Broken Models

Thoughts on whether UK debt is sustainable, why the IMF is right on European welfare, are we approaching peak China, how graft shaped Ukraine and Georgia, and celebrating two media survivors

Photo by R Onita on Unsplash

Here is this week’s newsletter. A warm welcome to new subscribers. Thanks as always to the generous paid subscribers whose support makes this worthwhile. Obviously these posts do take a lot of work so if you enjoy them and find them useful, please do consider becoming a paid subscriber too. At the very least, forward it to anyone you think might be interested. I look forward as always to your comments and feedback. And please do email me if you have questions or ideas for future posts.

• UK Politics: Not Sustainable

• European Debt: Unaffordable model

• Peak China? Bitter Anger

• Ukraine and Georgia: Eastern Approaches

• 25th Anniversaries: Media Survivors

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1. Not Sustainable

Last week I was rather smugly congratulating myself on having correctly predicted the fall in gilt yields since the summer as investors became increasingly confident that the UK government would raise enough tax to meet its fiscal rules (see Gilt Trip). The fact that chancellor Rachel Reeves appeared to have all but confirmed that the budget would include a manifesto-breaking rise in income tax was a double positive for UK government bonds: not only would it reduce demand in the economy, potentially paving the way for further interest rate cuts; the reassuring signal that it would send to the bond markets might help reduce the one percentage point risk premium currently baked into gilt yields.

Evidently, I spoke too soon. For sheer political ineptitude, it is hard to recall a worse week for a UK government in recent times. It began with Sir Keir Starmer’s advisers launching a bizarre attack on Wes Streeting, accusing one of the cabinet’s most effective performers of planning a leadership challenge, thus highlighting the prime minister’s unpopularity and vulnerability. It ended with Reeves abandoning the income tax rise for which she had spent the past fortnight rolling the pitch. As Fraser Nelson noted in The Times, Reeves has become the first chancellor whose budget has unravelled before she had even delivered it.

It is hardly any wonder that gilt yields rose sharply in response to this debacle. If I had been wrong-footed by the government’s U-turn, so too had many others. Over the past week, I have read any number of notes by City economists forecasting lower gilt yields on the assumption of a rise in income taxes. Many investors will have traded on the advice. What are they supposed to think now?

The Treasury belatedly let it be known on Friday that the tax rise was no longer needed because the fiscal forecasts had improved. That had some economists scratching their heads wondering what new information the Office for Budget Responsibility could have received that could have so dramatically and unexpectedly changed the outlook. After all, higher than expected wage growth and lower bond yields, which could have driven higher tax revenues and lower interest costs were hardly a surprise. Meanwhile old Treasury hands said that it was highly unusual for a chancellor to abandon what was to have been the centrepiece of a budget so close to the delivery date.

Inevitably, the suspicion is that Reeves buckled because of opposition from Labour MPs to breaking a manifesto pledge. I was struck that earlier in the week, the FT had reported that Kitty Ussher, a former Labour minister now working for Barclays, had gone into Downing Street to brief political advisers that the markets craved political stability and that investors were nervous about the parliamentary Labour party. They will be even more nervous now.

Of course, it is still possible for Reeves to meet her fiscal rulers using other tax-raising measures from a “smorgasbord” of other options - and I would expect her to do so. The problem is that trying to heap the burden of what many expect still to be a £20 billion fiscal consolidation on smaller targeted groups of taxpayers inevitably carries significant political risks, as the government knows to its cost from its past attempts to balance the books on the backs of farmers and pensioners. Such taxes also carry economic risks because they are likely to have an impact on both supply and demand, potentially pushing up inflation and making it harder for the Bank of England to cut interest rates.

All this means that gilts could be in for a bumpy ride over the coming weeks as investors wait to see how the budget lands. The question is whether a bad budget reaction fuels wider questions about the UK’s debt sustainability.

At an excellent event last week organised by the National Institute for Economic and Social Research (NIESR), all three panellists - Sir Charlie Bean, former board member at the Office for Budget Responsibility, Martin Ellison, professor of economics at Oxford University and Jack Meaning, UK chief economist at Barclays - were sanguine about the near-term outlook for UK debt. The current debt-to-GDP ratio of 97 percent is not out of line with other advanced economies and is more or less in line with its long-term average over the last 300 years. Gilt auctions in recent years have seen stronger than usual demand, being three times covered compared to a historic average of two times.

