With fiscal prudence thrown to the winds, are UK gilts again resting on a bed of  nitroglycerine?

Bill Gross
Bill Gross proved to be way off with his warning on UK gilts a decade ago – but his firm’s current concerns about government debt may be much nearer the mark

‘The UK is a must to avoid. Its gilts are resting on a bed of nitroglycerine. High debt with the potential to devalue its currency presents high risks for bond investors.” That was the warning issued 10 years ago, amid meltdown in the UK public finances, by Bill Gross, then head of the $200bn (£157bn) Pimco Total Return fund and self-styled “bond market king”.

He could hardly have been more wrong. Back then, the yield on 10-year gilts was 3.7pc; today it is close to an all-time low at less than 0.8pc. It was a spectacularly bad call, which makes you question whether Mr Gross ever truly understood how sovereign debt markets work in the first place.

In periods of subdued economic activity, money flows from high-risk assets (largely business investment, equity and property) into risk-free assets – government bonds underwritten by the taxpayer – driving down interest rates and economic activity in the process. Risk aversion is what causes the recession. Mr Gross failed to appreciate this 
 time-honoured phenomenon, and instead focused on seemingly rising credit risk, which is actually not really an issue for governments with their own currencies, able as they are to print the money to pay off their debts.

New warnings from Pimco that the UK government debt should be given a wide berth in view of promises from both major parties of a post-election spending binge should perhaps therefore be taken with a pinch of salt.

Only this time, Pimco’s chief investment officer for fixed interest securities, Andrew Balls (brother of Ed), may be on to something. Boris Johnson insists that once Brexit uncertainty is removed, hundreds of billions of pounds of international money will be rushing to invest in Britain’s new Jerusalem. This is not altogether impossible. But when it has happened in the past, it was largely the result of foreigners snapping up undervalued UK companies, which would not obviously be a great result.

Foreigners own over £500bn of gilts, as much as pension funds and insurers combined Credit: DMO

In other respects, it is just wishful thinking, and somewhat typical of the fantasy world in which UK political leaders from both main parties live.

Johnson’s deal does not “get Brexit done”. It is just the start of protracted trade negotiations that threaten one cliff edge after another. The uncertainty does not disappear with Johnson’s re-election as prime minister, though it would admittedly remove the threat of Labour’s Venezuelan-style alternative policy agenda.

I doubt the austerity programme introduced by George Osborne back in 2010 had much impact on UK gilt yields, but it did at least reassure that Britain was serious about living within its means. That comfort is in the process of being thrown to the winds. Small wonder that Britain's sovereign credit rating is again being questioned by the leading agencies. Nevermind Brexit uncertainty, there is also no predicting where fiscal policy might head. All things are relative I suppose, and against Labour proposals for economic renewal through debt-financed infrastructure spending, those set out last week by Chancellor Sajid Javid look reasonably restrained.

None the less, a key component of the old fiscal rules – to keep debt falling as a proportion of GDP – has been abandoned. This is a big moment, even if the ground for it was well-prepared. Judicious management of the nation’s purse strings, for long a Tory electoral selling point, has been replaced by the idea that so long as interest rates remain low, you can pile on the debt without consequence.

I don’t necessarily disagree with Javid’s approach. He’s trying to steer a middle course between the Scylla of Corbyn’s let-rip spending plans and the Charybdis of Osborne’s pinched austerity. But it is too simplistic to say that debt doesn’t matter because interest rates are low. They won’t always be so, and all debt eventually has to be refinanced. Javid promises to keep debt servicing costs to 6pc of tax revenues, Labour to 10pc, but what, pray, happens when rates rise unexpectedly, as they tend to, and these ceilings are breached.

It may be fine to pile on the debt when there is a baby boom going on; but in fact, the UK's demographics are the reverse, with the fiscal costs of an ageing population weighing heavily on the public finances in the years ahead. The demographics further steepen the challenge of achieving the higher productivity growth that might pay for today's spending promises.

Gilts may not be resting on a bed of nitroglycerine, but their long, long bull market looks to be drawing to a close.

Drug price red herring

One of the curiosities of free-market economics is that it doesn’t always deliver lower prices. A case in point is American drugs. Vibrant competition make most things in the US cheaper than elsewhere, though this is getting less so with the growth in producer monopoly. The exception is drug prices, where pharmaceutical companies are allowed to charge what they want and the free market perversely produces the reverse effect.

The differentials are so big that essentially no company can expect to be successful in pharmaceuticals unless it has a good foothold in the US. This is where the margins are made to finance drug discovery. The upshot is that America excels in available cutting-edge treatments. If you are rich, or have good insurance, America is the best place on earth to fall ill; if poor, it is the worst. Even long-established drugs are expensive.

The reason for this apparent anomaly is that there is no monopoly healthcare buyer to drive down prices, as there is in the UK and much of the rest of Europe, with our universal healthcare systems and strict value for money criteria. In Europe, the mass consumer rules, in the US it is the producer.

Why am I rehearsing this little lesson in micro-economics? Because Labour has chosen to make drug prices an electoral issue. Like so much political discourse these days, Labour’s point is disingenuous, scaremongering nonsense. But given the special hold our failing NHS has over the British people, it none the less hits the spot. In any free-trade negotiation post-Brexit, the US will be pressing to introduce its own drugs pricing system here in the UK. Yet the chances of it happening in practice are remote to non-existent. Any UK politician who felt minded to concede such a thing would be dead before he even reached the despatch box. Besides, it is difficult to see how it could be done without first breaking up and privatising the NHS, since American producer pricing power relies on fragmented buying power.

It is an article of faith among many Republicans that healthcare is not the universal entitlement that we take for granted in Europe. That view is surprisingly persistent, but eroding. Consolidation among private healthcare providers has already resulted in greater buying power, driving down prices across the board.

Speaker Nancy Pelosi meanwhile has a sweeping drug price reform bill before the House that would supposedly save the Medicare budget $345bn over 10 years. It stands no chance of passing the Republican Senate, but the direction of travel is already clear.

The American system of drug pricing is much more likely to move closer to our own than ours is to theirs. Research and development budgets need not necessarily suffer as a result; these days, much of the profit from high prices seems in any case to go not into innovation but to share buybacks.