129. How Serious Is The UK’s Debt Mess?

0:10Hello and welcome to The Rest is Money with me Steph McGovern and with me Robert Peston. So today we're joined by Dr Gerard Lyons, someone we've both interviewed quite a lot in the past. He's a renowned global economist. He's had quite the career really because he's done everything from advising Boris Johnson when he was London Mayor. You know, he's someone who regularly pops up at prestigious forums like the IMF and the World Economic Forum. He currently sits on the board of the Bank of China, so really interesting stuff to ask him around that. And he is currently Chief Economic Strategist at NetWealth.

0:43Oh, and he's also got a podcast as well with his daughter, the brilliant comedian Elf Lyons, called Elfenomics. Look, I've known Gerard forever. I'm not going to say quite how long because that would give too many clues about my age. Look, he's an interesting character. So just before we got into the calamitous Liz Truss quasi-quarting mini budget, he was seen as somebody close to Liz Truss, urging her on to sort of take risks and build a growth agenda. He now says that the mini budget wasn't his fault and he was actually urging, he was advising her not to do the reckless things of borrowing quite so much to fund tax cuts.

1:31We might see what he has to say about that today. But the reason I think we really need to talk to him is because there are very few economists who, for example, have been more immersed in the extraordinary growth of China's economy over the last 30 years. He worked for Standard Chartered forever, which was one of the most important Western banks in China. We've got the Chancellor just off to China, trying to persuade China to invest more in the UK. I have a couple of questions there about, A, is it realistic? And second, is it sensible to become more dependent on an economy that many people regard as a hostile state?

2:12And the other reason it's worth talking to him is because he has spent his life in the city of London and we are in a position where investors seem to be turning against the government. They are becoming more reluctant to buy UK government debt. The yield on government debt, the interest rate the government pays to borrow is at levels we haven't seen when it comes to those long term borrowing since the late 90s. So how worried should we be about all of that? Yeah, here's our interview with Gerard Lyons.

2:43Gerard, great to see you. We meet as the government's long term borrowing costs, the yield on the 30 year guilt, have reached levels, highs that we haven't seen actually since the late 90s. Now, we're seeing rising borrowing costs for governments across the Western world. Germany's borrowing costs are rising. Actually, one of the things that's very striking is that in America, the interest rates set by the central bank has fallen and actually borrowing costs for the government have gone up. So there are borrowing costs going up all over the world. So I guess the question is, is Rachel Reeves a victim of global conditions or is at least some of this rise in what she pays to borrow a problem of her own making?

3:36Hello, it's great to be on the show. Thanks for asking me. In answer to your question, I think it's a combination of both domestic factors and global factors. There's two things that have changed here in the UK, particularly in recent months, that have pushed borrowing costs up. One is that the financial markets are far more concerned about persistent inflation, and that will limit the extent to which the Bank of England can eventually cut interest rates. And the other factor is worrying about the government borrowing. Government spending is high. The Labour government inherited a very difficult situation.

4:05but as we started the new year many economists as well as the financial markets often sit back and reassess the situation and one thing is they've reassessed at the beginning of this year is concern about the future fiscal options in terms of government spending and taxation so those two factors are domestic namely worries about UK inflation and worries about the future policy options for the Chancellor but then against that backdrop there's the global picture now it's fascinating that in the states the u.s has become very optimistic about future policy under president trump the rest of the world has become more concerned but in between the two what's happened is financial markets in america now think that the u.s federal reserve their equivalent of our bank of england won't be able to cut u.s interest rates and that's had an impact also in terms of thinking not just in the states but globally so it's partly global but it's also domestic as well.

4:59The challenge, of course, is high borrowing costs start to feed through to the whole economy, impacting the level which companies can borrow. It starts to deter business confidence and also it starts to seep through also into the mortgage market as well. So it has longer term ramifications if indeed interest rates and borrowing costs remain high. So how worried do we need to be, Gerard, because that sounds like quite a pessimistic picture. Yeah, well, I think we should be concerned, but not yet pessimistic. The global backdrop is far more uncertain than usual just because of the change in US president.

