Does being “in hock” to the bond markets mean we can’t invest in net zero?

Keir Starmer’s supporters argue that replacing him as prime minister with a more left-wing alternative would unleash bond market turmoil and plunge Britain back into a 1970s-style economic crisis.   

They point to remarks made last year by Andy Burnham, the Labour leadership frontrunner, whose claim that the government was “in hock” to bond markets sparked fears of a repeat of Liz Truss’s disastrous premiership. Truss was brought down after just a couple of months in office when holders of UK government debt rebelled against her plans for billions of pounds of unfunded tax cuts.  

Could a similar fate await another prime minister that markets fear will be too spendthrift, this time from the left?  

A chastened Burnham has been much more circumspect recently. But questions still hang over the impact of a leadership battle on the UK’s stretched public finances and its spending pledges on the environment. 

There is debt, debt and more debt 
Thanks largely to the financial crisis, Brexit, Covid and war-driven energy shocks, UK government debt stands at almost £3 trillion, or around 94 per cent of GDP, the highest since the aftermath of the Second World War.  

The Office for Budget Responsibility (OBR) estimates that interest payments alone to service this debt will amount to around £600 billion over the parliament. That’s twice the annual NHS budget going to line the pockets of Wall Street bond traders and Saudi wealth funds. 

With debt this high, even small adjustments in market sentiment can add billions to the interest bill, as investors in UK bonds demand a higher risk premium, putting further pressure on the public finances. 

Why we shouldn’t slash net zero spending
This situation has important consequences, not just for the economy but for green investment as well. 

The Climate Change Committee argues that, while the total costs of reaching a net zero carbon economy are manageable and will mostly be delivered by the private sector, an annual £6 to £23 billion of additional capital investment needs to be publicly funded through to 2035.  

Last summer’s spending review saw a major uplift in capital investment in clean power, public transport and lower carbon measures for homes.  

But these apparently cast iron pledges appear already to be under threat as the government prepares to rejig its finances to pay for rapid rearmament, with capital spending and net zero likely to be cut back to fund the long delayed defence investment plan.  

The government clearly feels it is in a bind. With growth sluggish, it judges that more spending in one area automatically requires cuts elsewhere to avoid jeopardising its fiscal rules.  

Andy Burnham himself is sympathetic to environmental causes, and his Manchester mayoralty has a decent environmental record. But his spending priorities revolve around building more council houses, revamping social care and nationalising the water and transport networks. Clearly, some difficult trade-offs await. 

Bond markets want a coherent programme for growth
But is it really so simple? Are we actually in hock to the bond markets?  

Holders of UK public debt have three main concerns.  

One is undoubtedly political risk. No UK government has run a fiscal surplus (raising more in taxes than it spends) since the early 2000s, and debt has surged since the financial crisis. Successive chancellors have promised fiscal consolidation but failed to deliver it. It’s no wonder that talk of throwing fiscal caution to the wind makes investors nervous. 

Another concern is that high inflation erodes the real (inflation-adjusted) value of the debt, and the UK has a systemic problem of high inflation.    

The third is the UK’s poor demographics, with an ageing population, and low productivity, which act as a drag on growth and threaten its ability to service the debt over the long term.  

But could tight constraints on spending, particularly investment spending, be the cause of these problems, rather than an unfortunate consequence? 

As the economist Dimitri Zenghelis has argued, it’s far too simplistic to argue that bond markets would reject a coherent economic programme to invest in growing the economy, even if this raised borrowing and debt in the short term. 

A credible and well worked out plan to expand the UK’s productive potential through higher investment, supported by some sensible reforms to taxation and a fiscal framework that encourages, rather than penalises, productivity enhancing capital investment, stands a good chance of being accepted by bond investors.  

It is in this light that Keir Starmer’s proposal to cut capital investment to accommodate the rise in defence spending seems particularly short-sighted. The UK’s dismal record on capital spending is one of the main causes of low growth and productivity stagnation that has caused the debt to GDP ratio to soar.  

It also risks losing sight of the much bigger picture. Failing to invest in climate change prevention and mitigation is one of the biggest long term threats to the stability of the public finances. The OBR forecasts that economic damage from a 3oC temperature increase on 1990 levels will raise public sector net debt as a proportion of GDP by two thirds by the 2070s.  

If that comes to pass, we really will be in hock to the bond markets. But that would probably be the least of our worries.