Are the Tories planning to inflate away our debt?


11:15 am - July 21st 2010

by Left Outside    


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The coalition government has recently seen its poll ratings drop, its golden boy make a prat of himself and its face repeatedly hit by Balls.

What else to do next but to line up some inflation?

Via Ryan Avent and Buttonwood, I learn that the Government has recently switched from one sort of fund raising device to another. You may find this boring, but this is important.

The device abandoned are index-linked national savings certificates. These offered savings at the rate of inflation plus 1% for five years, with tax-free returns; they have recently been paying out at 6%, which I’m sure no one reading this would sniff at.

This fund raising instrument is a wise thing to use when inflation is low, because the Government only has to pay 1% on top of the inflation rate. However, despite the amount of money it needs to raise, and despite this being a very popular investment, the Government has withdrawn it.

What can we infer from this action? I think it is safe to assume that the Government, either alone or in coordination with Mervyn King, is planning to inflate away some of the nation’s debt.

This might be the first sign of this Government doing something sensible on the economy. The irony of course is that most people who identify as Conservatives will find the proposed policy positively evil.

But, in fact, I think this would be a good idea for a couple of reasons.

Because the UK’s debt is mostly long term , with an average maturity of 14 years, a little surprise inflation won’t lead to a significant rise in the cost of financing the debt. We can reduce our debt burden without risking increasing by much how much we pay for our debt.

The other good side to a rise in inflation is that it makes holding money less attractive and investing more attractive, which is exactly what our economy currently needs to boost demand, growth and jobs.

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About the author
Left Outside is a regular contributor to LC. He blogs here and tweets here. From October 2010 to September 2012 he is reading for an MSc in Global History at the London School of Economics and will be one of those metropolitan elite you read so much about.
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Reader comments


1. Dick the Prick

It’s a bloody good idea but there are significant risks.

I reservedly approve of this, on a personal level, as it’ll help to reduce the value of my non-student-loan bank debts (student overdraft, etc).

What’s good for the goose…, etc.

Can’t see savers being particularly happy though!

I doubt they’re ‘planning’ to inflate away the debt – especially as a lot of outstanding debt is index-linked anyway. But they will be very keen to hold interest rates down for as long as possible, and that has its own implications for inflation.

Ah tim, but a lot of debt isn’t index linked, so on net it still makes debt more addordable.

Plus, you might not think they’re planning to inflate away the debt, but thats the way they’re acting.

*affordable.

Bring back the edit function!

4 – Absolutely. My point was rather than planning to increase inflation to manage the debt, they are expecting that inflation will rise and acting to avoid that making debt repayments worse.

In other words, they are prepared to see a little inflation if that means they can keep interest rates low; they are not keeping interest rates low in order to trigger inflation. It’s a necessary evil and not a desired outcome.

Left Outside:

You have answered your own question. Why did the government withdraw the certificates? Because for the last couple of months they were paying out over 6%, which wasn’t worth it for them. What they should have done was to got rid of the +1% and reissued them. Most economists are predicting that inflation wll be over 3.5% for this year, and over 3% the year after, so arguably the govenrment realised that the cost of borrowing via this method was too expensive.

It is unbelievable that you think deliberately pursuing an inflation spike would be a good idea. It would hammer people for having been responsible and doing the right thing – particularly pensioners who have set money aside would be ruined.

More on why this is a really, really bad idea here: http://liberalconspiracy.org/2010/07/21/are-the-tories-planning-to-inflate-away-our-debt/

Whoops – I of course meant, more here: http://www.crashbangwallace.com/?p=87

10. Luis Enrique

Why were +1% index links paying 6%? Which inflation index is showing 5% inflation?

If they are planning to inflate way the debt, perhaps via more QE, that makes the cuts even less necessary.

They’ll need to raise the BoE’s inflation target though, won’t they, otherwise it’ll have to raise interest rates to tame inflation, which they won’t be able to tame because the govt is deliberately creating it. High interest rates in a middle of a recession …. ?

@Rumbold

Possibly, but this is a government that has to raise £160bn and this was an oversubscribed fund raising intrument which was only open to domestic depositors. What they can’t raise domestically they have to raise internationally, and that is more dangerous.

Even if it is a little pricey, it seemed a price worth paying to keep fundraising domestic. I think there’s more to it than you admit.

