the moment?
    From what I can make out from my grunts eye view it’s like this.
    The British government has been seen to have had no plan to deal with the financial problem, in fact it was seen to have panicked! This was not seen as a good thing!
    No wonder Labour kept asking the Tories what they would do, needed help didn’t they :o) , so can Labour be trusted in the eyes of the financial markets? I doesn’t seem so & the public should know about it.

    The market doesn’t think government bail out’s are really going to work, so what’s going on with this 200 billion euro bailout, who’s paying for that? What’s the point?
    The banks are playing for time & isolating “incidents” as they happen, not seen as a good move! Banks just seem to want to anchor down until 2010, as for the stopping of the recession half way though next year, that seems an insane thought.
    The markets are seeing the rules of capitalism ripped up, heavy, costly regulation isn’t seen as a way of repairing things, and they are saying “you can’t regulate your way to safety”!
    In one interview I saw recently it was said that Britain was heading for a post war crisis & an Iceland style crisis, which is going to make things worse for us, if at all possible :o(

    It seems fund managers, etc are now just looking for well managed companies that aren’t to do with the auto industry, that can’t be a good sign for auto companies & they don’t want companies that are funded by debt, OH dear!!!
    One good sign! Investment companies have been stashing money away apparently, which should help stock prices, at least someone knows how to save money!!!

    Britain is in deep trouble thanks to Brown & Labour NOT just America.

  5. jomama
    December 30, 2008

    This article is why I’ve termed government borrowing
    The Last Bubble™.

    Take a look at what will be the most likely outcome:

  6. Stuart Fairney
    December 30, 2008

    JR can you assist me, precisely what are the banks required to do vis a vis government debt purchase and this this optional or compelled?

    Reply: They are consulting on new rules for liquidity which would require banks to hold more in gilts to count as a liquidity buffer.

    1. Stuart Fairney
      December 30, 2008

      Crikey, enforced landing! really creepy and very statist of them.

  7. Ian Jones
    December 30, 2008

    The Govt debt issue really needs to be highlighted as we seem to be following the textbooks on what happens when Governments borrow and spend too much! The private sector is being crowded out on the availability of debt with even very very large industrial companies being unable to borrow except at high rates of interest.

    Low investment means low returns when the economy picks up (most Govt spending isnt investment no matter what they think!)

  8. Robert
    December 30, 2008

    John , I quite agree! I have been alerting people to the real possiblity that the UK is potentially ‘broke’ unless there is a massive reduction in government expenditure. For those of us who have been cautious over the last few years ahead of this recession/depression (yes, we have to ackonowledge that this may now be a real possiblilty!) wonder where we can put what little money we have? Cash now yields ‘sweet FA’ unless you tie it in for several years so for the last couple of months I have been buying Gold for several reasons – 1) As a hedge against the inevitable inflation that is likely to ensue as governments print money to get themselves out of this mess and 2) as I would not buy Gilts come what may – there is going to be huge issuance in competition with other cash strapped governments, yields will climb higher as gilt prices will fall, as well as another huge round of equity issuance from both the banks and property companies by the end of this spring and 3) the cost of carry is not expensive. I believe that this government is ‘officially’ underestimating massively the increase in welfare/social costs and the huge fall in tax receipts over the coming two years or so, let alone the additional funding that will be required by the part-nationalised banks and therefore their deficit forecasts are way too optimistic. I have to admit this year may well provide some interesting opportunities for those fortunate to both have cash and still have a job, for sadly there are going to be alot of forced sellers out there. Your conclusions are very much ‘on the money’, I just hope that the Shadow team realise this and adopt your proposals!

  9. Adam-
    December 30, 2008

    The MPC should indeed freeze interest rates, and perhaps even a small hike. Recent currency speculation is working on the assumption of more rate cuts and eventual printing of money. This is damaging confidence in the currency which is far more damaging than the “on-paper” fundamentals.

