On 28th October, another Healey delivers his first Budget. The latest estimates suggest higher bond yields have cut his fiscal headroom in half, from £23.6bn at the Spring Statement to about £11bn. By the Budget, I suspect, it could be close to zero.

As someone who has spent nearly 25 years in the City, I know full well that markets can force a government’s hand long before politics does. Governments can choose to ignore economists, opposition parties and sometimes even their own fiscal rules. What they cannot ignore for long is the bond market. 

I’ve said publicly that it will probably take a crisis to wake British politicians up. I’ve now reached a harsher conclusion. Britain needs a bond crisis! This is because a crisis can break the political deadlock that prevents reform in normal times. Measures that are thought politically impossible suddenly become unavoidable once the decision is made for you.

We remember 1976 as a humiliation, a reminder that if you spend years mismanaging the economy and ignoring hard choices on the budget, outsiders can force even tougher ones later. But it was also the only time since the War that a British government did what was needed at the speed required. The $3.9bn stand-by arrangement, then the largest the IMF had ever made to a member, came with punishing conditions: fiscal, monetary and incomes policy imposed all at once.

The public sector borrowing requirement had to fall from around 9% of GDP to 6% within a year. Domestic credit expansion was cut by about a third. Real take-home pay was expected to drop by around 7.5% by mid-1977. It was really a moment of capitulation forced on politicians that had delayed and obfuscated until somebody else made the hard choices for them.

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That October, while the Treasury was still negotiating with the Fund, the Conservatives published The Right Approach, the document that laid the ground for Margaret Thatcher’s election victory in 1979. Politicians knew what to do, but it needed the market to force them to act after years of delay. The crisis broke the deadlock, and what followed was a decisive shift towards sounder money, lower taxes and a more competitive economy. Sadly, such political weakness is still familiar today.

This pattern of delay and avoidance by politicians has been studied, and economists even have a name for why politicians kept avoiding the tough choices they eventually had to make during the IMF crisis. In 1977, Finn Kydland and Edward Prescott, who later won the Nobel prize in economics, showed that a policymaker who keeps re-optimizing will rationally abandon the plan that’s best in the long run, because the temptation to deviate today never goes away. They called it “time inconsistency”. Politicians often promise a long-term plan but end up changing it for short-term political convenience. Politicians lose the capacity for pre-emptive reform, because the political cost is immediate and the potential payoff can take decades.

Mancur Olson explained in The Rise and Decline of Nations why reform gets harder with time. Mature democracies build up “distributional coalitions” — organized interests whose purpose is to defend the status quo. The Blob, if you like. Layer enough of them together and the state becomes almost impossible to shrink. Alberto Alesina and Allan Drazen described what follows as a war of attrition, in which every group refuses to carry the cost, delaying stabilization until the cost of waiting becomes unbearable. In 1993, Drazen and Vittorio Grilli wrote a paper called, rather fittingly, “The Benefits of Crises for Economic Reforms”. Their conclusion was that making a crisis less painful can actually prolong it. Without pain, the pressure to fix the policy failure weakens considerably.

We fixed this problem for monetary policy in 1997, when Gordon Brown handed operational independence for interest rates to the Bank of England. Nobody has ever done the same for tax and spending.

That is why politicians resent the bond market so much, seeing it as a referee blowing the whistle on their spending plans. Andy Burnham once said Britain had to get beyond being “in hock to the bond markets”. Paula Barker, one of his MPs, went further, saying the markets would have to fall into line and telling the Commons that people were fed up with bond markets dabbling in the democracy of the country. But nobody forced ministers to borrow nearly £123bn last year. That was a political choice about what to spend and how much to tax. The gilt market simply took a view on the risk and quoted them a price, and if ministers are unhappy with that price, they have the option to adjust how much they borrow.

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Back in 1993, James Carville, Bill Clinton’s strategist, said he wanted to be reincarnated as the bond market because then he could intimidate everybody. He was complaining, because the market had just forced a newly elected Democratic president into cutting the deficit. What he was actually describing was the one institution in public life you can’t lobby or fob off. Our own political class would do well to remember that, and soon.