@Luis Enriuque,

My thoughts too on 5% inflation, but that’s what buttonwood (the economist’s correspondent) was being paid.

That’s why I added something conspiritorial about Mervyn King, Maybe Cam has struck a deal, tight fiscal/loose monetary in secret.

@8 and @9 – Mark, I’m sure that you, as a former stalwart of the so-called Taxpayers’ Alliance (representing less than one tenth of one per cent of all UK taxpayers, and still not publishing accounts or a list of donors) are keen on reducing the country’s debt.

So why are the TPA so quiet when it comes to the area of defence spending – particularly the upcoming decision on the Trident Missile System?

Some serious savings could be made there, but instead the TPA publishes more of its “research” attempting to demonise speed cameras, or calls for bus grants to be binned.

Anyone might think that the organisation was only interested in getting its copy into the papers.

@Mark Wallace.

I don’t buy the saver = moral / borrow = immoral thing you argue for. Its a judeo- christian hangover we need to get over. People in debt are also good people.

Unless you have a more fundamental criticism I don’t want to know.

15. Luis Enrique

(I see the 6% is from The Economist, so I can’t ask you to provide a source. I presume they’ve got their numbers right)

@cjcjc

Thanks. I forget how low inflation was last year. Base effects.

@TimFenton

Obviously I can’t speak for the TPA any more, but certainly when I was there the feeling was that Trident certainly should be considered but to do it properly requires research done to take into account the military strategic angle too – which as a small organisation the TPA doesn’t have in-house at the moment.

Personally I think a nuclear deterrent is an essential part of the nation’s defences, but the TPA has taken no view one way or the other.

I don’t think it follows that just because NS&I has withdrawn index-linked savings certificates, that the government is seeking to “inflate away our debt”.

In fact, NS&I has also withdrawn the fixed interest savings certificates:

“… we must also meet the government’s financing objective – called our Net Financing target – which HM Treasury set at zero (for the 2010/11 financial year) within a range of £2 billion either side of this. This means that we need to broadly balance the funds coming into NS&I with the funds leaving us.

We’ve seen significant amounts of money invested into these products recently, so we’ve taken this difficult decision to ensure that we do not exceed the upper end of our Net Financing target range.”

http://www.nsandi.com/ifa/savingcerts-no-longer-on-sale

There are all sorts of rules which regulate the extent to which a government-backed institution can pay interest to savers. Not too long ago, Northern Rock was subject to similar restrictions on “new business”, so cut rates drastically.

Index-linked and fixed interest savings certificates periodically go off sale, but usually come back when a few thousand people have transferred funds elsewhere.

Besides which, the government “borrows” far, far more money from the gilt markets anyway. It makes NS&I look piffling by comparison.

I don’t think it has anything to with the intention to inflate away debt. (And for all Gideon’s intentions to placate the bond markets, an inflation spike would have the opposite effect.)

19. Luis Enrique

You know, if you did want to inflate away debt, one good way to do it would be to have the central bank print money, buy government debt, and effectively use the printed money to FUND PUBLIC SERVICES INSTEAD OF CUTTING THEM. FFS.

there. my first use of angry man capitals in a blog comment. was it warranted?

“My point was rather than planning to increase inflation to manage the debt, they are expecting that inflation will rise and acting to avoid that making debt repayments worse.”

That’s my reading. It’s ferociously unpopular with the so-called responsible right, as Mark Wallace neatly demonstrates above. Got to protect those savers, even at the cost of the entire economic future of the country – this view is commonly linked with nationalistic ideas of a ‘strong pound’ which is likewise actually damaging, through requiring higher interest rates. Arguing with people holding these views is generally about as much fun as arguing anything else that requires an intellectual leap due to being non-obvious; evolution, climate change, quantum physics. I dust them from my shoes.

Mark and the other saving fundies may be surprised to note that George Osborne is apparently banking on *less* saving, which is of course entirely consist with a tolerance of higher inflation, although, this being the Coalition, is entirely inconsistent with Iain Duncan Smith’s comments about encouraging more saving on moral grounds. It’s apparently escaped IDS’s attention that we’re all savers now, particularly business. For instance, if I’m lucky enough to get a bonus I pay off credit cards rather than tripping down to the shops, on the basis that if I lose my job I’ll at least start off from a relatively neutral position. This isn’t being responsible, it’s being terrified. I’m not sure scaring people and then expecting them to fork out to start the economy moving is a well-thought-through strategy.

