In the weeks surrounding the UK budget you will hear a great deal about the link between the UK budget deficit and interest rates on UK government debt. [1] Most discussion will be predicated on a simple idea: the way to get interest rates on government debt down is to run smaller budget deficits. There is a bit of truth in this, but not for the reason that many journalists suggest. This post is about this relationship. The first and most important point to note is that the continuing increase in interest rates on government debt is a global phenomenon. That means that the impact any UK specific action on longer term UK interest rates will be small relative to recent increases. I discussed possible reasons for this global trend in this recent post, although as Chris Giles notes the range of explanations indicates how little we really know. One possible influence is the AI boom. Another is inflationary pressure caused by the US attack on Iran, coupled with belief that this will keep short term interest rates set by central banks higher. Another factor may be a global abundance of safe assets (i.e. government debt). While there appeared to be a shortage of such assets before the Global Financial Crisis, the aftermath of that crisis, the pandemic and large US deficits may have reversed this. However any impact a smaller UK budget deficit would have on this global phenomenon would be negligible, and (unlike the US and others) the UK budget deficit is forecast to fall to sustainable levels, so this is not a reason why small UK budget deficits would reduce longer term UK interest rates. . Although longer term interest rates are higher in all G7 economies, the UK has the highest, and this has been true for some time. It is important to emphasise that this is not because investors think the UK government is more likely to default than other countries (see Eric Lonergan here). Countries that create their own currency cannot be forced to default, and the UK government will never choose to default. Default only becomes an issue for governments that don’t issue their own currency, or who borrow in another currency. Eurozone countries are the most important of these, and for them the behavior of the European Central Bank (ECB) becomes critical. The ECB both created the Eurozone crisis and solved it in the early 2010s. The ECBk probably wants to let rising rates act as a warning to individual Eurozone countries to avoid unsustainable deficits, as in France at the moment, but not let them rise so much that it causes a fiscal crisis. This is a hard act to pull off because the ECB has little control over politics in France. As Paul Krugman notes, a lack of economic realism on both the political right and left over fiscal policy leads to political paralysis and unrest as well as rising longer term interest rates.. The most plausible and commonly cited explanation for why UK longer term interest rates are the highest in the G7 is that markets expect inflation to be most persistent here, which in turn means they expect short term interest rates set by the Bank of England to be higher for longer than in other G7 countries. Longer term interest rates are closely related to current and expected future short term interest rates through arbitrage. This is where the size of the deficit can matter, but only if changes in the deficit reflect policy changes that impact current or near future aggregate demand in the economy. If the current or near future deficit increases as a result of a Budget because the government is spending more on domestic goods or labour, that adds to inflationary pressure, meaning the Bank is more likely to keep short term interest rates high. If the deficit falls because it is taxing more from people who will respond to higher taxes by reducing spending rather than savings, the opposite is true. But if budget deficits rise because the economy is weaker, that indicates a reduction in aggregate demand and therefore lower short term interest rates, so longer term rates are more likely to fall rather than rise. This potential duality between financial variables like budget deficits and real concepts like aggregate demand in the economy is the source of so much confusion in policy debates. Sensible fiscal rules in advanced economies with their own currency are essentially a device to stop governments succumbing to the temptation to inflate aggregate demand by cutting taxes or increasing their spending. This temptation is generally increased when there is an independent central bank setting interest rates to control inflation, because the government that does succumb to this temptation will not suffer higher inflation as a result. True the government’s actions will lead to higher interest rates, but roughly as many voters gain from higher rates as lose. However a sensible fiscal rule has to recognise that the relationship between deficits and aggregate demand is far from precise, and in particular why it is folly to try and raise taxes or cut spending when the deficit is rising because the economy is weak. [2] The relationship between government budget deficits and longer term interest rates (including the interest rate on government debt) is all about inflationary pressure, and is not about market worries that the government might default. All the language beloved by journalists about ‘market jitters’, ‘government credibility’ and similar phrases obscures this basic fact. Just as primitive man didn’t have science and so explained changes in the weather as the actions of gods, so many journalists without economic training treat financial markets as an unpredictable and vengeful god and City economists as high priests. If the Chancellot did reduce the deficit by raising taxes or cutting spending (going beyond what is necessary to meet fiscal rules, as Martin Wolf suggests here) this probably would reduce UK inflationary pressure, whic...