Economics in business podcast episode 37 transcript

Barret Kupelian

Hello, everyone, and welcome to the October edition of PWC's Economics and Business podcast. With me, I've got Andy Haldane. Hello, Andy. Hi, Bar. And myself, Barrett Kupelian. And we'll be speaking a bit about the situation in the debt markets that's been grabbing headlines, as well as the implications for the budget and wider policy-making angles for the budget. So without further ado, can we just start off on the first thing, Andy? I think there's been a lot being written about the situation in the debt markets. We touched upon in the previous podcast, but now it's really picked up. So I suppose the first question is, what is your interpretation of what's happening in the government debt market and where do you see that evolving in the future?

Andy Haldane

Yeah, thanks, Barret. Well, in some ways, Government bond markets generally, globally, have been on the turn for four or five years now, actually, from their low point after COVID. But since we last did this podcast, we've seen a further significant turn for the worse in bond markets, not in equity markets, interestingly, continuing that pattern. The epicentre of that, as it tends to be, is the United States. although when the United States sneezes, the rest of the world catches a cold and the UK has certainly been guilty of that again. What is the foundation of those concerns? I think there's at least two or three factors driving it. One of them, which on the face of it, you might even consider benign, is that There's a lot of other borrowing going on in the private sector, in particular for AI investment and infrastructure. So there's a degree of indigestion in bond markets right now with AI hyperscalers issuing at scale and governments still issuing at scale and investors saying, hang on a second, there's a lot going on here. I'll charge a higher premium. That in some ways is the benign part of this. I think the less benign part is that pickup in borrowing cost is also being driven by fearfulness about inflation and therefore about higher central bank interest rates as a result of the straight over moves remaining closed and oil back at around $100 a barrel. And secondly, the penny is dropping ever so slowly on the fiscal plight. of many governments. Certainly the United States, which is still running a huge deficit, 5, 6% of national income. But also France, running a similar size deficit, and the UK, running a smaller but still significant deficit. And that sense that governments collectively, globally, have not yet got their fiscal house in order is adding to those upward pressures, which is taking borrowing costs in the UK and the US at a sort of 10 to 30 year horizon to between 5 and 6%.

Barret Kupelian

And thank you for that, Andy. I mean, the one thing I should say is that for the past 20 to 30 days, this has been the most popular question we get from our clients about the situation in the in the debt markets, particularly in the government side, which is then feeding into the private sector. But I mean, my interpretation of it is a bit of what I talked about last time, which is, the four Ds. You've got these big, long-term, mainly government-supported projects about, you know, additional defense spending, the digitalization agenda, which has to do with AIs and hyperscalers, the deglobalization agenda, as well as decarbonization. These are long-term projects that require quite large sums of capital committed in the long term. So in some ways, if you're a bondholder, you're spoiled for choice, and hence you can command that premium. I think why it's important is, you know, besides the obvious financial implications of it, the way I put it is that in this predatory world, fiscal space, i.e. your ability to leverage government's balance sheet if you've got that space. Fiscal space is actually power. So it buys you social stability, it buys you security, it buys you defense spending, and it buys you stability. So in some ways, I think, you know, the financial implications are quite clear, but in a predatory world, I think it's got an added level of importance. in a way that we probably haven't seen in the past, three, 4 decades, because the world is changing at a quite rapid pace. Now, I think there's quite a lot of focus in the UK, and maybe we'll go into that with some of what we think could happen in the budget. But I think it is a common story across most advanced economies.

Andy Haldane

Yeah, I mean, I strongly agree with that. I mean, it's in this uncertain era we're living in. If you are losing because of constrained fiscal space, one of the shock absorbers, one of the key shock absorbers, which is the government's ability to ride to the rescue, if something nasty or untoward happens, is a big loss, a significant loss and significant concern. Allied with which, of course, if this was just about government borrowing and the cost of doing so, it would be bad. But of course, these are costs that everyone feels. those higher interest rates are being felt by mortgage holders in the UK already, your fixed rate mortgages now being marked up very significantly. And if you're a business, borrowing in corporate bond markets, you'd have seen the cost of that also going through the gears. In particular, you know, some of the less good credits, subprime credits, have seen both their direct borrowing costs go up and their credit spread on top of that go up. So this is a squeeze felt by government, but also being felt now by households and by companies as well.