Last week in Liverpool, Burnham used his first conference as Prime Minister to admit that his generation of politicians had been too cowardly to fix social care. But within minutes of saying someone had to “rip the plaster off”, he confirmed the triple lock would remain untouched for the rest of this Parliament, with a slight tweak delayed until April 2030 — safely beyond the next election. It was a perfect demonstration of Kydland and Prescott’s point. 

Burnham also promised to repeal the Thatcher-era ban on public ownership of water companies. He wants to set up a publicly owned Great British Grid, and bring energy, water, and housing back under what he calls stronger public control. When he ran through Labour’s great moments, he named 1945, 1964 and 1997. He conveniently skipped 1974 to 1979, the government that ended up at the IMF.

For decades, successive governments have avoided enacting spending restraint by borrowing or taxing more: so much so that both routes are now at breaking point. Last week the 30-year gilt smashed through 6% for the first time since 1998, reaching an intraday high of 6.07%, and the 10-year hit 5.51%, its highest since 2007. That matters for the government’s debt-interest bill. In the year to March 2026, central government spent nearly £100bn on debt interest alone, nearly 80% per cent of the £123bn it borrowed. Andrew Griffith put the problem bluntly at Conservative conference this week: Britain has “a debt problem, a tax problem and a growth problem”. Any gilt investor should find that frightening, because it means we are mostly borrowing to pay the interest on what we’ve already borrowed. 

Taxation, too, is running out of road. The Office for Budget Responsibility’s March forecast had the tax take rising to 38.5% by 2030-31 — in other words, the state would be taking nearly 39 pence in tax for every £1 generated across the economy. This is the highest tax has been since the Second World War, and businesses are already reacting. After the rise in employer National Insurance, the Bank of England found that 44% of the firms it surveyed had reduced staff relative to what they would have done otherwise.

What used to be a managed decline has become a thunderous one, with shops closing and pay packets shrinking in real terms. Plenty of voters no longer expect any government to make the reforms to spending, tax and incentives that would materially improve their own living standards. Instead, they want it for their children and grandchildren, who may once have believed the old British promise that each generation does better than the last and are instead set to inherit the debt and the stagnation.

But the next crisis won’t be a rerun of the 2022 mini-Budget. That episode was a combination of unfortunate known and unknown events and suspect timings. The Bank of England confirmed active gilt sales the day before the mini-Budget, excessively leveraged pension funds didn’t hold enough collateral, and regulators failed to reform liability-driven investment strategies that matched long-term liabilities with long-dated bonds. The mini-Budget fiasco saw the 30-year yield rise by more than a percentage point in a few days. Sterling hit an all-time low against the dollar, and the Bank was forced to intervene to calm markets. Mortgage rates jumped, deals were pulled, buyers saw what they could afford collapse almost overnight, and the housing market froze. Within weeks the Chancellor and the Prime Minister were both gone.

Westminster took the wrong lesson from the debacle and decided that radical economic policy is dangerous. The real lesson was that tax cuts without credible control of spending won’t convince the market.

The former Bank of England governor Mark Carney, was right when he once said the country relies on the kindness of strangers. Britain is exposed to what economist Guillermo Calvo popularized as a “sudden stop”: a sharp withdrawal of foreign capital. Investors may suddenly refuse to buy our government debt leading to a failed gilt auction, or quickly sell off what they already hold. If that happens, gilts and sterling are likely to fall together.

A crisis would begin in the primary market with a weak or failed gilt auction, then another. In this scenario, dealers are left holding more gilts, prices fall and the move spills over into the secondary market. Collateral calls get triggered. Sterling weakens and foreign investors demand an even larger risk premium. The government is forced to refinance maturing and new debt issuance at substantially higher rates. Debt interest costs jump, and the sell-off becomes self-reinforcing. A gilt sell-off would push up mortgage rates for millions of households already under a cost-of-living crisis, valuations would collapse, borrowing costs for businesses would rise, and sterling would collapse hard. The consequences would hit more than the gilt market. Equities would sell off too, especially housebuilders, banks, and heavily indebted domestic companies.

And we would now reach an inflection point. Milton Friedman wrote in 1982 to the preface to Capitalism and Freedom, that only a crisis produces real change, but that what happens next depends on the ideas lying around. I have seen none of value from this, or indeed, the last government.