On the other hand, the panellists also pointed to a number of vulnerabilities in the UK debt profile. The first is that Britain is an outlier internationally in terms of the medium term outlook for interest rates being higher than the outlook for growth (in economic terms, “r>g”). That means that it will need a larger fiscal consolidation than most - somewhere in the region of 2-3 percentage points of GDP - simply to stabilise the debt. The second is that achieving fiscal consolidations by running budget surpluses is hard. The UK has achieved a budget surplus only five times since 1990, the last time being in 2001. The third vulnerability is that unlike some other heavily indebted countries such as Japan and Italy, Britain cannot rely on domestic investors to buy its debt. Foreign investors currently account for 30 percent of demand for gilts.

All of this means that the credibility of the UK fiscal rules are key to maintaining investor confidence - a point that was clearly demonstrated during the Liz Truss debacle. Starmer and Reeves clearly understand this, which is why the bond market started to sell off when the chancellor’s tears in the House of Commons earlier this year raised fears that she was about to be sacked or resign.

Whether the mistakes and misjudgments of the past 16 months have done such damage to their reputations that they no longer have the political authority to deliver on the difficult decisions needed to boost growth and cut debt we will find out soon enough. If they are unable to reconcile the competing expectations of the bond markets, the general public and Labour party members they can expect a challenge. Of course, in a tussle between the bond markets and the Labour party there is no doubt who will be the eventual winner. Either way, that risk premium on gilts may be with us for a bit longer yet.

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2. Unaffordable Model

The UK is hardly alone in facing long-term fiscal pressures. In my latest column for Euractiv, I highlighted a recent report by the International Monetary Fund that warned that European countries will need to reconsider aspects of the “European model” when it comes to generous welfare systems if they are to put their debts on a long-term sustainable footing:

The warning was contained in a report titled How can Europe Pay for Things It Cannot Afford? In it, the IMF noted that, faced with pressures to spend more on defence, health, pensions and climate, the debt-to-GDP ratio for the average European country is on course to more than double to 155% on a GDP-weighted basis. This could climb to an eye-watering 190% if rising debt leads to slower growth and higher interest rates. That is clearly unsustainable.

According to the IMF, even if European countries were to implement all the reforms recommended by Mario Draghi to improve the competitiveness of the European Union’s single market as well as ambitious reforms at national level to improve their own growth prospects, the average European country’s debt would fall to only 105 percent of GDP by 2040. That is still well above what the IMF considers to be a safe “reference level” of 90 percent of GDP - a level low enough to allow some degree of a buffer against future shocks.

That would still leave a quarter of European countries needing to find tax hikes and spending cuts of more than 1% of GDP for five years to lower debt to the reference level. To put that in perspective, over the last 30 years, few countries have been able to sustain such an adjustment for more than four years.

The IMF’s grim prognosis tallies with what other forecasters are saying:

Goldman Sachs, for example, reckons that France will need to reduce its primary deficit before interest payments from 4% of GDP to zero simply to stabilise its debt (which currently stands at 113% of GDP). Nor can European countries count on German government spending to lift their economies out of their debt trap. Indeed, Berlin’s borrowing binge will barely lift its own economy out of the doldrums. Morgan Stanley reckons that even when the full impact is felt next year, German growth will struggle to rise above 1%.

Of course, there is a big difference between the UK and other European countries when it comes to facing these fiscal pressures. Ironically, Britain finds itself in a similar position to the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) during the eurozone debt crisis who came under intense bond market pressure and were forced to undertake far-reaching reforms in response. Meanwhile, thanks to changes in eurozone governance and the creation of new European Central Bank tools to stabilise markets, highly indebted eurozone countries today such as Italy and France find themselves largely shielded from market pressure.

In the near-term, that may make the UK more vulnerable to a bond market crisis - but also makes it more likely that it will ultimately undertake the kind of reforms that have made the former eurozone crisis countries among the continent’s top economic performers today. The danger is that eurozone countries, in being spared such external pressure, delay the necessary reforms until it is too late, setting the stage for a far more cataclysmic crisis when it comes.

