The Independent View: Low borrowing rates signal economic weakness, not strength

As the head of an independent economic research institute, it’s not my job to attend the Liberal Democrat conference (or indeed that of any other party). But, following up this FT article, I’d like to share some thoughts on this line from a motion you will be debating at conference:

Conference recognises that the difficult decisions taken by the Coalition Government have ensured the credibility of the UK government’s position in the financial markets allowing the UK to borrow at record low rates.

and on an amendment to the motion which you’ll also debate:

Conference also notes that it would be a mistake to attribute record low public sector borrowing costs to accelerated fiscal consolidation rather than to a flight to relative safety.

The original text is economically ignorant nonsense. The amendment is partly correct, although it still gets the underlying explanation wrong at least in part. The current level of long term interest rates does not reflect “market confidence”; quite the opposite. Both economic theory and the empirical evidence suggest that the current level of long-term interest rates is primarily the result of economic weakness, not strength.

First, some theory. What determines the level of long term interest rates on government debt? The standard neo-classical view is that, as the Bank of England puts it in its handy beginners guide to monetary policy, “long-term interest rates are influenced by an average of current and expected future short-term rates”.

In other words, theory suggests that the low level of long-term interest rates in the UK reflects low expected future short-term rates. And what determines expected future short term rates? Again, the Bank of England is quite clear on this – expected inflation. And why does the Bank expect inflation to fall sharply in 2012 and perhaps beyond? Because the economy is weak:

Against this background, and that of its most recent projections to be published in the February Inflation Report, the [Monetary Policy] Committee judged that the weak near-term outlook for growth and the associated downward pressure from slack in the economy meant that, without further monetary stimulus, it was more likely than not that inflation would undershoot the 2% target in the medium term.

So record low public sector borrowing costs simply reflect the weakness of the economy. Is my analysis widely shared? Let’s look at the IMF’s last report on the UK:

Further slowing consolidation would likely entail the government reneging on its net debt mandate. Would this trigger an adverse market reaction? Such hypotheticals are impossible to answer definitively, but there is little evidence that it would. In particular, fiscal indicators such as deficit and debt levels appear to be weakly related to government bond yields for advanced economies with monetary independence. Though such simple relationships are only suggestive, they indicate that a moderate increase in the UK’s debt-to-GDP ratio may have small effects on UK sovereign risk premia (though a slower pace of fiscal tightening may increase yields through expectations of higher near-term growth and tighter monetary policy). This conclusion is further supported by the absence of a market response to the easing of the pace of structural adjustment in the 2011 Autumn Statement. Bond yields in the US and UK during the Great Recession have also correlated positively with equity price movements, indicating that bond yields have been driven more by growth expectations than fears of a sovereign crisis.

For an IMF report, this is remarkably clear. It is saying two things. First, just as I argue above, the reason long-term gilt yields are low in the UK (and similarly in virtually every other “advanced economy with monetary independence”) is weak growth, not “confidence” or “credibility”. “Bond yields are driven more by growth expectations.” That is, yields are low not because of economic confidence but because of its exact opposite. This is precisely what I and others (Simon Wren-Lewis here, and of course Paul Krugman in the US) have long been arguing. Indeed, the specific evidence the IMF cites – that yields have fallen when stock markets have fallen – is precisely that, in the UK, I first pointed here year ago.

Second, that there is no reason to believe that slowing fiscal consolidation would “trigger an adverse market reaction”. In other words, when the Chancellor said that “these risks [of slowing consolidation] are very real, not imaginary”, he was indulging in evidence-free speculation, not serious analysis. Indeed, the Fund accurately points out that the main reason yields might rise (slightly, not precipitiously) if fiscal policy were to be loosened would be because of “expectations of higher near-term growth”. As I pointed out here, this would be good news. So, the IMF agrees that the reason gilt yields are low is because of weak growth, not confidence; and that we could loosen policy with minimal risk and probable benefit.