So what is the case for a crisis? It is not that pain is desirable. It is that we need a trigger to clear away some of the distortions built up over fifteen years of near-zero interest rates, quantitative easing, a borrow-and-spend mentality within government, and political reluctance to change. Such an outcome would force a repricing of the state itself.

It is still theoretically possible to avoid the crisis. Labour would need to make the requisite changes before the country is forced to. The pain would be acute, but it would be temporary. The reward could be years of stronger investment, higher productivity and rising living standards as capital and labor move back towards productive uses. Spending and the tax burden have to come down. The triple lock and working-age welfare need radical reform in this Parliament, not tweaks in the next one. Energy has to get cheaper, and planning needs genuine liberalization.

John Healey has three weeks before the markets could force the issue. He could put welfare on a falling path and cut the public-sector paybill, and do voluntarily what his namesake was made to do in 1976. But nothing in fifty years of British politics, nor in the Prime Minister’s speech last week, suggests he will, and I’m not expecting much in the way of radical change on 28th October. 

Then the decision passes to investors who have no seats in the Commons and no interest in the electoral cycle — only adequate compensation for lending to a highly indebted borrower. They may decide to keep selling gilts until the government is forced to act. I’d rather Britain were spared that. History, however, tells me the cowardice of politicians will not allow it. And so the least-bad realistic outcome, painful though it would be, is a bond crisis.

About time. For Britain now lies close to a full-blown fiscal crisis, as public debt has been ratcheted up in several giant steps since the 2008 crash. Whatever Burnham’s fine words now, indeed, successive governments have long demonstrated remarkable degree of fiscal incontinence, whether that’s bailing out RBS or spending £70 billion on pandemic-era furlough. The result has driven up long-term borrowing costs — at 5.3%, 10-year rates are at their highest in nearly 30 years — crowding out the fiscal space for necessary public investment. Interest payments on UK debt alone are now approaching 4% of GDP.

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Burnham vs the bond markets

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How did we get here? The Chancellor is not wrong when he says that the UK used to be famous for getting “its house back in order when things go wrong”. The last example of an actual government default was back in 1672, when King Charles II suspended payments on debts owed to English goldsmiths as the kingdom’s profligacy began hampering the public finances. With war against France heating up, and a financial crisis in full swing, the Bank of England was established in 1694 to reform the state’s monetary system and support the management of government debt and borrowing costs.

Admittedly, British public debt was regularly racked up in wartime, when resources needed to be mobilized quickly. But an awareness of the need to borrow in future meant that after each splurge — in other words when peace was agreed — the Exchequer worked to move public finances into surplus: whether by spending cuts, or tax rises, or both. This ongoing commitment to stable finances, or “sound money”, underpinned Britain’s access to debt markets and nurtured low borrowing rates for centuries.

This fiscal orthodoxy wouldn’t survive the 20th century. A sequence of fiscal deficits in the Seventies led to the September 1976 crisis, when James Callaghan’s Labour government was forced to apply for a $3.9 billion loan from the IMF (some $23 billion in today’s money), with long-lived consequences for the country’s financial reputation. Though overall debt was considerably lower in 1976 — at just under 50% of GDP, compared to 94% now — interest payments on that debt were nonetheless approaching that magic number of 4% of GDP. Thankfully, a sustained debt consolidation followed, with the debt-to-GDP ratio duly falling to around 30% by the turn of the century.

Over more recent times, however, and encouraged by the seemingly blank check that years of ultra-low interest rates implied, governments have come to the rescue of banks, bond markets and households to the tune of billions of pounds. Public debt is unsurprisingly expected to hit the £3.5 trillion mark by 2030, representing around 95% of GDP. Worse still, these interventions have not kick-started the economy, or indeed provided the services and infrastructure needed for a modern country to prosper. To that extent, Britain’s addiction to debt has acted less like a springboard and more like a somnambulant pillow.

Little wonder that the bond markets have become so concerned about Britain’s ability to manage the public purse, further pushing up borrowing costs in the face of global shocks and our own domestic maelstrom. Whatever the complaints from people like Burnham — who, despite now softening his tone, has previously claimed that the vigilantes are undemocratic arbiters of the nation’s fate — any excess market sensitivity simply mirrors Britain’s fiscal woes. If the Government’s economic position were more credible, the vigilantes would cut us some slack.

