• HM Treasury punted on inflation… and lost your money
  • The bond market that defeated the French is sinking the UK
  • The German word for “debt” is the same as the word for “guilt”

The UK government is set to become a world leader… in interest payments. This year, our Treasury is expected to pay more in interest than any other in the developed world, as a share of tax revenue.

This may surprise you. Aren’t the likes of Italy and Greece much deeper in the hole than us? Then how do we manage to spend more on interest?

The answer, of course, is Brexit.

Unless you actually take a closer look at the numbers. Then you’ll discover the real cause lies in a particularly peculiar UK government policy. A real ironic head-banger of a decision.

Before we get to that blunder, here are some more figures to grind your teeth over.

A full 10% of our taxes will go towards paying interest this year – about the size of the UK government’s education budget and double the defence budget, depending on how projections play out. It’s also about double the 2020 burden!

This increase probably doesn’t surprise you, given how much the government has borrowed since 2020, and how much interest rates have gone up recently.

But here’s the embarrassing bit: in the UK, the share of taxes going towards paying interest is surging even as it falls among other developed countries on average.

We are, in other words, not just leading the world, but leaving the peloton behind in the race to fiscal failure.

To discover what’s gone quite so wrong, you need to understand some basics about how government finances work…

Usually, governments borrow money by issuing bonds. Investors give money to the government and, in return, the government gives them a promise to repay the loan at some point in the future, plus semi-annual interest payments in the meantime.

What makes bonds interesting is that they can be bought and sold on a bond market, just like stocks on a stock market.

It may seem unusual to be able to buy and sell a loan to someone, but it’s a key part in the history of our nation.

Because investors were able to sell their bonds to another investor who wanted to collect the interest payment, they became far more popular as an investment. More people were willing to loan the government money once they realised that they could easily sell up if they needed the cash.

Some would say that the UK’s especially successful bond market made it possible to defeat its foreign enemies in wars over the last 300 years or so. The UK government was able to raise more cash, faster and cheaper, than others.

Back to the mechanics for a moment.

The interest payments on bonds are usually fixed, although there are all sorts of varieties these days. The benefit of fixed-interest payments is that the cost of the debt to the government becomes a lot more predictable over time.

If the Bank of England (BoE) were to go completely mad and hike interest rates 50-fold in the space of 18 months, just hypothetically speaking of course, then the interest payment on the government’s existing debt wouldn’t budge. The interest payments on the existing bonds would remain the same.

Which, of course, begs some interesting questions about what has been going on recently…

What if the government and the BoE were to conspire to try and reduce the government’s debt burden by letting inflation soar out of hand, subsequently necessitating higher interest rates?

Then the value of government bonds would plunge as the money that they are denominated in falls in value without investors being compensated for this with higher interest rates, because those rates on existing bonds are fixed.

Inflation, in other words, is a stealth tax. It transfers wealth from the saver and investor in bonds to the government.

That is why, on average, developed countries will see their interest burden fall, with the UK as an outlier. Inflation has boosted tax revenue while costing governments little in terms of paying more interest.

But this policy only works in the short term as a form of shock therapy, because the government must borrow any new money it raises at the higher interest rates. The cost of higher interest rates is, in other words, passed on to the government more slowly than the rest of us.

So how did the UK government manage to completely muck up its attempt to repair the budget with inflation, like other countries are doing successfully?

Well, back when inflation was too low, and even the money-printing post-2008 financial crisis couldn’t pick it up off the floor, our Treasury decided to take a massive punt on something called inflation-linked gilts.

Instead of borrowing money at fixed rates, like other governments tend to, thereby making their interest cost reasonably predictable and stable, even in the face of interest rate hikes, the UK government borrowed a lot of money on terms that promised to compensate investors for inflation.

Inflation-linked gilts are bonds that pay more money to investors if inflation goes up, and less if it goes down. The idea is to protect the investor from inflation.

Of course, before 2021, the government thought this was a wonderful deal given that inflation was dead and buried, with the BoE dancing YMCA on its grave. The interest cost on inflation-linked gilts would remain low as inflation did.

Unfortunately, inflation turned out to be undead, and it promptly popped out and bit the BoE on the leg. Now it has turned on the government’s budget too.

I won’t tell you just how far inflation surged, because the government’s statistics are a load of rubbish and you know better than anyone how much your particular cost of living has gone up.

The result of the inflation spike, in the UK bond market, has been a dangerously large surge in interest payments for inflation-linked gilts.

According to the Financial Times, about a quarter of UK government debt is inflation-linked in some way. Next highest is Italy at 12%, and the rest come in below 10%.

That’s what I mean when I say the UK government took a punt on inflation remaining subdued when it issued so many inflation-linked gilts.

Just how big of a punt has it turned out to be?

Well, in the six months to August 2022, inflation-linked gilts accounted for 60% of the UK government’s interest expense while only making up 25% of issued bonds. And, as inflation has soared since then, things have only got much worse.

If you ask me, the decision to pivot borrowing to inflation-linked gilts is on par with selling the UK’s gold at the legendary “Brown Bottom” in the gold price. It’s a monumental mistake that has denied the UK government the ability to inflate away its debt like other countries have done.

Despite knowing of the sensitivity of the UK budget to inflation, we seem to have pursued the policy of allowing inflation to “accidentally” get out of hand anyway…

It’s a real blunder by those who could and should’ve known better.

In German, and supposedly other languages, the word for “debt” is the same as the word for “guilt”. In the UK, our bonds are called “gilts”, although the connection is supposedly a coincidence.

I would like to propose renaming inflation-linked gilts to “guilts” in honour of the combined nincompoopery of the Treasury and BoE. Only together could they have pulled this one off.

Until next time,


Nick Hubble
Editor, Fortune & Freedom