Gilts: The fine line between hope and despair
There's an unmistakeable smell of the 1970s about finance, politics and economics: the City recovering from a banking crisis; a super-tax on wealthy bankers; fears that international investors will stop lending to the British government; excitable chatter about the likelihood of a hung parliament.
All we need now is a power cut and I would swear I had been transported back to my teens (if only).
Against that slightly discombobulating backdrop, what has been bugging me ever since Alistair Darling announced his one-off tax on banks paying big bonuses is whether there would be any impact on the government's ability to sell £225bn of gilts to investors this year (and a similar amount next year).
Or to put it another way, would the Treasury pay for its raid on bankers pay by being forced to pay more when borrowing in the form of sales of government bonds?
It would certainly be wrong to attribute yesterday's fall in the price of gilts to bankers' retribution.
That was caused by bond investors' disappointment that the chancellor in his pre-Budget report did nothing to accelerate a reduction in the UK's record peacetime public-sector deficit.
This is how Michael Saunders, an economist at Citigroup, put it:
"The PBR offers little or no coherent plan to get the UK back to a sustainable fiscal stance over the next few years...There are still no plans for public spending after 2010/11, merely forecasts. This is not just a linguistic difference: it signals that the government has not yet decided on its public spending intentions for those years. This implies that the UK also has no plans to get back to fiscal sustainability."
Saunders adds: "The UK's fiscal route will, if followed, probably also lead to the UK losing its top-notch [credit-rating] status, for the first time ever."
It's only a view, and there are others who argue that the UK's AAA credit rating - which allows the government to borrow at very low interest rates - is safe, at least for the time being. Moody's, for example, said overnight that the outlook for the AAA ratings of the UK and the US was "stable", even though earlier this week the ratings agency said that both countries may "test the AAA boundaries".
That said, the clever old Debt Management Office - which organises the sale of gilts for the Treasury - will not be properly testing investors' appetite to lend to HMG till 6 January.
Which is when the next sale of conventional gilts takes place (there will be a small sale of index-linked stock next week, but that probably won't give much of a guide to how the market feels about the UK's credit-worthiness).
The point is that governments typically have an uneasy relationship with big financial institutions: there is a relationship of patron to client, in that governments provide lots of valuable business to banks and have ultimate responsibility for how they are regulated; but governments which borrow are not all-powerful, in that they require the goodwill of banks and investors to borrow what they need.
If bankers are grumbling about having their bonuses slashed by Mr Darling, are they really going to be enthusiastic salesmen for the bonds he wants to sell?
Finance isn't just about numbers and rates of return; it's also about emotion. And if the City were to be alienated from the incumbent government, that would not be healthy for either side.
That said, there is a semi-rational connection between the bonus super-tax and downgrades of the UK's fiscal prospects, which is that if genuine wealth-creating firms and individuals were to move abroad, that would lead to a shrunken tax base in the UK.
However the notion that the bonus tax would have a material impact on the British economy would of course be absurd.
But what also strikes me is how delicately balanced the UK is between vicious cycle of decline and virtuous circle of recovery.
For those who want cheering up, take a look at an analysis in this month's Financial World magazine by the noted monetary economist and former member of the Monetary Policy Committee, Charles Goodhart.
He believes the time has come for the Bank of England to cease helping the government to borrow, to stop buying gilts, to end the quantitative easing programme of converting government debt into money - for fear that to extend the QE programme beyond the first quarter of 2010 would pump up asset prices to dangerous levels (and see my note A bubble or 'stubble' or our own design).
As he implies, all else being equal, an abrupt halt to the Bank of England's acquisition of gilts could spark something of a crisis for the Treasury, because the Bank's purchases have almost exactly matched the volume of gilts being sold by the Treasury (though to be clear, the Bank buys in the market, not directly from the government).
Will conventional bond investors take up the slack after the Bank of England withdraws from the market? What will happen to the price of gilts and the interest rate paid by the Treasury in those circumstances?
It's an alarming prospect.
Except that all else isn't equal. Goodhart points out (as too has Stephanie Flanders in her blog) that - as luck would have it - big banks are about to be forced by the Financial Services Authority to make substantial purchases of gilts, to rebuild their liquid resources and make them less vulnerable to the kind of cash crises they suffered last autumn.
"Commercial banks have built up huge unused reserves at the Bank of England. It hardly takes a genius to recognise that three requirements can be simultaneously realised:
1) fund the public-sector deficit in 2010-11;
2) return the Bank of England's swollen balance sheet to normality;
3) rebuild the liquid assets ratio of UK banks."
Or to put it another way, commercial banks - the likes of Royal Bank of Scotland and Barclays - will be the big buyers of gilts after the Bank of England becomes a net seller.
Or will they?
I am not so sure. Because the Financial Services Authority has told me that - although it is obliging banks to increase their holdings of top quality government bonds as a bulwark against unexpected swings in funding needs - it recognises the dangers in forcing banks to buy vast numbers of gilts too quickly.
Here's the thing: by all historical standards, the price of gilts remains very high; so it would be madness to force British banks to buy tens of billions of pounds of UK government debt at the top of the market, because that would make the banks vulnerable to capital-eroding losses as and when the price of gilts returns to more normal levels.
In other words, the supposed happy coincidence between the government's funding needs and prudential regulation of commercial banks is not quite what it seems. If the Financial Services Authority had its way, it might actually be deterring banks from buying gilts at the moment of the Treasury's greatest need, because this would be when gilts were most over-priced.
That said, even if the banks were to devour gilts to the tune of tens of billions of pounds, that would not restore the health of the public finances, as Goodhart concedes.
He says: "immediately after the general election, whoever wins must execute a credible plan to restore the UK's fiscal position to a sustainable level".
Which is becoming a boringly familiar refrain.