Expert comment
jon.wallace
The UK’s mix of high fiscal deficits, rising bond yields, anaemic growth, high taxes and an impatient electorate can only be solved with politically brave choices.
All major advanced economies have seen rising long-term bond yields over the past year. But with the ten-year gilt yield at 5.2 per cent on 9 Sept 2026, the UK’s long-term rates are the highest in the G7. US ten-year yields are 4.8 per cent, Germany’s are 3.4 per cent and Japan’s 2.9 per cent.
Reasons for the UK’s relative weakness
The UK’s relatively high long-term interest rate reflects in part its lack of other economies’ advantages. Sterling does not enjoy the US dollar’s global reserve asset role. Gilts do not benefit from the strong home country preference of Japanese investors. And the UK does not have the financial and economic backstop embodied in EU membership.
But the main factor is most likely to be the UK’s relative economic weakness, leading to higher expected inflation and/or a higher real interest rate risk premium. Financial markets look at the UK and see a country boxed in with structurally low growth, mounting social and defence spending needs, and a tax take which is already at historically high levels. They believe this, combined with fraught domestic politics, makes the UK government more likely than others to try and escape its predicament by borrowing more to boost spending.
The problem is not just the prospect of additional borrowing. It’s the fact that it would take place at a time when the UK’s debt/GDP ratio is already at an historically high level of over 100 per cent of GDP.
This risks a negative feedback loop whereby increased market concern over debt sustainability leads to higher interest rates and debt servicing costs. That forces the government to raise taxes or make spending cuts, potentially weakening growth and further worsening debt sustainability.
Rising interest rate costs, along with slower growth caused by the Iran war, are expected to cut the UK government’s headroom under its fiscal rules from £24 billion in March to around half that this autumn.
A further problem is that much of the additional spending proposed by the government and opposition parties – whether on defence, social benefits, or personal tax cuts – would do little to address the UK’s long-term structural growth weakness, and particularly its low productivity growth. Total factor productivity declined between 2019 and 2024.
Several factors have brought the UK to this point. Some, such as the COVID pandemic and an aging population, were or are outside government control. But many have been self-inflicted. That includes the 2008-9 global financial crisis; the austerity measures that followed it; Brexit (which has cumulatively cost the economy between 6 and 8 per cent of GDP); the Truss’s government’s brief but dramatic divergence from fiscal responsibility; and the current Labour government’s inability to convince its backbenchers of the need to control social spending.
The 2022-3 inflation shock initially helped ease the UK fiscal burden, as nominal GDP accelerated faster than nominal debt. But it is also now one of the factors reducing bond investor trust in the authorities.
Policy options
Government and opposition parties argue, correctly, that the UK’s only escape from the current pernicious debt and interest rate dynamic lies in raising long-term economic growth. Higher growth will generate higher tax revenues which can be used to service and pay down debt. They also argue that this must be achieved while meeting the current fiscal rules. One opposition party has even called for tighter fiscal rules. But there is little consensus on the best approach.
The Labour government under Prime Minister Andy Burnham has emphasized direct action to reduce the general cost of living through such measures as eliminating VAT on domestic electricity bills and capping bus fares. The resulting slight increase in disposable income may support spending in the short-term. But the policy is unlikely to do much to support growth over the long-term. Indeed, the desire to limit price rises may inhibit future investment and distort price signals. Targeting financial support on the most vulnerable groups would better safeguard government finances.
More broadly, the government should rely on the Bank of England to control increases in the cost of living in line with its CPI inflation target. If it doubts the Bank’s ability to do so, it should review the effectiveness of the Bernanke reforms implemented after the post-COVID inflation shock.
The government is on much stronger ground in its efforts to maintain and expand public investment in infrastructure, housing and advanced technology industries. Research by the OBR suggests that a sustained increase in public investment of 1 per cent of GDP will increase GDP by 2.4 per cent over the long-term.
By targeting areas that the private sector is unable or unwilling to address (because private returns are too low) the government will crowd in private investment.
According to one analysis, public financial institutions could invest an additional £16 billion in public infrastructure over the next five years, while remaining within the fiscal rules – which allow such financial assets to be offset against debt.
Other government policies, such as regional devolution of some taxes and spending, or taking control of railways and failed utilities, could support the increased scale and effectiveness of infrastructure investment.
But it is critical that oversight systems are well designed and costs are minimized. The government must avoid mistakes like the escalation in cost of the HS2 highspeed railway, which now looks set to cost £100 billion for just 140 miles of track.
The government has pushed for deregulation in the financial services sector. And until recently, it wavered on robust implementation of the Digital Markets, Competition and Consumers Act (DMCCA) in the hope of attracting big tech investment. However, predictable, efficient and robust regulation is the soundest strategy for promoting long-term growth. Maintaining competition is the most effective way to promote innovation. Safeguarding the economy against systemic shocks – whether in the financial or digital sphere – is vital for resilience.
Some opposition parties have called for the abolition of the UK’s world-leading climate legislation, on the grounds that it is too costly. But that would be an enormous setback for the UK economy – potentially even approaching the scale of Brexit. Apart from undermining global efforts to limit escalating climate-related costs, it would greatly weaken the UK economy’s preparations to compete in the inevitable future net zero world.
Opposition parties have also promised dramatic cuts of up to £50 billion per year in spending on working age social benefits to fund tax cuts and/or improve debt dynamics. But this would immediately cut demand in the economy.
Meanwhile no major party has committed to address the escalating expense of the pensions ‘triple lock’, which is not means tested. Of the £145 billion currently spent per year on pensions, some £17 billion is due to the way the triple lock has increased payments faster than inflation since 2010.
The need for brave choices
Overall, boosting public investment is the one policy that is clearly on the right track to raise growth. But it is far from clear that this alone will be enough to enable the UK to escape its current debt dynamics.
Other policies also offer substantial growth, such as relaxing controls on immigration and joining the EU’s single market. But both currently appear politically unacceptable. Until the UK’s leaders are prepared to argue for such measures, and to confront issues like the triple lock head on, the negative feedback loop will be hard to escape.