Government is the only game left in town

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I mentioned a recent economic forecast from Tory think tank Policy Exchange yesterday. It was gloomy and rightly so, if for all the wrong reasons. One of the reasons is that Tory economists continue to insist there is risk of a UK government default on its bonds and that the bond market is going to stop buying our gilts. As Policy Exchange said:

If/when there is a double dip, many commentators will presumably urge that the Coalition’s fierce fiscal consolidation plans should be abandoned. That would be a bad mistake. With a double dip recession, tax
revenues are liable to fall below forecast and expected future debt levels relative to GDP will rise. In other words, the risk that financial markets will lose appetite for UK government bonds, triggering an upwards
spike in interest rates and the serious further slump that would entail, will rise materially. With a double dip recession, markets will be more demanding of urgent action, not less, and any sniff that the Coalition is
losing the political will to carry its programme through could be disastrous.

This is utterly ludicrous. As Reuters have reported this morning, the UK gilt yield hit new record lows yesterday as global bond markets continued to power ahead on growing pessimism about the economic outlook. The 10-year yield hit a new all-time low of 2.790 percent, having gone below the previous record set in March 2009 on Tuesday.

Record low yields on gilts means record high prices for gilts. And record high prices mean that people are desperate to buy our government bonds – because they’re the best thing to own right now. Why is that? Well, I’ve argued markets are irrational and get things wrong before now, and will do again, but the message they’re putting out right or wrong is that they think there is a double dip recession coming and that they see there being no prospect of growth in the private sector as a result and as such the safest place to put money is with the government who are the only people secure enough to be trusted with it and that they are the only people sensible enough to use it wisely and effectively.

Put it another way – the markets think that the austerity measures the government is creating will so stifle private sector activity that government is the only game left in town.

All of which says yes there will be a double dip – but not for the reasons Policy Exchange suggests. The double dip will be because of the cuts. And markets are likely to want to continue to lend to the UK government securities as a result precisely because – well, they are secure. In which case there is no risk of an interest rate rise. Deflation remains more likely.

Of course, such low rates also make the best option – borrowing to spend now on the part of government – so much cheaper too.

But I can’t see this government doing that.