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3. Peak China

In last week’s newsletter I speculated as to whether we had passed Peak Trump. Since then, there have been other signs to support this thesis. Last week, for example, the president eliminated tariffs on various agricultural items including coffee and bananas in an attempt to address the public discontent at the rising cost of living that led to sweeping Democratic party wins in recent elections. Remember when the administration used to insist that tariffs didn’t raise prices? Then there are the growing splits in the MAGA moment, not least over the Epstein files. Andrew Sullivan had a good read on this in his latest Weekly Dish.

Nonetheless, in the interests of impartiality, a hot topic in Britain this past week, I feel obliged to ask whether we may also be approaching Peak China? It’s not just that an economic data dump by the Chinese government showed that the economy is slowing. As GaveKal noted:

Property sales were down more than 20% year-on-year, investment was weaker, credit growth slowed and retail sales growth—except for gold and jewelry—remained lackluster. Notably, there was no sign at all in the data that the third quarter’s stimulus measures, which included new funding for infrastructure projects and additional subsidies for households, are having an effect.

Indeed, the January-to-October drop in fixed-asset investment marks the first time the country has seen a decline over the first 10 months of the year, stretching back to at least 1992, according to the Wall Street Journal. “While drawing historical comparisons is made difficult by methodological changes over the years, the only time fixed-asset investment declined on a year-to-date basis—aside from the past two months—was during the Covid pandemic in 2020.”

Of course, China is still forecast to grow at close to 5 percent this year. But what really caught my eye this week was an oped in the New York Times in which Beijing-based freelance writer Helen Gao talked of the growing despair of many in China about their dimming personal prospects and their belief that the policies have made China appear strong overseas are hurting them:

They see a government more concerned with building global influence and dominating export markets than in addressing the challenges of their households. A state crackdown launched several years ago on the private sector is widely blamed for undermining middle-class livelihoods, even as financial resources are channeled into industries that the government deems more strategically important, such as electric vehicles, solar power and shipbuilding. Meanwhile, the global chokehold China has secured on the supply and processing of rare earth elements has caused air and soil pollution at home.

Gao says there is “bitter anger” among people who consider themselves “the voiceless victims of the state’s obsession with world power and beating the United States”. That sentiment is likely to grow, not least because the latest five-year plan released last month makes clear it plans to double down on prioritizing national power over the common good:

Youth unemployment is so high that last year the government changed its calculation methodology in a way that produced a lower number. Even the new figure remains alarmingly high. An estimated 200 million people get by in precarious careers in a gig economy. Consumers, many of whom have seen their net worth shrink in an intractable housing market crash, are cutting back on spending, trapping the economy in a deflationary spiral.

A similar point was made by Bloomberg columnist Catherine Thorbecke, who noted a recent warning from a representative of DeepSeek, the Chinese AI leader, about the “dangerous” societal impacts of the technology:

Western tech leaders have long cautioned about a future AI jobpocalypse, mainly for entry-level, white-collar roles. But in China, a recent graduate labor crisis is already here. Tensions have been building for years, giving rise to trends like pretending to go to work or “professional children,” who stay at home rather than take a job they are overqualified for. A new shock could endanger the nation’s already fragile economic growth.

Of course, unlike Trump, Xi Jinping doesn’t have to worry about mid-term elections. Nonetheless, as Gao says:

China has long thrived under an unspoken social contract: The Communist Party granted the people more freedom to improve their livelihoods in return for political obedience. To many Chinese, the government is no longer holding up its end of the bargain.

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4. Eastern Approaches

By far the most dispiriting news of the last week was that of the massive corruption scandal unfolding in Ukraine. Tales of duffel bags filled with cash, apartments with golden toilets, audio recordings of officials discussing money laundering strategies and claims of kickbacks on construction projects designed to protect energy infrastructure will inevitably only amplify the voices of those opposed to supporting Ukraine and dampen the morale of its citizens as they face a winter of blackouts caused by Russia’s destruction of their energy infrastructure.

How far up the Ukrainian political system the corruption had spread we don’t yet know. So far, there have been no allegations against President Zelensky himself. But two ministers have been suspended and his former business associate, Tymur Mindich, fled to Israel after being tipped off that his apartment was about to be searched. Zelenksy appeared to try to block the investigations earlier this year by bringing the independent National Anti-Corruption Bureau of Ukraine (Nabu) and the anti-Corruption Prosecutor’s Office under political control before being forced to back down by popular protests and pressure from western allies.

