Sean O'Grady: Trouble on the streets – and in the markets

We're in this together, you might say. While all the talk has been about fixing the national public finances – with so far no real consensus on how this is to be done – local government, as ever, will find itself under even more pressure.

Indeed, experience of past recessions suggests that one of the easiest, most cynical and most politically expedient cuts for politicians in London to make is to reduce the support they offer local councils. Grants from central government represent well over half of local government's total revenues, so one of the unfortunate eccentricities of the way local government is now financed is that this "gears" increases in the council tax.

Because it raises only 25 per cent of council revenues, a shortfall in central funding means that all the burden of adjustment falls on to this relatively small base. That means much larger rises in those annual bills than in most other types of national taxation when the going gets tough. Or truly swingeing cuts. This, in turn, means that more of the political opprobrium will be aimed at town halls rather than at MPs or ministers, which suits those in Westminster nicely.

Look at history. It wasn't just its manifest unfairness that finished off the poll tax in the early 1990s, it was also the way the recession left local authority finances in complete disarray. The reforms that followed, which gave us the council tax, forced an unprecedented increase in Whitehall funding, and control of local government. That left councils even more exposed to problems at HM Treasury.

And those problems are real. The markets reacted badly to yesterday's depressing figures, but they did not panic. Not yet. A panic could mean trouble. Trouble comes in a spectrum. It could mean that interest rates continue to edge upwards gradually, and with them the debt payments that fall to taxpayers.

That ought to be manageable, though uncomfortable, unless the national debt rises to beyond 90 per cent of GDP. If it does, research suggests, an economy can enter a "slow death" spiral, where rising debt payments can be met only by continually rising taxes, which depress GDP even more.

At the other end of the spectrum would be a collapse in confidence in the ability of the Government to meet its obligations, Greek-style. A "gilts strike" by the markets, perhaps spurred by a downgrade in the credit rating of UK government debt, would devalue those widely held securities at a stroke: the destruction of wealth would make the subprime crisis look like a tea party, and affect almost everyone with a pension, for example. The vast quantity of gilts held in pension and insurance funds as supposedly ultra-safe assets would be worth far less, slashing the value of people's retirement funds and very possibly pushing those institutions towards insolvency. Much the same goes for other financial institutions with their reserves held in gilts – including the banks, who, like the pension companies, are required to hold a proportion of their assets in supposedly ultra-safe gilts.

Again the nation would face the "too big to fail" dilemma as balance sheets disintegrated. We would have to bail out these big institutions. Except that this time, the Government would no longer be able to issue new gilts to pay for the bailouts, leaving the whole system in meltdown. Or, more likely, the UK going to the IMF for emergency assistance. The Greeks may beat us to it, but we may not be that far behind.