Bank of England Governor Andrew Bailey warned governments may be left helpless in the event of another downturn as their firepower is sapped by weak growth and a series of severe shocks.
Speaking on a day that bonds fell · again over concerns about energy prices and France’s budgetary pressures , Bailey said fiscal policy must look credible to the markets.
“Higher borrowing costs and weaker growth raise debt to GDP levels, and at the same time, calls for spending to increase are louder. And if markets doubt the fiscal path, yields rise further, which then feeds back.”
The governor said that while governments can usually borrow more to cushion a severe downturn — and then rebuild fiscal space when the economy improves — this is more difficult in a volatile economic backdrop.
“When shocks become more frequent, underlying growth is weaker, and the succession of shocks leads to a higher level of government debt, this becomes much harder to sustain,” Bailey said at an event in Turkey.
While the UK has not been as badly affected by jittery investors as some other European economies, it nonetheless faces a perilous fiscal situation ahead of the Labour government’s budget on Oct. 28.
New Prime Minister Andy Burnham is under pressure to provide support for households and businesses squeezed by the effects of conflict in the Middle East. However, soaring borrowing costs have eroded Chancellor of the Exchequer John Healey’s already limited fiscal wiggle room with gilt yields around their highest level in decades.
Bailey said fiscal policy must “be directed towards stability and be seen by markets as credible.”
While the UK has suffered from pedestrian growth rates since the financial crisis, Bailey sees artificial intelligence as a potential game-changer that is already helping to support the economy.
“An important part of the story so far is economic resilience in the sense that recent supply shocks have hit the world economy at the same time as the potential growth dividends from AI have become clearer,” he said. “Artificial intelligence and robotics can drive scientific discovery, improve efficiency and raise prosperity.”
However, he also sees risks from the technology, including the possibility of an AI bubble bursting if investor confidence in its adoption dwindles.
“The rapid expansion of financing connected with artificial intelligence has created new exposures, while incidents involving frontier AI have underlined the associated operational, cyber and financial risks,” Bailey said. “Existing vulnerabilities in sovereign debt markets, credit markets and asset valuations could crystallize together.”
- In his speech, Bailey also said second-round inflation effects caused by the energy shock are “currently quite subdued”
- However, he reiterated that “the longer the pattern of higher energy prices persists, the more difficult this situation becomes” Recent history of rapid price increases “make it more likely that the public will raise its expectations of future inflation”
- He said officials cannot ignore structural changes in government bond markets with hedge funds now playing a bigger role. “The risk is that we can face conditions where heavily leveraged positioning shifts rapidly to sudden deleveraging flows”
- He said the Middle Eastern conflict has not caused financial markets to be disorderly. He added there are “risks from large and concentrated positions” and policymakers should be prepared for “wider disruption”