    As a saver the only thing I fear more about losing my current income, is losing the income I have already earned but chose to save. At best, Gordon Brown’s reflation program serves simply to rob me of a chunk of my savings to give to someone else. At worst, I fear Gordon Brown is a maniac who will do anything, absolutely anything to stave off a depression and cling to power – even printing money in Weimar Republic quantities.

    Fellow Redwoodians should study the Weimar Republic example very, very closely. It wasn’t a bunch of Marxists printing money to destroy the “bourgeois classes” in Hungary, or a bunch of thugs looting their economy for personal gain like in Zimbabwe: it was a fundamentally sound country with a weak government, huge debt, crippling deficit, and a shattered private sector.

    Now which country does that sound like?

    Most interesting is the effect that the loss of confidence had on the velocity of money in the initial stages – hyperinflation without a single Reichsmark printed!

  10. Mick
    December 30, 2008

    I rather fear that the real agenda is to inflate away the debt.
    God help us if that is the case.

  11. Kay Tie
    December 30, 2008

    We are talking here of ordinary gilts. What of index-linked gilts? Aren’t they (to some extent) protected against Sterling falls (since imported inflation is reckoned in the gilt uprating), and protected against hyperinflation from quantitative easing (assuming the Government doesn’t default)?

  12. chris southern
    December 30, 2008

    beurocracy needs cutting (especialy the quangos) and the taxes forced upon the people lessened (easily done by sensible spending)
    the amount of money we are forced to pay to the EU directly (and indirectly) is scandalous and one of the reasons why the infrastucture of this economy is collapsing.

    why don’t more and more politicians speak up for the people John?

  13. Mark M
    December 30, 2008

    On government borrowing, I’m having a browse through the pre-budget report tables as I thought I’d see what the state of our finances is and in Table B10 – Current and Capital Budgets there are two lines for debt.

    One labelled ‘Public sector net debt’ and one labelled ‘Treaty debt’ which is debt on a Maastrict basis. Could someone explain what the difference between these two figures is?

  14. mikestallard
    December 30, 2008

    Excellent remark in the Spectator over Christmas: depressions are caused by just two things; too much commercial paper and too much unsecured debt.
    The dear, clumsy, ignorant old government is, of course, therefore issuing more commercial paper and encouraging more unsecured debt……
    When governments have to depend on their own banks for capital to pay their wages’ bill, they are in real trouble: the rest of the world will have to muck in to cope with, not billions, but trillions of debt.
    Mr Brown is beginning to look like Kenneth Lay of Enron, or indeed John Law who bankrupted the French government in 1720.

  15. rugfish
    December 30, 2008

    I can’t see them doing any of that Mr Redwood, especially not cancelling Gormless Gordon’s goalless VAT trick. That shot seems to have hit the post a few times, bounced on the top bar and fallen to earth without a keeper. It would leave egg on his face because his full weight was behind it and you know he never, ever, does U-Turns.

    Maybe that party they all went to is now beginning to look decidedly empty as guests appear to have left a little earlier than expected. Maybe a few drunken hangers remain doing slow movements to 50’s Skiffle whilst simultaneously balancing the remnants of their stale ale glasses on their heads and patting each other on the back?

    Maybe someone could convince them whilst they’re in this drunken stupor that they lost the election in a game of blackjack or something?

    Maybe pigs can fly too in Labour’s economic sty they’ve made of our country?

  16. Andrew S
    December 30, 2008

    “The private sector went to the borrowing party in 2005-6”
    That’s not quite right is it? Surely you mean consumers, house-buyers, banks and Government. As opposed to private sector business borrowing.

  17. Roger Thornhill
    December 30, 2008

    If the Government forces banks to hold Govt debt, is this not a form of extortion, rent seeking or even racketeering?

  18. Bazman
    December 30, 2008

    Tony Montana should, if extreme in his conservative views be considered right? Absolutely disgusting hedge funds can eat it? Or not?