5:33But in terms of the UK itself, the budget a few months ago had a very negative impact. There was a very positive aspect to the budget in the sense that Rachel Reeves wanted to address longer term investment, which has been far too low for far too long. But the positive impact of that takes some time to feed through. Against that, what we've seen is a reaction to the increasing taxes in terms of taxes on national insurance. Whichever economy one looks at, whether it's America or Britain, the outlook depends on the interaction between the economic fundamentals, which are mixed, the policy outlook, which is also mixed, and confidence.

6:08So fundamentals, policy and confidence. And the key thing, Steph, is that in the States, confidence is really riding high. But here in the UK, confidence is very low. So I think a key thing is for the government here and Rachel Reeves to try and get on the front foot, to try and start to reassure people about confidence, about the outlook. But the underlying fundamentals and policy options are still very difficult, even allowing for that. I mean, one of the things that worries me when I talk to investors controlling very large pools of money is how gloomy they've got about the UK's growth prospects.

6:45We've got stats at the moment which show basically zero growth in the UK economy. Most economists are downgrading how much they expect the economy to grow in the current year. this is a government that says its number one ambition, its number one mission is to get the growth rate up. But when I talk to investors, they say they don't believe they've got yet a persuasive plan. And the problem, given the kind of concerns you've just raised, it's a double problem because if growth bumps along, tax revenues don't come in in the scale that they need. And we're in, therefore, to another wave, potentially, of tax rises, another set of tax rises, which the Chancellor has said she doesn't want to do.

7:37So, A, are you as gloomy as these investors about the growth outlook? And if you were the Chancellor and you wanted to persuade these investors to take more of a chance on the UK, what would you do? OK, a whole host of issues there. Right. If we want to reassure ourselves, we're not in isolation. Many other countries are in the same boat. Not that that often helps. In fact, the biggest challenge is facing Western Europe. So Britain, Germany, France, Italy, the four major economies of Western Europe are facing this difficult challenge of not only a weak immediate economic outlook, but adjusting to the changing global template.

8:16America is trying to make itself more competitive. The Indo-Pacific region over in Asia is becoming far more competitive. So we don't only have immediate challenges. It's about trying to reposition the economy so it becomes more competitive longer term. And it's important to mention that because the policy levers that if you're the chancellor that you want to pull are not only aimed at helping you now, but hopefully will put you on that right path for the longer term. So what should the chancellor do? I think we need to put it into three pots. and the Chancellor herself, unfortunately, can't pull the levers for all three parts.

8:49One is fiscal policy to reassure the markets about the fiscal outlook. The fiscal outlook is the combination of government spending, taxation and borrowing. Unfortunately, spending is high, taxes are already high and borrowing is high. And just on that, because, you know, she has a rule that says if she has no so-called headroom, then she's either got to cut spending more or put taxes up more. The problem with these interest rates going up for her, the cost of borrowing, is that there doesn't look to be any headroom there at the moment. And that's why people think taxes are going up again. Yeah.

9:21Fiscal rules sound really credible because the idea is you have a rule that forces you to stay on the straight and narrow. But sometimes, as you know, Robert, fiscal rules can constrain you. And if you have a rule that constrains you and actually forces you into a corner, then you ideally should actually get rid of that fiscal rule. But the Chancellor, for whatever reason, feels reluctant to do that. Obviously, like most rules, the best time to change them is when you're in a good position. If you change them when you're in a difficult position, the markets think, ah, gosh, you're trying to get yourself out.

9:53Let's step back. If you have a fiscal challenge, as we have in Britain, there's effectively five ways out. You grow the economy, you reform, you tax, you curb spending or you borrow. The ideal way out is economic growth. So if the markets became confident about economic growth, then they will start to become less worried. Of course, you could try and reform. Reform is very much in terms of public services. So public spending can be more efficient. So it reduces the upper pressure on public spending while still being able to deliver what the general public wants. Again, that takes time. The ideal way out is to have the world economy picking up.