So what underlies the Treasury’s contention that low interest rates reflect “market confidence”? It is, of course, true that reduced default risk should lead to lower interest rates on government debt, just as it should on any other debt. But, as I have pointed out before, there is not and has never been any significant default risk on UK government debt.  Nor is there any obvious evidence that movements in interest rates have been related to changes in market perceptions of default risk. As I predicted at the time, Moody’s recent decision to put the UK’s rating on negative watch had precisely no impact on market interest rates.

Finally, it is worth noting that, if we believed the original motion, the main thing driving interest rates would be the deficit, and in particular market expectations of the deficit going forward. Conveniently, the Treasury publishes a summary of external forecasts of the economy. These forecasts change over time, and here is the average of external forecasts for the deficit in 2013-14, plotted against ten year gilt yields:

Higher deficits lead to higher interest rates? Not exactly. If anything, the opposite, certainly over the last year – because, of course, both higher deficits and lower interest rates are driven by economic weakness, precisely as theory predicts.

To conclude, we know, both as a matter of theory and evidence, why long-term interest rates are low. It reflects the persistent weakness of the UK and international economies. There is no mystery here. The original motion simply ignores the facts.

* Jonathan Portes is the Director of the National Institute of Economic and Social Research. Previously, he was Chief Economist at the Cabinet Office. He blogs at Not The Treasury Point of View.

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This entry was posted in The Independent View.


  • “the reason long-term gilt yields are low in the UK (and similarly in virtually every other “advanced economy with monetary independence”) is weak growth, not “confidence” or “credibility””

    So presumably Germany is facing even lower growth than we are, on the basis of your argument, given that its bond yields are negative. Sorry, but your argument falls flat on its face.

  • A very interesting contribution. The debate about this amendment shouldn’t be about differing political views (I’m certainly not a LiberalLefty). The original motion includes some things that are simply untrue.

    Even the US, which has a huge deficit and can barely pass a budget, has record low borrowing costs. It’s only Spain and co. – which have comparable deficits and deficit reduction plans but don’t have their own central banks and currencies – that have to pay more.

    The original motion suggests either senior LDs don’t know what they’re talking about, or are willing to mislead and distort public debate – putting party politics ahead of people’s futures. Neither option is invigorating. Conference can do better.

  • “But, as I have pointed out before, there is not and has never been any significant default risk on UK government debt.”

    Why is that, then Jonathan? Well in part it is true that we have our own currency and can print more if necessary. But it is also due to the fact that we have a government which accepts the needs for fiscal consolidation, unlike Labour, who pay lip service to it but in fact are busy spewing out unfunded spending commitments and pretending that if they just threw a lot more money away by cutting VAT that would somehow make things right. Seriously, how much confidence would the markets have if Labour were put back in charge right now?

    This just goes to show how a presumably intelligent person can come up with ill founded arguments because their background instincts cloud their perception of the facts and cause them to ignore very important ones entirely.

  • Bill le Breton 20th Sep '12 - 3:05pm

    It is good to see you here.

    Would you also agree that weak growth in NGDP suggests over tight monetary policy?

    Would you further agree that unless we change the target that the Chancellor (and in a coalition the Chief Secretary) confirms each spring to the MPC, any slowing down of the fiscal consolidation is likely to be offset by further tightening by that Committee?

    Do you agree that the two year forecast for inflation is presently around 1.5%, well under the present target?

    Would you therefore also wish to see Danny Alexander and Nick Clegg pressing for a relaxation of the MPC’s target to allow slower fiscal consolidation to operate efficiently and that ministers of the crown exercise greater vigilance over the MPC’s performance?

  • Richard Dean 20th Sep '12 - 3:06pm

    Borrowing rates are surely the sum of expected inflation and relative risk? I see no reason for me to purchase a bond solely on the basis of expected growth per se.

