The world is dangerously close to a new crisis

Telegraph

10 hours ago

Last week we saw yet again the power of the financial markets. Pretty much as soon as Rachel Reeves's tears were seen in the House of Commons, or Reevesgate as I shall call it, both the price of gilts and the pound fell, echoing on a much smaller scale what happened in reaction to the Truss/Kwarteng mini-Budget in 2022.
Behind the human drama and the obsessions of the political class, there lurks a much more important problem. The elephant in the room is the appallingly high level of government debt, which is running at about 100pc of GDP. Last week's mini-crisis may simply be the harbinger of much worse to come.
According to many on the Left, supported by some economists, nothing like this should happen.
Do you remember the Magic Money Tree (MMT) that briefly flourished when Jeremy Corbyn was leader of the Labour Party? Conveniently, the initials MMT also apply to the economic doctrine known as Modern Monetary Theory, which avers that governments can borrow from the markets willy nilly without consequence.
You don't hear much about that idea these days. And with good reason. It is perfectly plain that there are limits to the markets' appetite for government debt. We have reached them.
The UK's awkward position on public debt is by no means unique in the world. In the US, the so-called ' One Big Beautiful Bill' has just passed Congress.
The consequence is going to be an increase in the US budget deficit. Indeed, it is difficult to see how this is going to come down anytime soon from its current rate of about 6pc of GDP. At present, the US debt ratio is running at about 100pc, but if the deficit continues at current levels, it is reasonable to suppose that the debt ratio will reach 120pc by the mid-2030s.
The most acute worries around government debt in Europe are now focused not on Italy, where the debt ratio has stabilised, but on France. There, the debt ratio was 113pc last year and it is still rising.
What is most concerning about France is the apparent unwillingness or inability of the government to reduce the deficit. Indeed, measures taken a few years ago by President Macron to reduce government spending by increasing the retirement age are again under threat. And if Marine Le Pen's party were to win power, it would probably increase government spending considerably.
In many ways, though, the really interesting bond market is Japan's. (Interesting in the sense of the old Chinese curse.) For many years Japan was the poster child for all those people who argued that gargantuan government debt didn't matter. After all, for years its gross debt ratio was above 200pc. Yet for a long time the yield on these bonds was next to zero.
Not any more. Against a backdrop of inflation having risen to over 3pc, the yield on Japan's 10-year government bonds has increased to 1.5pc.
When the ratio of government debt to GDP reaches these levels in emerging markets then usually the prospect of default looms on the horizon. When a country borrows in its own currency, however, default can be avoided simply by printing more of the stuff.
Mind you, this usually ends in inflation, which is a form of default by the back door.
The US, Japan and the UK borrow in the currency that they issue. So default is not a worry. The same isn't true for countries within the eurozone because, although they borrow in their own currency, they have no control over its issuance. That rests with the European Central Bank.
If it happens, a US recession could help to keep inflation subdued over the next year or two and that may forestall a bond market crisis. Yet, of course, that is a double-edged sword because any weakness in the economy will worsen the deficit.
The same is true for the UK but the risk of a recession is probably lower here because we haven't suffered the tariff shock that President Trump has imposed on the US economy. As it is, over here recent signs on inflation have been fairly encouraging. If inflation does fall back convincingly, not only would that tend to encourage markets to take longer bond yields lower, but it would also encourage the Bank of England to cut short-term interest rates and that would tend to bring down short-term borrowing costs for the Government.
But we face an acute vulnerability, namely the exchange rate. Of course, even the United States must confront this problem, although it is much less serious for them. For a start, as the world's largest economy and the issuer of the world's reserve currency, the US can get away with things that the rest of us cannot.
Moreover, the US is a much less open economy than the UK and so any given percentage drop in the exchange rate has a smaller effect on inflation than it does here.
Every financial crisis in Britain somehow or other involves the pound. Given our huge public indebtedness and very substantial international net liabilities, coupled with a still enormous current account deficit, we are seriously vulnerable to a loss of confidence. If the pound were to drop considerably, you could kiss goodbye to the prospect of lower interest rates and lower bond
yields. Indeed, the opposite might happen.
This is the significance of Reevesgate. Normally, the obsessions of politicians with this or that policy tweak and the manoeuvrings of particular individuals have very little significance. But in today's financial context, if the markets sniff the idea that Britain is about to enter a period of political chaos when the Government is unable or unwilling to stabilise the public finances, then they will move in for the kill.
Whether the Chancellor is Reeves or someone else is not the important issue. The fundamental question is whether the Prime Minister has the will to assert his authority and control the public finances.