10:33And that gives us some nice tailwinds. Lower oil prices this year could help. So it's possible that growth could come in helping it out. We'll get on to Trump, but actually there are perfectly good reasons to fear that won't happen. And no government anyway should subcontract the fortunes of its country to sort of events outside its own borders. That's right. Well, so come back to controlling the controllable. So I was saying earlier, you've got three things if you're a chancellor. Fiscal policy, you need to reassure and hopefully start to pull levers that make people more confident about the outlook.

11:05Second, there's monetary policy, which is obviously outside the Chancellor's control. That's the Bank of England. UK interest rates are relatively high now, 4.75%. I think interest rates will fall this year. I've read the inflation interest rate picture quite well. So my feeling is that the markets can sometimes get ahead of themselves. Now the markets have been pulled back. The markets three, six months ago thought interest rates would fall aggressively. Now the markets in the UK think interest rates will fall gradually. and bottom around 4%. So I think interest rates will come down. So 4.75 % now will probably get three rate cuts by the autumn.

11:42That helps. Then the third factor is the supply side, the magical supply side. The best way to think about this is all the eyes. If you're the Chancellor, you need to encourage not just the general public and general businesses in the UK, you need to encourage the international investors you asked about, Robert. And there the eyes are innovation, investment, infrastructure and incentives. All of those need to be aligned. And sometimes it takes a lot of time. As I said earlier, the budget, even though the budget got a thumbs down generally, one important aspect of that was measures to try and turn the investment picture around.

12:18And this has been a problem for 30, 40 years. So putting it all together, what should the Chancellor do? She should basically address the worries about the fiscal side. Hopefully, the Bank of England will step in to help her with interest rate cuts while keeping inflation under control. And then it's putting a whole host of measures in place to address the supply side. Of course, growth is the issue. If growth disappoints, as you mentioned earlier, it makes everything far more complicated. You know, the Chancellor said to us when we interviewed her after the budget that she really didn't want to put up taxes again.

12:50But it sounds like from what you're saying, given the picture you've just painted, that she inevitably is, though, isn't she? And, you know, talking to businesses at the moment, the addition to the national insurance contributions, the change in business rates for retail and hospitality sector, the increase in the minimum wage. This is all absolutely hammering businesses. And yet there could be more. Well, the tax on national insurance for jobs was a bad decision, quite frankly, and that doesn't help. But on top of that, the way you pose your question really touches on where everyone is at the moment.

13:22They're starting to sort of double guess what might come next. It's important to stress that a higher tax take is already factored in for this year. So the Chancellor, in all likelihood, won't have to do anything this year on the tax front. Obviously, we have additional challenges with the comprehensive spending review, which is going to add to pressure on public spending at home. President Trump is likely to force the UK and other Western European countries to step up more in terms of defence spending. So those external pressures are there. So if you have public spending under upper pressure, it comes back to those options I touched on.

14:00Growth hopefully will start to deliver for you. If not, then you need to start to think about comprehensive reform. I mean, one of the things that people don't seem to have noticed is that the Chancellor has asked the Office for Budget Responsibility to provide another fiscal update in March. All right. March 26th, I think, from memory. If, as seems likely, that says there is no headroom. she will be in a very difficult position because you say no more tax rises this year. I'm not so sure if what we see in March is that a tiny amount of headroom at the moment goes negative. OK, what the Chancellor needs to do if the OBR comes back in March is to really try and get on top of the situation.

14:50You need to actually win over confidence of the markets at home and overseas. And the point is it's the fiscal rules that you touched on earlier. The OBR, I think, has done a very good job. In fact, they've read the economy very well. They're the independent forecaster. They were quite upbeat. So you don't share Liz Trusses. You're a great ally of Liz Truss. You don't regard the OBR as this liberal conspiracy to bring down, you know, essentially the right of this country. Well, I met Liz Truss twice before she became PM. I'd never met her again after she became PM. In fact, to be frank, I had more breakfast with Alistair Darling when he was Chancellor than I've ever had meetings with Liz Truss.

15:25but no one ever says you're Alistair Darling's advisor, etc. The truth at the factory, as you know, Robert, you meet all these politicians because you try and give them advice. But the OBR, actually, there's an external review of taking place of the OBR that reports in February. So I was one of the experts brought in to speak to these two people from the Netherlands. And I basically gave them my view. I thought the OBR was very credible. The challenge, of course, with the OBR is that many of their forecasts are seen as being absolute truth. And the margin of error, not that we should be talking about margin of errors on podcasts, is that one year ahead you can be out.