    Ok, risk of default on UK bonds is probably very low, but It does not follow that there is no risk in UK bonds. Labour might get elected and increase inflation above my present expectations, or some other inlfaton-causing event might occur. This would mean that I would lose out when it came to being repaid, since I would be getting less than I would have if I had known what the actual inflation would be.

    But growth has risks too, and growth seems to be always accompanied by inflation. So yes, expectations of growth would increase both of the things that affect borrowing rates, so the low rates do tell me that the UK is going nowhere fast.

  • Richard Dean 20th Sep '12 - 3:22pm

    Yes, Germany is facing even lower growth than we are.

    Germany’s success has rested on a compliant workforce and on its exports, some of which were only made possible by German banks lending to the countries they exported to. The debt crisis in the Euro means that many of its customers can no longer afford to buy, or even pay back what is owed, and the global crisis means that more of its export markets are drying up. Germany is over-producing for its remaining markets and its only solution is to shrink its economy.

    Germanycannot accept a Greek or Spanish default because that would be worse than partial repayments. It cannot leave the Euro because the result would undoubtedly be a devaluation of its financial debt assets. It cannot accept Eurobonds and Euro inflation for the same reason. It is in this mess mainly as a result of its own pretend blindness in previous years.

  • I found this article interesting. I don’t know enough about economics to argue either way, But I do sometimes suspect that Britain is too important to the banking sector to default and that the bond market argument is used to convince us plebs that the tail wags the dog, Anyway if borrowing is the biggest risk, why are the bond markets not already punishing Britain for borrowing more with lower growth than under the last government and with lower projections of growth every few months? Could it not be that the financial sector is simply rewarding policies that fit with a world view of low taxation and less red tape.?

  • @ Bill le Breton
    “Would you also agree that weak growth in NGDP suggests over tight monetary policy?”

    Low growth is due to far more than just monetary policy. It is also due to the state of our banking sector which is rebuilding its balance sheet at the expense of the rest of the economy as well as households and businesses being unwilling to borrow because of uncertainty.

    Given all that, an even looser monetary policy would simply be “pushing on a string” in terms of effectiveness.

  • @Richard Dean
    “Yes, Germany is facing even lower growth than we are.”

    And presumably you are pencilling in a boom in Italy and Spain on the basis of their bond rates?

  • Bill le Breton 20th Sep '12 - 4:22pm

    RC, As that dear old liberal democrat Milton Friedman wrote in 1968, “As an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly.” You’ll find it here:

    If you are only a little intrigued by these ideas, Marcus Nunes has recently put together a great analysis of … well it’s in the title.

    Firms won’t use their cash or borrow more until their expectations change. Banks won’t lend until their expectations change. They need a story that they can believe in. At present the story they do believe in is one of stagnation and a falling general price level.

  • Richard Dean 20th Sep '12 - 5:47pm

    @RC. Where else can they go? Look ….

    Germany: Low inflation, low risk, so low borrowing rate. Markets collapsING, so negative growth
    Spain: Inflation, high risk, so high borrowing rate. Markets collapsED, so no growth

    But maybe there’s another factor. Investors investing in German things basically can invest in bonds or put their money in banks. If the risk that banks will default is sufficiently high, the expected returns from putting money in banks can be negative, and in that case bond rates can be negative too, just a little less so. It’s a question of minimizing losses.

  • Richard Dean 20th Sep '12 - 6:12pm

    @Bill le Breton. I agree.

    But a story that is created only from a desire to have a credible story is not a credible story.

    Where will we get a credible story from?

  • Tony Dawson 20th Sep '12 - 7:24pm

    @Adam :

    “The original motion suggests either senior LDs don’t know what they’re talking about, or are willing to mislead and distort public debate ”

    Why not both? 🙁

  • Bill le Breton 21st Sep '12 - 7:48am

    And now the Governor of the Bank of England needs to say sorry. (though he would be advised not to ask Nick Clegg for advice on the mechanics)

    It was the Governor who stood outside the negotiating room in the old tennis court of the caninet office in May 2010 rev-ing up the anti for accelerated deficit reduction. Last night he said that he now, £750 billion pounds of lost output later, considered that there was room for an easing of the pace of deficit ‘consolidation’.