Barret Kupelian

And it's worth pointing out the historical picture as well, which I like doing, because it gives you a nice context into how long of a period we've been whereby government bond yields have been on a sustained downward trajectory. So I've got it noted down here in 1981, I think it was, the US 10 year Treasury touched, I think, 16%. So that was almost the peak in terms of micro rates. And ever since then, for 40 years, if you plot the chart, it's quite impressive. It's been on a downward spiral, almost a linear line, bar some noise. And I think 2021, 2022 was that trajectory point. And now they've been on a on an upward trajectory. But if you're a policy maker and if you're a business, you've had that tailwind for about four decades and now it's changed. So it's almost a headwind now because you've got the additional cost of funding these large sources of borrowing. So it is a different world out there. And as economists, we're great at identifying these big trends, the mega trends that will lead to higher costs of borrowing, we're not as good as identifying the turning points. But I think it's quite stark that 2021 and 2022 was that point where this turned and now we seem to be in this different era. So I suppose the message for businesses is that, you know, we're not seeing us going back to, you know, the conditions where monetary policy was lax. I think we are in a different world, so best prepare for it.

Andy Haldane

Yeah, and you're right. We've had a, we had up until just after COVID, you know, what had been a 50 year bull market for bonds. In fact, some of the historians have looked even further back. And if you draw a, if you smooth out enough, you could argue you've gone through a 250 year period of a bull market in bond markets. That now looks decisively to have turned, who knows whether it's for 50 years or 250. But this is a brave new world, both for governments, given the debts that they've racked up over the course of this century, and for the private sector. I mean, the one thing or the most important thing, you know, keeping growth afloat in the United States has been all matters AI, AI investment. But there must come a borrowing cost at which some of that bubble, if it is indeed a bubble, begins to burst, but some of that investment no longer looks economic. I'm not sure what that critical threshold is, but you know, just the point where the hyperscalers are borrowing to finance that investment, we see the cost of that borrowing going up and that poses a double threat to the economy. Because if that investment tapers away, what's keeping growth afloat?

Barret Kupelian

So that would be a nice segue then maybe to start speaking about the budget. This is being recorded early October and the budget is late October. So I suppose, you know, let's start off with a relatively open-ended question. What would you like to see in the budget?

Andy Haldane

Well, Had we been having this conversation just a few weeks ago, before the latest leg up in borrowing costs, I'd have said the best case would be a sort of low drama, no drama budget. I mean, the last few budgets have been a bit too exciting, a bit too much speculation, and speculation is a tax on business. And indeed, the last two budgets have brought growth to a screeching halt, but into that uncertainty. That I think had been the government's plan to have something that was low-key relative to its recent predecessors. Regrettably, I think that hope has been torpedoed by events. So the rise in borrowing costs that we've mentioned will have without question added to the fiscal hole that needs filling and therefore puts us into a slightly hard, a land of hard choices on the budget front, harder choices than would otherwise have been the case. That is to say, we may have a hole of anywhere between 5 to 10 billion to find if we are to preserve a decent amount of headroom, which I think is important for reasons of prudence. What I'd like to see, if there is a hole to be filled, is for that to be filled by a reduction in public spending rather than an increase in taxation. We've seen very encouragingly since the new administration, the Andy Burnham administration, a bounce in business confidence and a bounce in consumer confidence. That's the good news. I think that bounce is pretty fragile, though, Barrett, and it wouldn't take much by way of tax rise to snuff it out. So my hope would be that if the books are to be balanced, as they'll need to be on the 28th of this month, the skew of that rebalancing is achieved by doing what's necessary to curb public spending. We saw just last week the government announced the end of the triple lock. That's good news. That was good news for bond markets as a signal the government's willing to take costly action to curb spending. The less good news, of course, is that won't happen until after the next election. and indeed those money's already been set aside for extra spending. I think we need further signals that this government is serious about getting its arms around public spending and the budget actually provides the opportunity to do just that.

Barret Kupelian

I mean, we actually agree, 2 economists agreeing in the same room, and that's a first. I mean, the way I was thinking about this is both the content of the budget as well as what happens in the run-up to the budget. And I think one of the things that seems quite different with this fiscal event compared to the last few ones is that the rumour mill hasn't started. And the reason why we care as economists about that is because what we saw in the previous fiscal events historically is this start-stop economy developing. Rumours start to pick up. spending is reigned in anticipation of what could or couldn't happen. And then once everything's announced, you get this reconfiguration of decisions and then you get spending picking up again. We haven't seen that, at least for the time being, which is good news.

Andy Haldane

And that I think has been a conscious effort by the new government to curb that.

Barret Kupelian

And it's been felt in the confidence numbers, in the private sector confidence numbers, as you've said. I mean, the second point is, I agree, it's do not pencil in more tax rises than what's already been announced, which then the implication of that means if there is any need for further spending, it's a matter of reallocating existing resources and or curbing where necessary. And then the third point I would say is probably focus a bit more on business costs. We can talk about it later on. It has implications on bond markets as well. I think businesses have been saddled with costs, quite a few costs in a short period of time. And in a relatively low growth era, even though the UK economy has been growing a bit faster in the first half of the year. With all this uncertainty going on, I think taking a look at that might actually be quite helpful. to help breed a bit more confidence.

