Is Britain heading for a big debt crisis?

The run up to the Budget in November has already been dominated by headlines about a “meltdown” in the bond market and a yawning “£50 billion” black hole that will have to be filled by more tax increases. Some have even speculated that the UK is heading for another IMF bailout. Mercifully, the prospects may not be quite as dire as these reports suggest. But the recent increases in the cost of government borrowing are consistent with an emerging fiscal crisis. The chancellor is increasingly boxed in by her own fiscal rules – and there is no painless way out.

The problems are most apparent in the yields on 30-year UK government bonds, known as “gilts”, which have jumped to their highest level since 1998. This partly reflects a global shift upwards as investors become more jittery about increases in public debt worldwide. Similar headlines are being written in many other countries, notably France and Japan.

Nonetheless, the UK now consistently has the highest bond yields in the G7 group of advanced economies. The cost of new government borrowing for 10 years is currently around 4.6% in Britain, compared with 4.0% in the US, around 3.5% in France and Italy, 3.2% in Canada, 2.7% in Germany, and just 1.6% in Japan. This is all the more remarkable because UK public debt is not particularly high by international standards. In fact, the ratio of debt to national income in the UK, at around 100%, is lower than in Italy, at 135%, and much lower than in Japan, at 240%. Even Greece, with debt still over 150% of GDP, can borrow at 3.3%.

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Why the UK seems stuck in a doom loop

Why has the UK become such an outlier? There are three main reasons.

First, many international investors are losing confidence in the Labour government’s willingness to take tough decisions to bring borrowing down, especially after the recent failures to curb welfare spending.

The prospect of more tax rises is simply reinforcing fears that the UK is stuck in a “doom loop” of sluggish growth and deteriorating public finances.

Second, the Bank of England has been actively selling its holdings of government bonds, reversing the previous policy known as “quantitative easing” (QE), and doing so more aggressively than other central banks.

The Bank itself has said that the new policy of “quantitative tightening” (QT) may have added as much as 0.25 percentage points to 10-year gilt yields. This additional selling is especially damaging at a time when there is less demand from defined-benefit pension funds, who traditionally have been big buyers of longer-dated government bonds. In turn, this helps to explain the relatively large rise in the yields on 30-year gilts.

Third, there are fears that higher inflation in the UK will keep official interest rates higher for longer too, while adding to the cost of inflation-index-linked borrowing (of which the UK has a relatively large amount). By contrast, yields in the euro area and Japan are anchored by relatively low inflation and the relatively low interest rates set by the European Central Bank and the Bank of Japan.

This does not mean that a full-blown debt crisis is imminent in the UK, or even inevitable. The increase in bond yields only affects the cost of new borrowing, not that of existing debt, which provides at least some breathing space. The average time remaining before each conventional gilt has to be refinanced is more than 13 years, with only 16% falling due in the next three years. The average left on index-linked bonds is even longer, at more than 17 years.

It is worth stressing, too, that the rise in government bond yields has been relatively orderly, with little contagion to other markets. Investors have been demanding higher returns to compensate for higher risks, but there has been no shortage of buyers at the lower prices. And when more cash is required, the government’s Debt Management Office is now selling more gilts with shorter maturities to avoid having to pay the higher interest rates on longer-dated bonds.

So far, this episode is therefore still different from the crisis in the wake of the mini-Budget in September 2022. The sell-off in gilts then was accompanied by a panic in the mortgage market, prompting residential lending to dry up. The sharp falls in the prices of gilts also caused immediate problems for some pension funds. The pound slumped too.

Is a 1970s-style debt crisis looming?

The UK is not yet on the cusp of an IMF bailout, either. Admittedly, an increasing number of commentators are warning of a “1970s-style debt crisis” unless the chancellor changes course.

These voices include three leading economists – Jagjit Chadha, Andrew Sentance and Willem Buiter – who are not the usual suspects and whose views should be taken seriously.

Chadha and others have also made the reasonable point that IMF involvement might enhance the credibility of the fiscal framework and restore some market confidence, thus attracting more private capital, which could dwarf the limited resources available to the IMF.

Nonetheless, the circumstances now are also different from the 1970s. The bailout from the IMF in 1976 was a US dollar loan. This was mainly used to pay back other countries that had lent foreign currencies to the UK government as it attempted to prop up the pound. That is not the problem now.

The UK is not facing a sterling crisis (at least, not yet) and the government would be right to let the pound fall if it were. Any IMF bailout would also come with such punitive conditions that it would be politically unacceptable, including big cuts in public spending.