  19. Lola
    December 30, 2008

    Trouble is Mr R, is that we have got another, what, 18 months of the current Junta before we have a slim chance of electing into power a vaguely financially competent government to sort out this mess. Two points, one, can we really afford to wait that long? And two, are your lot up to it?

  20. Adrian Peirson
    December 31, 2008

    Are you aware that the EU has reintroduced the Death Penalty.

  21. FatBigot
    December 31, 2008

    There is no such thing as a free lunch and there is no such thing as a free party. Someone has to pay, not always the person who thinks he will have to pay and not always on the day of the event. But payment day always arrives eventually and, as a general rule, the longer it is delayed the more expensive it gets.

    One thing I find both irritating and distressing about the current situation is that no one in government or, I am sad to say, on the Conservative front bench has the guts to stand up and say “sorry chaps, this is going to be really painful”. We need to have someone tell the country that cheap credit will not return, that vast amounts of existing credit must be repaid and that current house price reductions are not a temporary blip but a reflection that a one-bedroomed basement flat in Islington was never really worth more than ÂŁ175,000 even though someone paid ÂŁ350,000 for it.

    I hope 2009 will be the year other politicians are prepared to follow your lead, Mr Redwood, and be honest about just how bad the situation is. I can only guess at the figure, but looking at the amount of credit card debt I would say that something like ÂŁ1trillion currently in the UK economy is pretend money and must be removed before we can say we are living within our means.

    My fear is that the government will just print more money in the hope that will hide the problem. Hide it, it might; remove it, it won’t.

    And on that cheery note, thank you, Mr Redwood, for informing and stretching my grey matter in 2008. Having been the only one of your contributors to wish you a happy birthday this year, I hope I am not the last to wish you a very happy New Year.

    1. JJWS
      January 1, 2009

      Fair point – happy new year Mr R et al

  22. Acorn
    December 31, 2008

    Don’t forget the wind bubble John.

    This morning (new years eve), have a look at the outstanding contribution the nations wind turbines are making to our electricity supply. At 09:15 they are supplying a glorious 4 MW out of 42, 797 MW of generation.

    Then look at the reason why on the Met Office pressure chart.

  23. Robert
    December 31, 2008

    Happy New Year John , keep up the excellent work and many thanks for your very consistent insights. I am forever hoping that the Shadow team ‘bite the bullit’ and show some leadership and get ‘ahead of the curve’ (here I know I differ from Brian Waldron who proposed the do nothing strategy), this wqas what I suggested to you at a City Circle event some 18 months ago. But as an optimist better late then never!

  24. Ralph Musgrave
    January 6, 2009

    No doubt Redwood’s 8 suggestions have their merits, but there is a much easier way to cut government borrowing: have government spend WITHOUT taxing or borrowing, i.e. have government print money, or “underfund”. Tim Congdon and others advocated this in a letter in the FT recently: Though smart people like me were advocating it much earlier ( To be more accurate, government could finance the spending required to get out of the credit crunch with printed money – obviously governments cannot finance more than a small proportion of their total expenditure this way.

    Money printing would not be inflationary until demand became excessive, but by that time the problem is solved (or at least unemployment would be moving back where it was a year ago). As to the idea that bond markets take a dim view of governments that print money, bond markets can distinguish between irresponsible and justifiable money printing. The US Fed has printed unprecedented amounts in the last few months, yet long term US treasuries are more popular than ever. Those purchasing them clearly do not expect excessive inflation in the US any time soon.

    As for the idea that large amounts of money need to be printed, it should be remembered that government borrowing is deflationary, while government spending is reflationary. Indeed they may very nearly cancel each other out. Thus the total that needs to be printed is nowhere the amount that would otherwise need to be borrowed.

  25. […] So far this hasn’t been much of a problem. In fact there has been a bubble in the gilt market – as investors flee towards safety – pushing yields to new lows, as John Redwood points out here. […]

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