Lets start the clean up now

FTAlphaville has just reported that the 10 year UK government bond yield has hit four percent, giving a spread over BoE's bank rate of an unprecented 350 basis points. As the chart above clearly illustrates, before the crisis the spread was negative and comparatively small. Something is going badly wrong in the UK government debt market.

With its massive borrowing requirement, Brown and Darling are trying to issue historically unprecedented quantities of new debt. So lets go back to basics and remind ourselves about supply and demand in the debt market.

An increase in the supply of bonds will pull down prices, and push up yields. For those unsure about the relationship between bond prices and yields, take it on trust that there is an inverse relationship between the two. With government debt issuance starting to accelerate, it is as inevitable as night follows day that yields will start to increase.

The Bank of England thinks it has a solution to this problem of rising bond yields. It will print cash and buy up government debt. In effect, the bank is trying to increase demand in the hope of pushing bond prices up and pulling yields down. In short, the BoE thinks it can manipulate demand.

However, it is a solution that can only work if you assume that private sector holders of government debt are brain dead and unable to calculate the long-term consequences of unrestricted cash creation and uncontrolled government borrowing. Inflation is always the inevitable result of this reckless expansion of monetary and fiscal policy. And since inflation destroys the real value of government debt, investors need to be compensated with an inflation-adjusted yield, which is why long-term interest rates are beginning to rise alarmingly.

The Bank of England could just keep on buying the debt to try to put a c eiling on yields. After all, it has an unlimited capacity to create cash. However, it doesn't take a lot of imagination to see how this strategy could quickly spin out of control. Faster monetary growth means of course higher inflation. Investors would quickly realize that UK government debt is too dangerous in terms of inflation risk and start to dump their UK bonds. It is not inconceivable that there could be a run on UK government debt. It has happened before, most recently in the mid-19 70s.

The Bank of England also has an answer to this potentially horrific scenario. It defends its current strategy by pointing to the threat of deflation. The truth, however, is that the UK economy never came near the deflationary trap. The CPI inflation rate is well above target and if fuel prices are excluded, then the adjusted CPI is well above three percent. Moreover, there are signs that this unparalleled surge of cash creation and the gigantic fiscal deficit has begun to feed through into output. There are some signs that growth may resume in the third quarter. If this does prove to be the case, then the danger of a sudden inflationary spiral would be both extremely serious and immediate.

So what is the alternative? The Bank of England must discontinue printing cash immediately. At the same time, it should hoist the bank rate by 300 basis points, allowing it to reconnect with interest rates in the rest of the economy. This will have the practical implication of restoring a degree of interest-rate control to the monetary policy committee. These two policy changes would almost certainly see bond yields rise sharply. The government would have to announce an emergency budget which would announce a credible fiscal consolidation strategy. There would be a need for some immediate budget cuts, tax rates would have to increase, particularly VAT.

In terms of the real economy, output would contract. In the short run, unemployment would continue to rise. However, the economy would benefit enormously over the medium term by having in place a prudent and sustainable monetary and fiscal framework.

The question confronting the UK economy today is not inflation versus deflation, but a mild recession today versus a catastrophic depression in the future. Consider the consequences of continuing with the present strategy. If bond yields continue to rise, all interest-rates will be also pulled up, thus creating the conditions for a prolonged recession. Sooner or later, UK policy makers will have to tackle this ever more chaotic macroeconomic mess. I say lets not hang around for another financial crisis. Let's start the clean up now.