Trapped in a time of zombie government

A year or two ago, there was much talk about “zombie” companies, kept alive by low interest rates, just muddling along without the cash flow to invest or generate growth. They were holding the economy back through low productivity so it would be better if they closed down, releasing staff, resources and premises for more useful deployment elsewhere.

Since early 2021, interest rates have risen from almost zero to 5.25% and are set to rise further, but business insolvencies, though higher than a year ago, have failed to take off. It seems there were far fewer zombie companies than we thought.

But there is one massive enterprise the zombie thesis fits perfectly: the British government. It used low interest rates to finance an extravagant spending spree both before and during Covid, ran up huge debts and obligations, and is now desperately looking for a way out.

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The yield on government debt has risen sharply, from almost zero for ten-year gilts in 2021 to 4.5%, the highest for 15 years. A yield of 5.7% had to be offered in a recent auction to attract buyers for £4bn of two-year gilts. 

When yields spiked higher last autumn, the new chancellor, Jeremy Hunt, thought he could defuse the threatened financial crisis by whacking up taxes. For a couple of months, the policy appeared to be succeeding and ten-year yields dropped back to 3%. But they have since risen to new peaks. 

This makes it ruinously expensive to borrow, while persistent inflation is undermining the government’s finances by pushing up the cost of inflation-linked debt.

The problem is that gilt yields, having been too low for years, are now set to go too high. Pension funds, shoehorned into buying gilts by regulators, have lost a fortune and those that compounded their exposure through liability-driven investment strategies last year have lost even more. They will be very wary of further investment and will require generous yields.

Many advisers who prematurely advised investors to buy gilts now have egg on their faces. To be fair, most of these recommendations were for short-dated gilts with low coupons that offer tax-free capital gains until redemption. Investors with longer-term horizons, especially those liable for income tax on the interest, should wait. 

On the optimistic assumption that inflation can sustainably be brought down to 3%, a ten-year yield above 5% would be justified, but the odds will only be firmly on the investor’s side at a yield of 6%.

Higher taxes hamper investment

This is terrible news for the public finances, especially as there are clear signs that Hunt’s policy of raising taxes is failing to generate the needed revenue. 

The higher taxes go, the greater the determination of people and businesses to take evasive action. Moreover, high tax rates are damaging to investment, innovation, work incentives and economic growth. This leaves just one policy option: spending restraint, or austerity. Capital spending is always the first to be cut by governments, which probably means that HS2 will be axed even though tens of billions have already been spent on it. Otherwise, the state’s cunning plan is to get the pension funds to pay for infrastructure investment.

The big cheeses of the financial world love being flattered by governments – invitations to Downing Street, sitting on top-level advisory committees, the hustle of the media, the promise of gongs – but hopefully they will remember their obligation to their customers and put financial returns first.

Public sector lacks management skills

Cutting current expenditure is difficult. Serious reform of the NHS could save a great deal of money but is a non-starter. Restraining pay in the public sector has appeal, but has already been tried and leads to strikes. Raising productivity and efficiency in the public sector is nice in theory, but the sector doesn’t have the management skills. Those with ability will always be poached by the private sector.

This means that spending restraint will probably fall on those who can’t strike, notably pensioners and those on welfare. Devaluation will be sought to encourage growth while the consequent inflation will help disguise spending cuts. 

A change of government will bring no respite. Labour is already rowing back on spending commitments and kyboshing talk of nationalisation. It still dreams of raising additional revenue through abolishing non-domicile status and levying VAT on private education. It has detailed plans about how to spend the proceeds, but its numbers are laughably overoptimistic. It would be prudent to wait for the revenues before spending them, but these are likely to be negligible, if not negative. The spending plans will probably be shredded.

Begbies Traynor, the insolvency specialists, say that the remaining zombie companies will be killed off by the end of next year. Zombie government will last a lot longer, whoever forms the next government. But don’t worry, as that should be pretty good news for the economy and markets.

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