Debt rule tweak can help UK avoid moron premium

Repreeve. Next week, Rachel Reeves needs a velvet hand in an iron glove. The Labour chancellor’s Budget will have to thread a fine line between borrowing enough to power Britain’s ailing economy and being seen as fiscally responsible to keep markets calm. If she goes beyond a slight tweak to the government’s fiscal rules, she might awaken memories of former Prime Minister Liz Truss’ disastrous tenure.

Two years ago, then-Chancellor Kwasi Kwarteng beat a hasty retreat from an International Monetary Fund summit in Washington. Upon arriving in London, he was sacked by Prime Minister Liz Truss, as punishment for a “mini-Budget” of unfunded tax cuts which sent UK government bonds reeling. Within a week, Truss was gone too.

Reeves’ moment of truth comes next week with her first Budget. The task is daunting: raising some 40 billion pounds to pay for public services and investment without upsetting voters with higher taxes, antagonising businesses or unsettling markets.

The last goal is key given that Kwarteng’s first (and last) Budget sent yields on UK 10-year government bonds, or “gilts”, soaring from around 3% in mid-September 2022 to more than 4.5% in a fortnight. That surge prompted TS Lombard economist Dario Perkins to talk of a “moron risk premium”.

Reeves has already pledged to fund day-to-day spending with taxes but has been vague about her borrowing plans. What is certain is that the government will change a rule stating that public debt as a percentage of GDP must fall at the end of a rolling five-year period.

The most conservative, scenario is that Reeves will exclude the Bank of England’s losses on its bond portfolio from the debt calculation. That tweak would give her an extra 25 billion pounds of borrowing capacity, according to Goldman Sachs - and should be small enough to keep gilts’ yields in check. But the government hasn’t ruled out more radical changes, such as targeting  a measure of debt that includes all of the state’s financial assets and liabilties. That could free up some 50 billion pounds in extra borrowing. Reeves could argue that the extra space would be used sparingly and only on growth-enhancing investments like infrastructure.

That would be a risky manoeuvre. Yields on 10-year gilts are already above 4.2%. Admittedly, that’s largely due to rises in U.S. yields and the trajectory of UK interest rates rather than fiscal fears. But counting on investors traumatised by the 2022 crisis to believe in Reeves’ restraint and ability to pick “good” investments is a dicey proposition. It’s odd for a UK government to go into a Budget without clarifying the fiscal rules. Gaming them to borrow more would be much, much worse.

Context News

The UK finance minister, or Chancellor, Rachel Reeves will announce her first Budget on Oct. 30. The event, which will set out the new Labour government’s tax and spending plans, will aim to plug a 40-billlion-pound funding gap, the Financial Times reported. A senior government source told the Guardian that Reeves would change the government’s fiscal rules and target public sector net financial liabilities (PSNFL), instead of public sector net debt. PSNFL is a wider measure that includes all of the state’s financial assets and liabilities. That would give her extra borrowing firepower of around 50 billion pounds.