In a blog post about George Osborne’s Autumn Statement and what the future holds for the interest rate the UK government must pay on its debt, the BBC’s Economics Editor Robert Peston drew on conversations with his mates in the financial sector to concoct a story about the possible differences between Tory and Labour governments. Economists Paul Krugman and Simon Wren-Lewis objected to some of Peston’s post, causing Peston to write a response today. It’s not very impressive! This is the contentious passage from Peston’s original blog:
“Mr Market matters because he decides what price the government pays to borrow, and whether the government will continue to benefit from the current record low interest rates.
The Tory view is that those interest rates can only be locked in if the government continues in remorseless fashion to shrink the state and net debt.
What Labour would point out is that countries in a bit of a fiscal and economic mess and currently refusing to wear the hair shirt that the European Commission thinks necessary, such as Italy and France, are also borrowing remarkably cheaply.
And here is where Mr Market may be capricious, according to my pals in the bond market.
They say the UK’s creditors would probably be forgiving and tolerant of George Osborne borrowing more than he currently says he wishes to do, in that his record of reducing Whitehall spending by £35bn since taking office in 2010 has earned him his austerity proficiency badge.
But Ed Balls has never been chancellor, although he was the power behind Gordon Brown when he ran the Treasury and much of the country, both in the lean years from 1997 to 2000 and the big spending Labour years thereafter.
So Mr Balls has yet to prove, investors say, that he can shrink as well as grow the apparatus of the state.”
In his follow-up blog, he goes on to write:
“But does that mean a plan to reduce the deficit has been irrelevant to the borrowing costs paid by the HM Treasury? That seems implausible.
The government inherited a deficit (a gap between what it spends and what it raises in taxes) of 10% of national income or GDP. Wren-Lewis and Krugman would presumably agree that a 10% deficit is unsustainably high – and if it recurred for years would prompt fears for the UK’s solvency.
So getting the deficit down from 10% – or perhaps promising to get it down – must have had some bearing on the so-called risk premium for lending to the UK government, or the interest rate that the UK had to pay to borrow.”
So he’s selling the idea that the interest rates on government debt are determined by the bond vigilantes who look at how serious governments are at dealing with their deficits, weighing up the risk of default and setting rates accordingly. The trouble is, this is a total fairy story. Simon Wren-Lewis points out in his blog that interest rates on debt are based in part on expectations about future short term rates, and those expectations are for short term rates to stay low because the economy is still weak.
This is true, but there is an even more fundamental reason why Peston’s theory is a fairy story. The UK has its own currency, so the concept of solvency risk just does not exist. Don’t believe me? Here’s Alan Greenspan and head of the OBR Robert Chote making the same point, and this chart from Paul Krugman makes drives the point home well by comparing the rates paid by countries of the Eurozone with major economies outside the Eurozone.
Peston is not alone in believing this fairy story. The 2010 election was basically fought on this basis (although we don’t hear much about credit rating any more), but as economics editor he should be offering his viewers and readers some more reality-based analysis. Fair play to him for highlighting the disagreement over his first post, but he only succeeded in compounding his error by raising the issue of solvency. Let’s hope this conversation continues.