Popular myth massacre

I always try to write something interesting for this blog. Maybe I don’t always succeed, and maybe my interest in economics isn’t shared by all my readers, but I am always extremely grateful to consensus economic thinking for supplying material for me to comment on. It is the gift that keeps on giving.

The latest consensus commentary, which inspired this note, is typical of many accepted wisdoms that journalists and economists write about—opinions and theories that have existed for a long time and that most people agree with but that aren’t true.

The commentary concerns the recent speculation and officially sanctioned leaks about the new administration’s first budget. Various ideas have been trailed in the media about what it might contain, and some of those have now disappeared, having rightly been dismissed as not very sensible. Others are now gaining traction. One of the more recent ideas is that the Chancellor, Rachael Reeves, may change how the deficit is calculated by separating capital spending from current expenditure. This presentational change may allow for the government to borrow more money (to spend on public investment) than that projected in the Spring budget and allow it to “escape” from its debt rule commitment, which requires debt to fall as a share of national income between four and five years out.

Briefly, the background to the budget is the much-discussed “black hole in the nation’s finances.” As I wrote in my last blog, this is one of the biggest economic myths doing the rounds at the moment. To set the scene, I should update you on where we are now in relation to the last administration’s forecasts, which were laid out in the March budget earlier this year.

1. The latest estimates from the ONS put the level of nominal GDP (which drives tax revenue) in Q2 2024 2% higher than the OBR forecast in the spring 24 budget.
2. If the economy grows at the same rate that was forecast last March, in the current financial year (to April 2025), the nominal GDP will be about £55-60 billion larger than the OBR forecast. This will, of course, drive much greater tax revenue (over £20 billion) than was forecast in that budget (see my last blog).
3. The new government has committed to more than £20 billion of additional in-year expenditure than was set out in last spring’s budget, largely due to recent public sector pay awards.
4. Excluding investment spending, my favourite UK economist estimates that the current budget deficit is about 1% of GDP in 24/5.

So, to return to the commentary I was alluding to earlier. In recent weeks, the UK gilt market has been quite weak, and yields have risen on the 10-year gilt from about 3.8% in the early part of September to just over 4.2% now.

These are some of the issues that the financial media have talked about as explanations for this move in gilt yields:

1. There are concerns that Rachael Reeves’ budget will result in additional levels of government borrowing, resulting in greater debt issuance and, therefore, higher yields on government debt.
2. Higher government borrowing would lead to adverse outcomes for the UK economy, including higher borrowing costs and lower growth.
3. The yield spread of gilts over equivalent German government bonds has widened, justifying the idea that expected higher UK government borrowing is the driver of these higher yields.

When I asked ChatGPT what higher government borrowing leads to, it responded with the theory of Ricardian equivalence, which basically says that if the government borrows more, the private sector saves more, and decreases in public borrowing will lead to lower private saving. It then helpfully added that especially large government deficits crowd out the private sector and can lead to trade imbalances and even financial crises.

Now, this is all relatively conventional thinking and reflects, in part, maybe, a sort of mini re-run of the gilt market’s wobble around the time of Liz Truss’ budget back in September 2022. However, as much as I have to respect the reality of what is actually happening in the gilt market where, in the short term, yields have clearly risen, I cannot resist the temptation to place some very interesting facts in front of you which completely contradict many of the accepted wisdoms on this issue. After doing that, I will give you a very quick summary of what I think is going on and what I think will happen next.

So here are the facts relevant to the long-run relationships here in the UK: first, between the level of government borrowing as measured by the deficit and 10-year gilt yields; and second, total government borrowing and economic growth, and I will bet that both will surprise you.

First to the long-term relationship between 10-year gilt yields and the budget deficit. The surprising fact is that there isn’t one. I will just repeat that to be completely clear. There is no relationship between the level of the budget deficit and 10-year gilt yields over the 68 years from 1955 through to 2023. In other words, since 1955, what any incumbent UK government has decided to borrow to bridge the gap between expenditure and receipts has had no effect on the rate of interest on that borrowing as measured by the 10-year gilt yield.

Those mathematicians reading this will recognise the significance of an R squared of 0.0079.

Now to the relationship between total government debt and economic growth in the UK. Again, there isn’t one, as is abundantly clear in the chart below. (R squared of 0.0026)

So, in summary, in the UK, over the last 68 years, there has been no correlation between the size of the budget deficit and 10-year gilt yields and no correlation between the level of total government debt and economic growth—absolutely none, to be absolutely clear!

What does this mean?

1. We should all treat established thinking on this subject with extreme scepticism.
2. We should look to other explanations for changes in gilt yields and market interest rates.

So, if it isn’t the deficit or the book of outstanding government debt that drives gilt yields, what is it? The answer is that inflation and its impact on bank base rates is what drives 10-year gilt yields, and this close relationship is demonstrated in these next few charts.

First the relationship between inflation and gilt yields:

And now to bank base rates and 10-year yields.

And finally, to a more contemporary guide to the relationship between 10-year yields and market interest rate expectations. In other words, what the market believes base rates will be in the near future rather than where they are right now.

Finally, I promised an explanation of what is going on at the moment in relation to gilt yields and what I think will happen next.

1. 10-year gilt yields have risen 46 basis points since September 16th, identical to the increase seen in the US 10-year yield since the same date. Both bond markets are being driven by the same thing, namely heightened inflation concerns following the recent increase in the oil price and, specifically, in the US, some slightly stronger labour market data than was expected.
2. The higher gilt yield has absolutely nothing to do with Rachael Reeves’ upcoming budget.
3. Barring a major increase in the conflict between Israel and Iran, I expect oil prices to settle down again in the relatively near future.
4. The downward path in UK and US inflation will resume in the months ahead.
5. Gilt yields will return from whence they recently came and should reduce further as inflation in the UK falls back to the 2% level in the relatively near future.
6. The increased gap between 10-year gilts and their equivalent in Germany is the product of concerns that the German economy may be flirting with recession again and has nothing to do with the upcoming UK budget.

Summary

And so, to summarise this post. Contrary to popular belief, the budget deficit and the government debt-to-GDP ratio have absolutely no bearing on the level of gilt yields in the UK or on the UK’s growth rate. This may seem counterintuitive, but the evidence is unequivocal. Gilt yields are driven by UK inflation and market interest rate expectations; it really is as simple as that.