How Britain’s economy collapses, step by terrifying step
With huge national debt, the UK is dangerously exposed to our international lenders – which could bring about a nightmare scenario
John Healey has an unenviable task on his hands. The size of it was underlined on Monday when the UK’s borrowing costs rose ahead of the Chancellor’s speech at the Labour conference.
The truth is that the investors who fund Britain’s debt addiction are right to be wary. Andy Burnham, the Prime Minister, insisted last week that the UK is “too exposed” to the bond markets, months after saying we were “in hock” to them.
It is though his own words that have deepened that exposure. The PM’s implication in the Commons that social security was a higher priority than national security left investors very, very nervous. Gilts (government bonds) are the dominant supplier of funding for national budget deficits (and hence, debt).
Around 33 per cent of investors in gilts are foreign; they may not be studying every nuance of economic and political life in the UK. They may rely on broad judgments about the prospects for the nation. So statements from senior politicians matter.
When the bond markets take fright, that can lead to full-on economic crisis for a nation as precariously poised as the UK. So if a catastrophic collapse were to happen, this is how it could pan out in extremis.
Step One: Oil price shock
It may start with a shock – say, Saudi Arabia cuts more (or all) of its oil exports following an Iranian pipeline attack. This is a highly plausible and very live risk.
Oil prices could rise to $150. A rise beyond that would be on the table.
The UK – very exposed to international energy prices – finds inflation spikes in just a few months to 6 per cent. The Government carries on with its Budget plans by raising new taxes on the highly paid and wealthy. It pledges to spend all this and more on social programmes, energy price support and Burnham’s much-vaunted devolution plans.
Meanwhile, in response to the oil shock, bond markets around the world take fright, but particularly in the UK. Rates on 10-year gilts spike to 9 per cent, giving existing holders a heavy capital loss of around 30 per cent.
Step Two: The US and EU retrench – Britain doesn’t
The US announces an emergency package of spending cuts, thus reviving the US bond market. Most EU countries follow suit, but the Government in Britain is unmoved.
The pound, stable for so long, begins to fall against all the major currencies, and overseas gilts holders see their losses rise to 50 per cent – a combination of continually increasing long-term interest rates and the weakening currency.
A sharp-eyed journalist spots that the gilt-price collapse has left the Bank of England facing more than £100bn in further possible losses (far more than previously acknowledged) on the bonds bought under its quantitative-easing programme. Taxpayers will have to cover these losses.
This announcement stuns the already reeling gilts market, and the next gilt auction is uncovered – in other words, insufficient investors apply to buy them all.
Step Three: UK Government runs out of money
Meanwhile, the Bank of England’s Monetary Policy Committee has been raising interest rates by whole percentages at a time to try to combat the spiralling crisis. Rates by this time sit at, perhaps, 10 per cent.
The housing market falls, but there is so little volume that it is hard to tell how far. For the first time in three decades, instances of negative equity are everywhere. That is householders owing more on their mortgage than the value of their home.
Banks start to give warnings of mortgage defaults, which spooks the equity markets as well. The Government’s failure to auction gilts gives it a dilemma. It can press on with even higher interest rates (to give gilts investors a return worth their while), but risk a full-on housing collapse and business insolvencies in doing so.
Or, it can risk having to substantially fund the deficit and maturing gilts by essentially printing money, risking an inflationary spiral.
The budget deficit has already ballooned with the higher interest rates and the fall in taxes from the weaker economy – and now runs at £250bn, or 8 per cent of GDP, with no sign of the rise slowing down.
Inflation now crosses the 10 per cent threshold, and, unlike in 2022, is heading further upwards.
Ballooning prices of imported food, goods and energy lead to widespread strikes in the public sector as workers seek higher wages to compensate.
The pound, for so long in the 1.20-1.40 range versus the US dollar, falls below par, and then to $0.90 against it.
Step Four: Political chaos and gilt default
John Healey, the Chancellor, resigns, quickly followed by Prime Minister Andy Burnham. The departing PM had fatefully failed to call an election under pressure from his backbenchers, citing their resistance to being ruled by the capital markets.
Angela Rayner is elected as the leader of the Labour Party.
The Government then fails to repay the interest and principal (original sum) due on a maturing gilt because no British bank is willing to provide emergency credit. As a result, the markets effectively ban the UK from the gilt market.
The unions call a general strike (although that call is largely ignored). The pound falls to 0.70 against the US dollar; inflation is 25 per cent and rising.
Step Five: Breakdown of society and the economy
Rayner is compelled to hold an election. It produces not only outbreaks of violence and intimidation at the polling stations, but a hung Parliament with no clear majority for any party.
With time being of the essence, the King steps in to invite the leaders of the largest four parties to agree to form a “wartime-style” coalition. The Cabinet would comprise members in proportion to their parties’ Commons representation.
This coalition agrees to vicious cuts to public spending, including freezing state pensions and welfare payments rather than increasing them in line with inflation. They also cut public sector workers’ pay by 15 per cent, and fire 200,000 civil servants.
But under mounting pressure from the unions and the public sector strikes, the coalition collapses. There is unrest in many cities.
Aftermath
If we get that far down the road of financial, political and societal chaos, who knows where it would end, and what the aftermath would look like? Similar crises in other countries have led to dictatorship, often involving the military.
In others, inflation has run away into high double or even triple figures. Rarely do countries emerge from such a meltdown with new vigour and confidence.
I admit: the above is unlikely. Highly unlikely. But it is not impossible, certainly not the financial aspects.
If you think I’m being fanciful about how high interest rates could go, in October 1976 the Labour government was forced amid the then crisis to issue a 22-year gilt paying a fixed interest rate of 15.5 per cent!
And if you think there are limits on interest rates. Think again. In the overnight interbank market the night before the pound was forced out of the Exchange Rate Mechanism, on Sept 16, 1992, Sterling interest rates went to 3,000 (yes, that’s three thousand!) per cent.
How Parliament and other institutions would actually behave in such a crisis is of course unknowable until it happens. But the UK is too close to meltdown for comfort, and I don’t believe this Government is taking the threat seriously.
If our Prime Minister can suggest that social security is more important than national security, he may also believe that social security is more important than financial security.
Neil Record is a former Bank of England economist and was chairman of the Institute of Economic Affairs. He founded Record Plc, a specialist asset manager, in the 1980s and remains an investor
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