The Big Lie #1 - Austerity is needed to appease the bond markets

It is often said that truth is the first casualty of war. It could equally be the first casualty of politics as well. Given the extent to which politicians have appeared to play fast and loose with language and semantics in recent times it is perhaps unsurprising that their collective credibility and reputation, both at home and abroad, appears to be following the same trajectory as that of a test firing of a North Korean rocket. Whether it is politicians being "economical with the actualité", or Orwellian doublespeak of the type invoked by David Cameron recently where the term austerity has been magically redefined to mean "efficiency", the first casualty of UK political debate now always seems to be the English language. Of course none of this is accidental. It is all designed to disguise the reality behind a particular policy or action so that the voters are hoodwinked into believing in an illusion. 


One of the biggest fictions we are currently being expected to swallow is the one regarding the necessity of the current coalition government's deficit reduction measures and their apparent success. The argument that has been advanced by those on the Right on an almost daily basis since the last general election in 2010 is that the only way the Government can finance its deficit is if it can establish the confidence of the bond market. And the only way it can do that is if it slashes spending. And the central piece of evidence used to corroborate this claim has been the yields of government bonds or gilts. 


Gilt yields are currently at historic lows despite the Government running up record budget deficits over the last four years. Now we are told that these low yields are a direct result of the confidence that the bond market has in the Government's economic strategy. We are told that the Government cannot, or dare not, borrow any more money to stimulate the economy otherwise gilt yields would rise dramatically. We are told that our economy would then go the same way as that of Italy, or Spain, or worse still Greece! But how much of this is really true? The answer is hardly any of it. The reality is that our gilt yields are low because our borrowing has been almost completely self-financed over the last four years. That self-financing has come in the form of Quantitative Easing (QE). 


Up until April 2002 the last Labour government ran a financial surplus in its accounts. Then over the next six years this turned into a modest deficit of approximately £35bn per annum. While not ideal, these deficits were nevertheless sustainable in the long term as they typically increased the national debt by a smaller proportion than the corresponding annual increase in GDP due to economic growth. As a result the debt-to-GDP ratio was actually declining after 2006 despite the nominal debt level still increasing, and as a result it was actually more serviceable. It is therefore economic fantasy to suggest, as some on the Right have done, that these deficits caused the financial crash. The real cause was the set of economic policies implemented by the Thatcher and Major governments in the 1980s and 1990s, particularly with regards to the liberalization of consumer credit, laissez-faire bank deregulation and a wholly disfunctional housing policy. The result was the worst recession in living memory and a national debt that has increased to £1022bn. Of this total, over £500bn has been added since the start of 2008 - almost half the total. So why have gilt yields remained so low when the supply of gilts from the Government to the bond market has been so huge? The answer is QE. 


Since 2008 the Bank of England (BoE) has "printed" an additional £325bn of new money in the form of Quantitative Easing and used this money to purchase UK gilts. Irrespective of the fact that this was done through the secondary bond market, the net result is that 65% of all the new gilts issued by the Government since 2008 have in effect been acquired by the BoE. That means that only about £180bn have actually been purchased by the private sector, or £45bn per annum. That is only fractionally more than were purchased each year prior to the crash, and this has been going on for nearly four years now. In fact QE has been operating for so long now that the financing of government deficit spending has become semi-detached from the bond market to such an extent that it is almost operating in a parallel economic universe. That is partly why yields are so low and as you can see it has nothing at all to do with the international financial markets supporting the deficit reduction plans of the coalition. 


But that is not the whole story, for one of the additional consequences of the financial crash is that UK banks are now forced to hold more assets to strengthen their balance sheets. As a result UK banks have needed to buy more UK gilts themselves in order to increase their own financial stability. It is therefore highly debateable if there has been any significant increase in the purchase of UK gilts by overseas investors in recent years, yet capital flight from the PIIGS (Portugal, Ireland, Italy, Greece and Spain) has driven up the relative demand for UK gilts.


Only yesterday did we see further worries about the Spanish economy driving yet more capital away from the Eurozone and forcing it to look for safer havens elsewhere. The result was a further drop in UK gilt yields. And all of this is happening at a time when the supply of UK gilts, contrary to popular opinion, has actually been significantly reduced, or has at least been far less than the headline figure of the UK government deficit. So, given these two complementing drivers, it should hardly be any surprise that UK gilt yields are so low, irrespective of the general state of the economy, which in case you had missed it, is lurching from one recession to another. That is hardly the sort of performance that is usually associated with inspiring the confidence of international investors. 


You can of course look at all this from another perspective: that of the balance between supply and demand and its effect on market prices. Low gilt yields are an indication of excess demand and insufficient supply. Consequently they represent a market price signal that says: "The market wants more!" In which case why should we not supply more gilts to the market, particularly when we can put those gilts to good use? Those who believe in the power of markets, and the price signals that they send, cannot have it both ways. If high yields are a sign that government borrowing is too high, then low yields can be a sign that it is too low. And as I pointed out previously, when it comes to low interest rates you can have too much of a good thing. Ultimately banks, including central banks, cannot push money out into the economy when there is no demand, or no cost to holding it. In such circumstances monetary policy is like pushing against of piece of string and a coordinated and complementary fiscal policy is then also needed. 


