Like the US the UK is facing low interest rates, despite having a high budget deficit and public debt. Why is this?

The UK Government issues its debt in the form of Guilts, currently the interest rate the government has to pay on a year guilt is 0.32%. This is lower even than the base rate, surely investors would be better off just putting their money in a bank account? Well to start with large financial institutions and investors can’t simply put all their money in a bank account, if the bank collapses they will loose all their money (and the government only insures £85,000).

But why is the interest rate still so low despite the Governments large debts and deficit? The coalition government claims that if it were to detract from its austerity plans that the markets would loose faith and the government would have to pay much higher rates. But is unlikely this would really happen. Currently the government is behind its deficit reduction schedule and it hasn’t seen any dramatic increases in the rate it pays. Surely the markets would be more scared and hence charge a higher rate if they believed the economy would be lacklustre in the future. And with the austerity program at the moment, things don’t look rosy for the UK economy!

It is more likely that the Guilt rates are so low because the rate reflects risk. It reflects the risk of the government defaulting (refusing to pay) on its bonds. Like with the US, this is highly unlikely to happen in the UK for the sole reason that we have our own central bank which can print its own money (unlike eurozone countries who aren’t able to print more euros to finance their debt). This means we would never default on our debt, if worst came to worst we would simply print our way out of our debt (if you’re thinking why aren’t we doing this now then, look at Hyperinflation in Germany during the 1920s and in Hungary during the 1950s!). Therefore the Guilts are relatively risk free (although if we did finance by printing more money the interest rate would fall as there would be more supply and hence foreign investors would receive less money than they invested). This is reflected by the low rates.

Also the Quantitative Easing policies being administered by the Bank of England are reducing the rates. The BoE is buying government bonds off of investors who would then go out and buy more bonds (as well as other assets) there would therefore be an increase in demand for Guilts (and other assets) which would lead to an increase in the price of the Guilt, this in turn would lead to a lower interest rate (if this is confusing see this lesson). Therefore the BoE is also responsible for the UK Government having low interest rates.