16:01It'd be a bit like you trying to predict Arsenal and we trying to predict Fulham at the beginning of the season. Our forecast can be sometimes right of the mark. The OPR, usually one year ahead, is a half percent out in terms of their forecast of the economy. What we're saying here is basically they do a pretty credible job. They're pretty good. On the margin, they're as good as anybody out there is what you're saying. Actually, I think Richard Hughes, who runs it, has done a very good job. So I hope he stays there. But the challenge, of course, is these fiscal rules. One of the difficulties in recent decades in the UK is because economic policies lack credibility.

16:34Often the chancellor of the day, and it's not just Rachel Reeves or her predecessors immediately before her, whichever chancellor it is often thinks we should have a monetary rule or a fiscal rule. And often what happens is in the good times, it's like adding fuel to the fire. And in the bad times, it's like being in the hole and digging deeper. if your fiscal rule says growth is weak your tax revenues are not going to be as high your budget numbers are not going to be met hey presto what must you do you then start to cut spending or raise taxes but if you're an economist you think and if you're of keynesian persuasion as i tend to be you tend to think well that's the worst thing you do you need to actually sort of say this fiscal rule is not fit for purpose the challenge to reuse that word is that if you're Changing the rules is often better to do it when you're presenting it in a credible way and not when you're sort of back against the wall.

17:26So she can't change it now because if she changes it now, markets will say she's cheating and her credibility will be even lower than arguably it is now. OK, if interest rates start to fall and if inflationary pressures start to ease, then the Bank of England will be able to cut short term interest rates and longer term borrowing costs, which are currently very high, should start to ease off their current highs. That will make that backdrop very positive or less negative than it currently is. On top of that, it's important to have a credible policy saying you're combining fiscal policy, monetary policy and the supply side agenda.

18:02So we've got a credible policy for growth. The difficulty, of course, is that if the economy underperforms, then you get back to the really difficult questions of those options. Growth, reform, taxes, austerity or borrowing. If growth doesn't deliver and if you're not delivering on reform, then there's no easy way out of it. you have to think of those other three areas, curbing or controlling spending, raising taxes. If you start to do both of those in terms of curbing spending and raising taxes in difficult economic times, it's a death loop, or you borrow more. But of course, the shock absorber is that if the economy underperforms, then interest rates could and likely would fall by more than we are talking about.

18:46So it's not as if, though, things can't be moved. The global backdrop, of course, is one where, as we've touched on earlier, there's so many other factors at play. So no one should kid themselves it's an easy outlook, but it's trying to retain business and consumer confidence at this sort of difficult time. One of my kind of beefs around this, Gerard, is whether monetary policy really works anymore, though, in the sense of, you know, we keep talking about the global backdrop, which impacts so much in terms of our inflation here. Do you think it works? I've heard you talk about monetary policy before and had criticisms of it.

19:22So what do you think now? Do you think it works? Well, I think we've had a whole long period of poor monetary policy in the UK. Like the day Russia invaded Ukraine, which did add to inflation, UK inflation was already in more than three times the inflation target, almost approaching 7%. So monetary policy was on the wrong path before. Interest rates were kept too low for too long. that led to asset price inflation, led markets to not price properly for risk. It meant zombie companies stayed in business, growth companies couldn't access funds, and inflation picked up. Even though inflation at the moment is relatively low, the reality is that the cost of living in terms of the price level is 30 % higher than three years ago.

20:06So most people are still feeling the pinch. So in that respect, Steph, it's difficult to reverse that. So you might feel that monetary policy isn't working in terms of being able to reverse that sort of cost of living aspect. But the point you touched on is a critical one. Not everything is under Britain's control. So what the Bank of England needs to do is to be on the front foot to curb domestic inflation pressures. Surface sector inflation is pretty high in the UK at 5%, which is largely not wholly, but largely reflecting domestic pressures. So monetary policy can work, but you've touched on the key point, which is that the external environment, which is outside our control, is exerting a big influence.