Of course the real tragedy is that despite having access to what has effectively been free money for four years, both the last Labour government and the current coalition have failed to do anything effective or imaginative with it. Rather than using it to stimulate a programme of infrastructure investment, it has instead been used to refinance the banks, and indirectly to prop up house prices. Once again successive governments and the Bank of England have shown that they are more worried about negative equity than they are about unemployment; that they prize inflated asset values over real economic growth. As a result, all this free money has in effect been used to insulate the rich from the consequences of their own mal-investment rather than improving and protecting the lives of the poor. 


The choice of austerity is therefore a political choice not an economic one. Just because there is a lot of debt in the economy does not mean that there is no money at all. It just means that all the money is in the pockets of the wrong people. The current government with its tax cuts for the rich and its attacks on the incomes of the poor clearly wishes to keep it there.

Nick Clegg and the Tories - deal or no deal?

So who should Nick Clegg and the Lib Dems do a deal with? And what should they seek to get in return?

Clearly their first priority must be electoral reform. This is clearly their best opportunity yet to secure a set of reforms that could completely change the dynamic of British politics. Unfortunately, there are a number of major obstacles standing in the way that could prevent them from achieving this.

The first problem is this. On issues of policy (tax, electoral reform, Europe, the economy) the Lib Dems are much closer to Labour than the Tories, and so are most Lib Dem activists. Unfortunately, the same cannot be said for most Lib Dem voters, particularly those in many of the seats in the South of England where the Lib Dems are the main opposition to the Tories. So while most Lib Dem party members and MPs would be much happier forming a coalition with the outgoing Labour government, they could face a backlash from some of their voters and the Tory press if they did. David Cameron may not have won the election last Thursday, but there is no doubt that Gordon Brown lost it. Therefore Nick Clegg would be committing electoral suicide if he was seen to be supporting a Prime Minister who had been rejected by the voters.

The alternative Lib Dem-Labour scenario is that a coalition between the two parties could be agreed, but with Gordon Brown stepping down as PM. But would Gordon Brown ever agree to that? I suspect not, but even if I'm wrong, who would replace him? No-one from within the Labour Party has the mandate, and a new leadership election would take too long. So how about if Nick Clegg were to be the new PM? That might be more popular with the electorate, but then the problem switches to the question of who would be his Chancellor of the Exchequer. The public would also want Vince Cable, but it is inconceivable that any coalition between the Lib Dems and Labour could be agreed with the Lib Dems holding both of the two top posts in Cabinet when they are by far the smaller party. And the alternative is that Gordon Brown might demand his old job back.

Finally there is the problem of stability. A Lib Dem-Labour coalition would still fail to command a majority in the House of Commons. It would need the additional support of the SDLP, the Greens, and either Plaid Cymru or the SNP or both in order to govern. Yet the greater the number of partners, the greater the risk of collapse. The question the Lib Dems should therefore be asking themselves is this. How long would such a coalition need to exist in order for it to deliver electoral reform in time for the next election? And how likely is it that it would happen? The doomsday scenario is that this coalition would collapse before any real reform could be enacted, and that at the ensuing general election the Tories went on to win decisively, with the Lib Dems routed. Electoral reform could then be off the political agenda for another generation.

So if a Lib Dem Labour coalition is fraught with difficulty and danger, how about a pact with the Tories? At first sight it is hard to see, though, how a pact between the Tories and the Lib Dems (whether in the form of a formal coalition or an informal one) could work given the massive differences in policy between the two parties and the mutual hostility of many of their respective MPs. Moreover, the Tories would never agree to electoral reform of the House of Commons. However there is one thing that the Tories could deliver that would be a total game changer - reform of the House of Lords.

David Cameron and the Tory Party claim to support a fully elected upper chamber, so now Nick Clegg needs to call their bluff. The outgoing Labour government has claimed that it was opposition from the existing Tory life peers and hereditary peers that blocked and delayed reform of the House of Lords in the final years of Gordon Brown's premiership. David Cameron on the other hand can deliver the necessary votes in the House of Lords needed to get reform through quickly. That should therefore be the price that Nick Clegg should demand for limited support of a minority Conservative government in the House of Commons. The critical factor here is speed. If reform of the House of Lords is not in place before the next general election, not just in legislation but in operation as well, it can always be repealed by a new (Tory) government in the House of Commons that may seek to break any promises and cancel any deals agreed previously. There is little honour in politics, particularly if it gets in the way of the exercising of unbridled power. However, once an elected House of Lords is up and running though, no House of Commons will be able to abolish it unilaterally. It would need a broad consent in The new House of Lords as well, and turkeys don't usually vote for Christmas. In short, once it is up and running, a directly elected House of Lords is here to stay. It is irreversible.

Now at first sight this might all seem like a small and insufficient concession for the Lib Dems to extract from the Tories given that most people see the House of Lords purely as a revising chamber. I believe, though, that reform of the House of Lords is the real key to total electoral reform in this country. It represents the small crack in the dam that will eventually bring down the whole structure. As the new House of Lords would be elected by PR, it would be more proportional, more democratic, and therefore more legitimate than the House of Commons. It could act as a block on extreme policies promoted by governments with Commons majorities but minority support from the electorate. In effect it would lead to coalition governments without the need to reform the voting procedure for the House of Commons, though that would surely follow. In short, it would totally change the rules of the game. That is why Clegg must seize the opportunity now. He may never get another chance.