Put another way, if the UK government were willing to take these tough decisions, we would not need the IMF in the first place. An IMF-imposed austerity programme would surely be the end for both Rachel Reeves and Keir Starmer, especially with the emerging threat from Jeremy Corbyn’s new far-left party. The markets would not necessarily be reassured.

More positively, the prospects for the UK are still better than in the 1970s – in some respects. The economy shrank by about 4% in total in 1974 and 1975, unemployment rose sharply (from a low of 3.7% in 1974 to a peak of 11.8% 10 years later), and both inflation (peaking at 24% in 1975) and interest rates (the Bank rate hit 15% in 1976) were much higher.

Averting a debt crisis: try the stop-gaps first

Finally, there are other things the authorities might try before calling in the IMF. In an emergency, the government could borrow short-term funds through an existing overdraft facility at the Bank of England, known as the “Ways and Means” (W&M).

There is a recent precedent; an agreement in April 2020 allowed for more use of the W&M during Covid, although this was never actually needed.

And if the bond markets did become disorderly, the Bank of England could step in to buy gilts again on a temporary basis – as it did (remarkably successfully) in September 2022.

But this is only partially reassuring. These stop-gaps could backfire if they are seen to underline just how big a mess the public finances are in, and if the government does not use the breathing space to tackle the underlying problems. Less positively, the public finances are now in a bigger mess than in the 1970s.

The annual budget deficit was similar (averaging 6% of GDP in 1974 and 1975), but the stock of debt was far lower (about 48% of GDP, compared with 96% now). Another new risk is that roughly a quarter of government debt is now linked directed to the rate of inflation.

In any event, the latest bond-market wobbles could hardly have come at a worse time. In a few weeks’ time, the Office for Budget Responsibility (OBR) will start to crunch the numbers for the Budget.

Importantly, the OBR’s forecasts will be based on whatever the markets are assuming about the path of interest rates over the next five years. These assumptions could therefore eat further into any remaining headroom against the government’s fiscal rules or, more likely, make the existing shortfall even larger.

In turn this could prompt Reeves to announce even larger increases in taxes, hitting consumer and business confidence hard and having an immediate impact on economic activity.

It is also still possible that the nervousness of bond investors will spill over into other markets, including equities. The property market already appears to have stalled again.

Sterling is especially vulnerable too if the loss of international confidence becomes a rout, which again could have an immediate impact on other asset prices, on inflation, and on the real economy.

At the moment, the risk of a sterling crisis is being minimised by the fact that other countries are in trouble, too. But that could easily change if the UK were seen as an even bigger outlier.

Time may be on the government's side

The main hope now is that conditions may improve before the Budget itself on 26 November. The relatively late timing has raised fears that a longer period of speculation and uncertainty will undermine confidence further. But there could be some advantages too.

Perhaps most obviously, the delay leaves more time for global bond markets to calm down, taking some of the pressure off borrowing costs in the UK.

This could also work in the opposite direction if there is more bad news from elsewhere, perhaps the US (for example, higher tariffs could finally feed through into consumer price inflation, exacerbating the tensions between Donald Trump and the Federal Reserve), or from France, or from half a dozen other countries where concerns about fiscal sustainability are also growing.

Fortunately, an improvement in global sentiment is not the only potential upside from having a late Budget. The second positive is that the UK government would have more time to find some new savings on the welfare bill to replace the £6 billion lost to the U-turns on working-age benefits and winter-fuel payments. These savings would still have to be acceptable to Labour MPs, but the government would have longer to get the politics right.

The government will also have extra time to persuade the OBR that the planned increases in public investment and supply-side reforms will boost the productive potential of the economy.

Indeed, the growth assumptions will be even more important than the assumptions about inflation and interest rates. The increase in gilt yields since the OBR’s forecast for the Spring Statement might add about £5 billion to the shortfall that has to be filled by spending cuts or tax increases. But this shortfall could swell to £50 billion if the OBR adopts the same pessimistic forecasts for productivity and growth as those used recently by the National Institute of Economic and Social Research (NIESR).

Fortunately, NIESR’s £50 billion is an outlier. It is still possible that the chancellor will be able to keep the fresh pain down to around £20 billion, with at least £5 billion of that coming from welfare savings rather than tax increases.

That might be the least bad outcome, and perhaps even a relief to some. But there can be little doubt that the UK is in the early stages of a crisis that could play out in many different ways – with or without the involvement of the IMF.

Julian Jessop is an independent economist.

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