    For those who have wondered why I have been banging on about NGDP targeting for the last couple of years you might like to see the article refered to by Jonathan Portes above:

    There is a growing consensus building for this approach. But it is one that the Lib Dems could and should have been advocating for months now. If our treasury people (including Laws) had done so, they would be at the head of the game, directing the campaign that would bring recovery.

    So what Clegg and Laws and Alexander should really apologies for is listening to establishment figures like Mervin King and crypto tory economic fantasies like ‘expansionary deficit reduction’.

    £750 billion buys a lot of education, a lot of health, a lot of welfare; it brings a lot of fairness, a lot of hope, a lot of life chances, a lot of liberty across our society.

  • Absolutely, Bill. And apologies to those of us, like you, Richard Grayson and others, who have consistently urged a different line. a failure to apologise, or to properly acknowledge that changes have to take place, looks even more like the Orange Book tendency ignoring the evidence, and actually wanting a pseudo-Tory economic line.

  • I should have said “apologies are owed by the leadership to Bill (and others urging the same)”.

  • Richard Dean 21st Sep '12 - 1:58pm

    I wonder of the capital flight to Germany (Libera Eye20th Sep ’12 – 7:52pm ) might be a better explanation for the negative German interest rates? Or an equivalent explanation?

    For a country with a shrinking economy, the last thing the country needs is inflows of mobile capital that cannot be invested in productive activities – because the economy is shrinking – and which therefore will sit in a deposit accounts and has to be serviced with positive interest. Where would the money come from to pay the interest? And there would be a significant risk that the mobile money might leave as fast as it arrived, possibly creating chaos as the banks adjust.

    In other words, might the capital inflight be making german banks even riskier? Might Germany’s sometime negative interest rate be interpreted as an attempt to mitigate the risk, by discouraging more capital from entering the country’s banking system?

  • Richard Dean 21st Sep '12 - 2:48pm

    Bill – where does the figure of £750 billion lost output come from?

    A story built only on a wish is a bubble that bursts!

  • Paul Reynolds 21st Sep '12 - 3:34pm

    ‘The original text is economically ignorant nonsense.’. Strong words. Jonathan, do I understand what you are proposing correctly ? Your analysis is that the UK’s planned reduction in state ‘capital & revenue’ spending and its other fiscal measures is not the main reason for the UK’s relatively low borrowing costs. The real main reasons are low growth and low inflation expectations and expectations that the currency will not lose significant value (and perhaps a lack of low risk alternatives for bond purchasers, as well). Putting it round the other way, if I understand you, a further increase in state spending and/or a reduction in taxes, (or at least a reduction in planned spending cuts and in planned tax rises) will not have the effect of increase the UK’s cost of borrowing. Therefore state spending can safely be increased, or at least reductions in spending can be halted.

    Therefore there is no great benefit to reducing the deficit, and by implication, the 22% increase in UK net borrowing this fiscal year so far compared with last year, is nothing to worry about and it can even be safely increased. Have I understood correctly your position, and if not can you clarify where my understanding is wrong ? Many thanks. NB there is no criticism of your position implied.

  • Paul Reynolds – the way you express this gives the impression that you think your postulation of Jonathan’s views are unusual or something? Rather than fairly mainstream for many economists? Am I reading your implication correctly? Many economists, and politicians not committed to the more orthodox lines of the two main parties in Britain (or their “business”acolytes) viewed the situation like that in 2010. Which was, of course, a key reason why the Lib Dems lost so much support at that time – that had not been the vibe in the party – we know that party establishment was moving right over the previous few years, but up to that point that had not expressed itself loudly in public that most voters knew it to be the case! People still genuinely believed the Lib Dems to be different “from the Two Old Parties”, as Nick Clegg so eloquently put it, not another version of the same.

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