Nor has Britain helped itself when it comes to more specific policies. With the establishment of the Office of Budget Responsibility (OBR), after all, the Treasury seems to have become little more than the Government’s policy cheerleader — vacating its former role as a “critical friend” seeking to correct policy errors and nurture growth. Not unrelated, Whitehall’s relaxed attitude to raising debt means the Treasury has an incentive to see inflation as the way out of our fiscal mess. Yet if that reduces the value of Britain’s elephantine debt, it soon sparks other challenges, not least in the weekly supermarket bills of millions of ordinary people.

The Burnham government must take its share of the blame as well. The prime minister’s commitment to Labour’s 2024 manifesto, precluding changes to income tax or VAT, has been an ongoing sore, especially as spending commitments never seem to be matched by spending cuts (the pension triple lock, for one, looks as immovable as ever). That’s even as Healey has committed to those totemic fiscal rules, under which Britain, uniquely among advanced economies, has imposed an IMF-style program on itself, precluding room for economic maneuver let alone a substantive discussion about the appropriate objectives for fiscal policy.

The bitter irony, here, is that, for all its theoretical sternness, the OBR has done little to steady the economic ship in practice. Changing countless times since the Coalition founded the Office in 2010 — leaving the bond market to merely guess at what comes next — the fiscal rules have in any case obviously been “honor’d more in the breach than the observance”.

For instance, the rules currently impose an expected reduction in public debt over the next three years. But that does little to constrain debt in earlier years, while acting to squeeze the policy debate into one arbitrary and imaginary number. Basing everything on forecasts has also increased the incentives for political game-playing: why would a Chancellor worry about their accuracy today when they may not be in post tomorrow? The result is a painfully short-termist policy environment, one where managerial KPIs are lauded over the fundamentals of building state capacity and encouraging a more stable financial climate for private investors.

How then do we get ourselves out of this self-imposed mess? It won’t be easy, but there’s plenty Healey and Burnham could do. The working principles for any government should first mean committing, over the course of a parliament, to a level of debt that falls materially relative to GDP. Next, debt service payments must be sustained at much less than 4% of GDP, with the aim of giving Whitehall more room for fiscal maneuver.

In practice, of course, that means finally cutting welfare; tackling the triple lock; increasing public-sector productivity; and cutting its workforce. As far as possible, meanwhile, measures to control and reduce public debt should become “timeless” political facts, followed and accepted by any government, allowing future Chancellors to be judged on the same standard as their predecessors. That equally means sticking to the analysis of actual fiscal outcomes, and scrapping those shifting and capricious OBR projections. Let’s be clear about our tax-and-spend priorities, and phase debt reduction accordingly — rather than focusing on “headroom” to the exclusion of sensible policy initiatives.

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It would also help if Britain stopped relying on foreign assessments of the economy. Every year, the IMF in Washington DC and the Organisation for Economic Co-operation and Development (OECD) in Paris produce two each. Just this week, indeed, the OECD warned that the UK would grow slightly less than expected next year, piling ever more pressure on Healey as his first Budget looms. Unfortunately, and whatever the justification for the unease of people like Georgieva, both bodies are arguably stymied by their limited and inexperienced staff knowledge of the UK. Certainly, developing its own home-based independent public assessments, perhaps drafted by a research institute in conjunction with market and industry experts, would allow Britain a more rounded and authoritative assessment of the state of the economy.

That, in turn, might finally allow more thoughtful public discussion of the big economic questions of our time. What, for example, might happen if debt continues to remain high over the course of this Parliament? How much could things be improved by bolstering productivity? How can we create more stable demand for UK bonds? Getting some answers feels more urgent than ever. After all, the markets don’t have infinite patience, and the day is coming when government failure to cut debt leads to a fully-fledged fiscal crisis — one where a “sudden stop” limits Britain’s ability to roll over debt or access market funds. That would be disastrous for the Government’s fiscal reputation, let alone the countless public services kept afloat on cheap debt.

The way things are going, an emergency of this sort may be the only thing to shake the politicians from their stupor. Either way, we’ll wish we listened to the bond vigilantes far, far sooner.