The assumption of enormous financial sector liabilities by the UK government represents a reckless doubling-up on a losing position, just as the deflation of the credit bubble is hitting tax revenues. The net result, according to the National Institute for Social and Economic Research, is that increases of 9-10% in the basic rate of tax are required to restore the government finances to balance by 2023. To get back to Gordon Brown's previously-stated target of capping public debt at 40% of GDP would require an unbelievable increase of 25% in the basic marginal rate, according to the NIESR.
The only other solution, says the NIESR, is to implement government spending cuts of £50-60 billion a year for the next decade. This seems a highly unlikely outcome, with none of the main three political parties in the UK prepared to authorise even the smallest reductions.
But the tax increases required to balance the government's finances are surely not going to happen either. Why? Because the burden of paying them already falls on a rapidly-shrinking percentage of the labour force, and there must be a limit on how much people can pay. A second report, quoted in the Daily Telegraph, reveals that the average UK worker paid £7.27 per hour in tax to the Treasury last year, up from £6.63 the year before. There were significant jumps in council and car taxes but, more importantly, the number of taxpayers shrank from 31.6 million to 29.3 million. This situation is set to worsen even further this year and next, with a further rise in unemployment and more tax increases.
At what point does the tax burden become unsustainable for the ever-smaller number of payers? In an interview I conducted last week with Australian economist Steve Keen for the next issue of Exchange-Traded Funds Report, Keen argued that the scale of the credit bubble was so large, and so much bigger than that which preceded the Wall Street crash of 1929, that there is simply no way back to a sustainable economic growth trend without a wholesale writing-off of debts. In his view, we've already passed the tipping point where the system can be restored to balance, and a much more chaotic outcome is likely.
In the case of government debt it's very easy to imagine a scenario where a rise in bond yields quickly makes the interest burden on the existing debt stock unbearable, leading to a further rise in yields and a collapse in investor confidence. Interest costs alone are forecast to be £43 billion in the next fiscal year, according to the latest budget, and that's with gilt yields at or close to historic lows. No wonder the Bank of England announced an extension to its quantitative easing programme yesterday. They are desperate to prevent yields rising, which they clearly have a tendency to do in the absence of such intervention.
It's possible that we are heading for a Japan-style outcome, where public debt to GDP ratios increase severalfold, while bond yields head down towards zero. But investing in expectation of this seems like a highly risky bet to make. Japan has had a massive savings surplus for years, whereas the UK and its anglo-saxon sister economies have almost no net savings.
For the time being credit default swap spreads on UK (and US) government debt have contracted, as expectations of recovery in the economy have helped to reduce worries about state finances. The government risk index published by Credit Derivatives Research shows this graphically. I find this improvement hard to reconcile with what is becoming ever clearer about the state of government finances. Sovereign bonds seem one of the riskiest investments out there to me, and I'm sticking with precious metals in my pension plan.