20:46Now, it might be the case that oil prices turn out to be much lower this year because a lot of bad news has been factored in in terms of geopolitical risks into the oil markets. So we might be lucky and get lower oil prices if it starts to help. Food prices might not sustain their high levels as a result if oil prices come off. So there might be some helpful tailwinds, but the uncertainty is the tariff impact. I mean, an argument that I would make is that it's absolutely clear that business confidence has collapsed and consumer confidence is low. Inflationary pressures are therefore, in my view, lessening really pretty fast.

21:30But the Bank of England spends all its time looking in the rear view mirror at data that is out, you know, that is no longer relevant. Yeah, I've been saying the same for months. Monetary policy used to be forward looking. We used to say that, well, economists always took the view and the Bank of England that changes in interest rates and monetary policy more generally. So it's not just interest rates, it's quantitative easing. The Bank of England is actually making the problem worse because they're pushing up guilt shields by actually selling government debt. They should stop doing that. That would take some of the pressure off.

22:03And indeed, they could start to buy government debt if they wanted, but they should at the very least stop selling it. It might sound esoteric in the technical issue, but it does have widespread ramifications. But on top of that, the Bank of England needs to restore some confidence that they don't communicate well. And instead of being forward looking, they're very coincident. so that means that instead of taking actions now on policy that will impact in 3, 6, 12, 18 months they're responding to the latest data so they need to get ahead of the curve the Chancellor has tried to do that through the budget the Bank of England tends to always be reactive a coincidence so monetary policy hasn't been good in the UK if we contrast the Bank of England with the European Central Bank partly because Germany and France are much weaker the European Central Bank is cutting rates far more aggressively and what's also happening is America doesn't feel the need to cut interest rates as much because the US economy looks very strong.

23:00So Britain suddenly is caught with the markets thinking UK rates should be more like American rates but at the same time our growth picture is as poor as the growth picture on the continent. So we're caught between having interest rates much higher than the real economy needs in the UK but the reason for that is because inflation is far more persistent in the UK. So it's a very difficult monetary policy background. Gosh, we're going to make all the listeners sound really pessimistic here. But the reality is that the economy is in a difficult situation. It's not been run particularly well for the last few years.

23:35Debt levels are very high. But unless you get the growth picture coming through, then you are forced to make some very difficult decisions. But if you're forced to go and autopilot to think it's spending cuts or tax increases, then you actually make the economic picture probably even worse. So you need to start to really force through those reforms. Try not to raise taxes. Energy costs we haven't talked about. UK energy costs are the highest in the world. That is really having a damaging impact on business. Now, I'm very much in favour of the green agenda. I'm on the advisory board of the Grantham Research Institute.

24:12and so we need to adjust the energy crisis. What we have in the UK is we're going on a slightly different path. Other countries are having energy addition, we're going for energy substitution. What does that mean? Take Norway, they're very on the front foot on the green agenda, they're bringing on renewables, but at the same time they're still going into fossil fuels because they need to keep energy costs down. And the argument with energy addition is that renewable costs start to come down, that starts to push out the fossil fuels. We've leapfrogged into trying to substitute renewables immediately for fossil fuels at a time when the so-called baseload, the reliability of them is not so high, so the cost is high.

24:55So that means that we have high energy costs. So given that we're not going to change our energy policy, the question is, is there a plan B? And the argument is we should start to break the UK energy market into regions. So that would allow places that are rich in high-end wind suddenly to benefit and we don't have to turn the grid off. So we need to basically, without reversing policy, we need to actually start to think more intelligently to start to address the energy crisis with your commitment to renewals if you're going to stay on that path, but then start to reduce the energy costs. The point is that there are levers that can be pulled.

25:34And the other thing is the planning reform. A year ago, economists in the FT survey were asked, what's the one thing that you would do if you could run policy? And there is a real danger when all the economists say the same thing. You tend to think run for cover. But practically all the economists a year ago said change planning reform. For whatever reason, the conservatives didn't do that. Labour, to their credit, is changing planning reform. You need to execute that because if you do that, then suddenly it makes it easier to build properties. Obviously, they're pretty expensive to buy and to rent.