Question:

You propose much more aggressive cuts to public spending, in order to cut the deficit and allow tax-cuts. But our public-sector debt has been much higher than the projected levels in the past without causing big problems. Why are you proposing to cut so aggressively when it is not necessary?

Answer:

I've done a lot of digging into what conditions in the past really caused problems. The broad conclusion is that the deficit is the immediate problem, but that the effect that the deficit will have on interest rates will be magnified by the level of the debt on which we have to pay interest. The attached graph shows the relationship. It turns out that, if you add the rate of inflation to the level of the deficit as a proportion of GDP, you get a very good indicator of interest rates (until inflation gets out of hand).

I have included in the graph the government's projections for borrowing and inflation for this and next year. Even on that optimistic basis, the upwards pressure on yields/rates will be massive, if the relationship continues. There has never been a time since the war when the combination of inflation and deficit was at that level and rates were below 10%.

Quantitative Easing (QE) is no more than a short-term get-out, with a high price to pay in the medium-term. It may suppress yields in the short-term, but by raising inflation expectations it increases the upwards pressure that will take effect as soon as they stop QE. That means either continuing QE and hyper-inflation, or an inevitable step-up in yields and rates pretty soon, unless we dramatically cut the deficit to reduce the combined upwards pressure.

QED. The least bad option is to cut the deficit immediately to a level where rates should not be under pressure to go above (say) 7% (this is for medium-length or undated gilts, so you can subtract at least a couple of percent for the short rate and therefore the base rate). Given inflation of around 2%, that means a deficit of around 5% of GDP, or around £70bn. That is roughly where we managed to get it down to in the suggested budget, with savage (and politically unpalatable) cuts.

The more modest proposed cuts of the mainstream parties should see either 10-year rates being pushed up beyond 8%, which should result in large numbers of people pushed out of their homes and businesses going bust, or more reliance on QE and a delay and exacerbation of the problem. My bet is that they'll try to see if the market will absorb the debt at low rates, and when it looks like it won't, they'll start another round of QE. But another round of QE will push up market lending rates even if it holds down government borrowing rates for a while, and the economy will start to pay a gradually heavier price that counteracts the effect of QE.

Interestingly, a friend is finding that there are very few lenders willing even to offer a 5-year fixed-rate deal, and rates seem to have gone up significantly in the last couple of weeks.