Nonetheless, there is a positive side to this story, as Marc Campion noted in a Bloomberg column:

The true surprise should be that an alleged conspiracy to skim $100 million from the nation’s life and death efforts to keep lights and heat on has been exposed. Not just that, but that the exposure was official, made public after a 15-month investigation into operations at the state nuclear power company JSC Energoatom.

Indeed, this episode goes to the heart of why Ukrainians are fighting at all:

The war began in 2014, after then President Viktor Yanukovych was toppled by mass protests against the epic scale of his corruption and the captivity to Moscow this created. Graft was the glue with which the Kremlin had held its neighbor in check since the 1991 Soviet collapse, infiltrated its security services, manipulated its leaders and gutted its military…

Zelenskiy was unable to stop Nabu because the checks and balances of Ukrainian democracy don’t lie in its core institutions. They rest, instead, in the sure knowledge its leaders have — based on repeated experience — that if they try to steal an election, or roll back hard-won gains such as the creation of genuinely independent law enforcement, Ukrainians will take to the streets in their millions.

I think this is broadly right. Even so, it’s hard not to contrast what is unfolding in Ukraine with news emerging this month from another post-Soviet republic: Georgia, where prosecutors have charged eight of the country’s leading opposition figures, including a former president, Mikheil Saakashvili, with plotting to carry out a coup. A week earlier, the government had asked the country’s constitutional court to outlaw Georgia’s three largest opposition parties.

Georgia’s descent into pro-Kremlin authoritarianism is all the more dispriting when one considers that of all the post-Soviet states not yet in the European Union, it had once seemed by far the most pro-western and democratic. That was until Georgia Dream (GD), a party created by Bidzina Ivanishvili, a billionaire oligarch who made most of his fortune in Russia, began to push the country away from its path towards EU membership. The Economist explains what happened:

EU candidate status was supposed to offer Georgia an incentive to push ahead with democratic reforms. Instead it has had the opposite effect. Mr Ivanishvili sensed that his patronage network was at stake and panicked, analysts say. “He understood that if he passed all these reforms, de-oligarchisation, the rule of law and human rights, he would lose power,” says Kornely Kakachia, head of the Georgian Institute of Politics, a think-tank.

It is a reminder that the tentacles of corruption run deep throughout the post-Soviet space, particularly where extensive commercial links to Russia remain strong. Even in the midst of war, there is inevitably a Russian-link to the Ukraine scandal, with the money reported to have been laundered by a former Ukrainian MP who is now a Russian senator. Indeed, it is the same determination to preserve patronage networks that unites GD with populist governments across central Europe including in Hungary and Slovakia. As The Economist noted:

Critics have taken to calling GD a Russian proxy. That is misleading. For the party and its billionaire founder, doing business with Russia and China and abandoning integration with Europe are what it takes to safeguard their interests. “They’re not guided by any love of Russia,” says Mr Kakachia. “This is a strategy for regime survival.”

Ukraine has a chance in its response to this scandal to take a different path. Let’s hope that it does. But the experience of Georgia shows that it will not be easy.

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5. Media Survivors

As it happens, two publications that I was involved with in their early days celebrated their 25th anniversaries this month. Both MoneyWeek, the UK personal finance magazine, and breakingviews.com, the financial commentary and analysis service, were launched at the very height of the dotcom bubble at the end of 2000. I helped produce the dummy edition of MoneyWeek and subsequently wrote a column for it and occasionally edited it for several years before joining breakingviews.com, which was just starting to establish itself as a powerful voice in European and later global financial journalism.

It is wonderful to report that in a world that has seen so many media ventures struggle and fail, both publications continue to thrive, proof that sometimes the depths of a crisis need not be a bad time to start a business. MoneyWeek is now the UK’s best-selling personal finance magazine while breakingviews is now ReutersBreakingviews, a distinct and valued part of one of the world’s most respected media organisations. Along the way, both have adapted and evolved but what is striking is how much remains true to their original mission. I enjoyed working for both of them and am proud to have played a small part in their story.

My congratulations to the founders, Jolyon Connell of MoneyWeek and Hugo Dixon of breakingviews, for creating something of enduring value. And to former colleagues, many of whom still work at both titles. And if you would like to see Wealth of Nations become a thriving media enterprise in 25 years time, I do hope that you will consider becoming a paid subscriber or sponsor.