Senior central bankers warn that while emergency interventions can buy time during market liquidity crises, long-term financial stability ultimately depends on governments taking decisive political action, says Helen Thomas
Two of the world’s most senior central bankers have issued a warning that politicians would do well to heed: governments may believe they have years to repair their finances but bond markets can decide otherwise in an afternoon. Last week, Pablo Hernández de Cos, General Manager of the Bank for International Settlements, warned that government bond liquidity can dry up suddenly, shrinking fiscal space “well before any limit implied by long-run fundamentals is reached”.
Three days later, Bank of England governor Andrew Bailey reinforced the message. He warned that higher public debt and a changing investor base have made sovereign bond markets increasingly vulnerable to sudden reversals.
The danger is not necessarily that governments cannot repay their debts, but that investors demand a sharply higher return to finance them, undermining the government’s fiscal plans. Rising debt-servicing costs then absorb more government revenue, leaving less available for public services or responding to future shocks. If investors rush to sell and market-makers cannot absorb the supply, yields can rise far beyond what underlying fundamentals justify. Fiscal sustainability is therefore not simply an exercise in projecting debt-to-GDP ratios decades into the future. It also depends on the willingness of financial markets to fund governments in the meantime.
This is uncomfortable for politicians accustomed to treating the public finances as an accounting exercise. Fiscal rules can be adjusted, growth forecasts revised and spending commitments postponed. The mathematics might satisfy the Treasury, but it cannot guarantee the confidence of those expected to fund the borrowing.
Across the developed world, governments face mounting demands for defence spending, ageing populations and economic investment, just as successive inflationary shocks have complicated the task of managing their debt. Britain must reconcile its spending promises with fiscal credibility; France faces political instability alongside deteriorating public finances; and even America’s reserve-currency privilege cannot indefinitely insulate Washington from the cost of borrowing.
Politics collides with reality
These different political circumstances are colliding with the same financial reality: governments need investors to absorb enormous debt issuance, just as the nature of those investors is changing.
This was the second important element of Bailey’s warning. Sovereign bond markets increasingly depend on leveraged investors, whose willingness to participate depends on funding costs, volatility and their capacity to maintain positions. They provide valuable liquidity in normal conditions, but margin calls and forced selling can magnify market moves. Investors willing to finance borrowing yesterday can become sellers tomorrow.
The UK discovered the consequences during the 2022 gilt crisis, when leveraged pension fund strategies were forced to sell assets into a falling market. The Bank of England intervened as a market-maker of last resort, temporarily purchasing government bonds to prevent disorderly trading from developing into a wider financial crisis.
Four years later, the episode is still largely remembered as the downfall of Liz Truss. Yet focusing on the Prime Minister risks missing its more instructive lesson. The potentially most expensive measure, the original two-year Energy Price Guarantee, had been announced before Kwarteng’s mini-Budget. The crisis was not simply about the size of the fiscal commitments, but about their credibility, financing and the vulnerabilities of the gilt market.
More importantly, the political response was remarkably swift. Tax measures were progressively reversed, the Chancellor replaced and, within weeks, the Prime Minister had resigned. The Bank’s intervention remained temporary, ending its emergency purchases on 14 October as intended. It had bought time for pension funds to reduce leverage while the political system began correcting the fiscal course.
This was a market-functioning rescue, not an open-ended commitment to finance government borrowing. It worked because the Bank addressed a technical breakdown while the political system was moving to restore fiscal credibility.
That distinction goes to the heart of the dilemma now confronting central banks.
If yields rise because investors have lost confidence in fiscal sustainability, that is the market performing its disciplinary function. If they spiral because leveraged investors are forced to liquidate into an illiquid market, emergency intervention may be justified. Unfortunately, both processes can occur simultaneously.
Hernández de Cos warned that even well-designed interventions can be interpreted as serving fiscal objectives when public borrowing requirements are high. What happens if politicians refuse to recognise that their policies are contributing to the instability? Central banks can provide liquidity, but they can’t indefinitely suppress the cost of unsustainable borrowing without compromising their credibility and potentially their inflation objectives.
There is another instructive example of the relationship between political decisions and market discipline.
In July 2015, Greek Prime Minister Alexis Tsipras called a referendum on the terms demanded by international creditors. Having campaigned against austerity, he secured a decisive rejection of the proposals. Yet within days, confronted by a collapsing banking system and the prospect of leaving the euro, he agreed to a new bailout framework requiring substantial reforms.
It was an extraordinary political reversal, followed by years of painful adjustment. Nevertheless, Greece ultimately regained market access and investment grade.
Britain and Greece faced very different circumstances. The UK retained monetary sovereignty and confronted a market liquidity crisis; Greece depended on external assistance and faced the possibility of leaving the single currency. What they shared was the need for political decisions to resolve pressures that financial intervention alone could not eliminate.
The lesson is not that governments must subordinate every economic decision to bond investors. Rather, fiscal credibility determines how much flexibility they retain when markets become unstable. Central banks can buy time during a liquidity crisis, but the effectiveness of their intervention depends partly on what politicians do with that opportunity.
In 2022, Britain demonstrated how quickly adjustment can occur. Greece showed how prolonged and painful it can become when delayed. With debt burdens higher and market liquidity potentially less dependable, policymakers would do well to recognise the distinction before the next crisis forces it upon them.
Helen Thomas is founder and CEO of Blonde Money