Andy Haldane

I completely agree. I mean, important for business confidence. They would say if you ask business, and you speak to them all the time, and I do too in various sets I wear, that the cost of doing business has gone through the roof actually over the last decade. We did some work with my Chambers of Commerce hat on and we looked at a 70% increase in the cost base over the past decade as a result of government actions of various types. Dramatic scaling up of costs. And of course, you can't detach this from concerns about the cost of living. Because if that's being laid on businesses, unless they take it all on their own margin, which frankly, almost no business is capable of taking all of that on margin, some or perhaps all of it needs to be passed on to the consumer in the form of a higher cost of living. So if we are to tackle at source the cost of living challenges, which I think the government is committed to doing, they can't do that without tackling at source the cost of doing business, which has gone through the gears. And if government can do something in this budget to at least put a lid on those costs, that I think would make a dramatic difference both to business sentiment, their willingness to invest, but also ultimately the cost of living, which will otherwise be challenged by higher energy prices and probably higher borrowing costs.

Barret Kupelian

And it's quite telling if you look at the growth experienced in the public sector versus the private sector since, well, in the past five years, the public sector has grown, well, output in the public sector has grown by 8% cumulative, private sector is just 2%. So if you really want to change the fortunes of the economy, you need both engines of the economy firing at a full pace. Which then I suppose leads me into what I would like to see in the budget. And the line I usually use is, I'd like to see less on tax policy, but more on economic policy. And by that I mean, you know, the government redirecting some of its thinking on the big markets in the UK economy. And by that I mean, the energy market, there's a clear issue there with us having one of the highest industrial electricity prices amongst our competitors, which then makes us uncompetitive. The labour market, as we've spoken, you know, in terms of costs, there's been quite a lot of hiking of taxes and regulation in that area. And then finally, the wider goods market, which is our trading with our nearest and dearest as well. And if there is some redirection of attention to these areas, I'm not saying solve it on day one, but at least try to tackle some of the supply side issues they've been facing. It could actually alleviate business costs and by extension consumer prices.

Andy Haldane

I think on those, I mean, one of the encouraging things I think from the Prime Minister's speech at the party conference in Liverpool was he did offer out some hope on all three of those fronts. He spoke about doing more to tackle the energy challenges and the cost of energy, highest energy costs in Europe. He spoke about the importance of getting, freeing up the labour market in particular for young people. He spoke about strengthening our links with the EU in particular on the trading front. That's the good news. I mean, the less good news is most of those were put on the back burner. Most of those were, the date for that was certainly not this year and possibly not until after the next election. So there is a case for thinking how many of those could be brought forward to the front burner to try and provide that extra stimulus. the government, the business needs to get investing and to get growing.

Barret Kupelian

And just to get a better idea to our viewers and listeners about why this is important, besides the obvious, the implications it has for businesses, you can actually circle back this argument back to bond markets, which is one of the reasons why there's been quite a lot of attention on the UK with respect to its own yields is that we're amongst the G7, our yields are on the top end of our peers. I think France might overtake in the next few days, but we'll see how that manifests. And the reason for that, if you dig down the numbers, our cumulative inflation in the past five years has been about 27%. whereas in the G7, ex-UK has been about 22%. So essentially in the past five years, we've had an at least one percentage point inflation compared to our G7 peers. Now you could trace this back to some of the arguments that we mentioned, these supply side factors, higher energy costs, labour costs, the friction of trade, So actually tackling those might have an indirect impact on our cost of borrowing, which is actually what the government would want and would, bizarrely enough, give it a bit more fiscal space in the future if there's credible steps made in that fashion.

Andy Haldane

Yep, I agree. And it works through two channels. I mean, those measures would prospectively lower our sensitivity to global events and therefore the inflation rate. But there would also come, you would hope, with a growth dividend. which also helps out in terms of the fiscal arithmetic, in terms of shrinking that ratio between our public debt and national income. And growth is the great redeemer of debts and curbing inflation comes a close second. So things that speak to those, which ultimately supply side policies rather than demand side stimulus policies are absolutely the name of the game. I mean, the tricky thing with that is they take time. But that means the best time to start is now.

Barret Kupelian

And with that positive message, looking forward to see what there will be in the actual budget at the end of the month. And thank you for coming here, Andy.

Andy Haldane

Great to speak to you as other Barett.

Barret Kupelian

Thank you. And thank you everyone for listening in.