Astonishingly low interest rates on UK government debt: causes and effects

We all know that the UK government has run up a colossal national debt - £1475bn as I type this sentence. And it’s rising fast, since the UK government also has a fiscal deficit to finance this year, which will add even more to the total stock of debt.Yet the cost of borrowing all this money is falling to new record lows. Why? And should this influence the government’s economic policy in any way?

The key to borrowing from the bond market at low rates of interest is to sell bonds at a high price (this forces down the yield, which I explain here). I’ve just been writing about Russian government debt, with the news that Russia’s government bonds are rated as ‘junk’. This pushes down the price of their bonds down, which forces up the cost of borrowing (the yield).

The UK government is in the opposite corner. According to Robert Peston from the BBC, there are two big immediate causes of the rising price of UK government bonds, meaning that it is cheaper than it has ever been for the Treasury to borrow for maturities of ten years and thirty years.

• First, inflation in the UK, driven mainly but not totally by falling oil prices, is heading towards zero in April and may turn negative or into deflation thereafter. Inflation being so far below the 2% official target means the Bank of England has been signalling a delay in the fateful day when it will raise the interest rate it controls - probably till well into next year
• Second, has been the announcement by the European Central Bank that it plans to buy more than a billion euros of eurozone governments' and private sector bonds, in a big programme of quantitative easing. This has driven up the price of German bonds to record prices, which in turn makes UK government debt seem better value to investors.

So bond prices are mainly driven up by the slow pace of economic activity, and the limited opportunities for good returns on money elsewhere in the economy. A further underlying cause of the record high price of the official debt of mature western economies is widespread pessimism that economic growth will be subdued for years and maybe decades - since that encourages investors to make low-risk investment in supposedly high quality sovereign debt.

Peston goes on to say that at times like these there are plenty of economists who argue that the government should take advantage of these record low rates to borrow even more, to finance big infrastructure and investment projects. In the Keynesian tradition, if a British or German government borrowed more to build new high speed train lines, roads and schools then the underlying growth rate of the European economy would pick up.

But those with a supply side perspective might say that with UK government debt so high and still rising, it is more sensible to reduce the deficit as fast as possible - just in case interest rates don't remain at these record low levels. Reducing government spending to pay for tax cuts is the best route to restore long run growth and competitiveness.

Economists like Jeff Sachs take a third view, which would see government setting an investment agenda for both the public and private sectors, thinking carefully about the type and purpose of those investments.