21. Mike Thomas

20,

There are 7 times more savers than borrowers in the UK.

All of them would like to earn real interest on their money. Saving money has nothing to do with the value of Sterling either.

Also as the rest of your admission goes, you are also happy to deleverage your own personal finances and yet you seem to think that savers should not and should spend, spend, spend?

Where do you think the bank got the capital in the first place to be able to lend you the money?

If you can handle the volatility, may I recommend higher yielding investment trusts which currently offer yields of 5-6% (Edinburgh IT, Merchants IT, British Assets Trust some examples). The dividends over time will grow at least in line with inflation.

“There are 7 times more savers than borrowers in the UK.”

Source?

21 – where does this ‘seven savers for every borrower’ meme come from?

http://news.bbc.co.uk/1/hi/business/8405901.stm is a year old and fascinating reading – 35% of people have never saved, 25% have no or negative net worth, 48% have some form of unsecured liability.

76% of assets are property or pensions (wtf?!)

62% have savings accounts – 75% of those with > £500.

25. Mike Thomas

23,

Building Societies Association. I’m sure you can manage to use google.

It seems that the seven savers per borrower thing relates to building societies and mortgages and goes:

For every mortgage held with a building society, there are seven building society saving accounts.

It’s a good job that building societies are the only place where people go for loans and savings, otherwise the 7/1 ratio might change….

Thanks Nick.

I expect you get that number from counting everyone whos ever had a savings account and everyone who took out a loan this year.

Oh Mike, it appear I ascribed more malfeasance to you than was needed. Your stat is still wrong though.

Mmm. Across all accounts, and partially based on that BBC article, I’d expect there to be more net savers than net borrowers, but I wouldn’t expect it to be anything like a 2:1 ratio.

But anyway. Many people with a savings account negatively hit by high inflation will also have a mortgage account which benefits from low interest. Inflation spanks people on fixed incomes hardest (that would be pensioners), and helps out people with debts a bit. It’s more swings-and-roundabouts than “OMFG catastrophe”, so let’s move on, shall we?

30. Mike Thomas

28,

The fact is households hold more in assets than they do in debts. So allowing inflation to take hold would hurt them more than relieve them of liabilities.

http://www.statistics.gov.uk/elmr/04_08/downloads/elmr_apr08_sbano.pdf

I apologise these numbers a little out of date.

As for the ratio of building society savers to borrowers, the ratio is now 8 to 1. Bearing in mind the national ratio of the deposit amounts that building societies hold (20% of the total on deposit and 35% of all Cash ISA) I imagine that they have a big say in the nation’s savings habit.

http://www.bsa.org.uk/faq/mortgagerate.htm

So a policy of inflating an incompetent government’s debts away would do more than hurt a few people on fixed incomes, it would seriously hurt the assets and investments of tens of millions of people.

You seem like you need a short refresher in to the importance of savings to the economy. This looks to fit the bill quite nicely for you.

http://www.lloydsbankinggroup.com/media/pdfs/halifax/2010/50YearsofSavingsReportFINAL.pdf

The problem for me is, the vast majority of those household assets are virtual, junk and/or overvalued – being pension funds and housing. Not coincidentally, I don’t have either of those classes of asset. I don’t see either of them as particularly exalted or worthy investments, worthy of protection. But that’s a personal beef.

In terms of the 7/8-1 ratio – it’s entirely misleading. It takes all the different savings accounts that building societies have, and compares them simply to mortgages. So it’s assuming that the remaining chunk of the sector has similar ratios, and that the only kind of debt that matters is mortgages. It also ignores the disparity between the amount of cash in an average mortgage, compared to an average savings account. It’s a hyped-up number designed to suggest that savers vastly outnumber borrowers (who caused all the problems currently experienced, as we all well know) and should be protected as much as possible.

Borrowers are about as important to the economy as savers are – just in different ways.

32. WhatNext?!

@31

Nick,
In what way are pension funds “virtual, junk and/or over-valued”??

I would agree that housing is over-valued, and has been for ages, but no one could sensibly call it “virtual” or “junk”.

Please explain …..

33. Richard W

‘ What can we infer from this action? I think it is safe to assume that the Government, either alone or in coordination with Mervyn King, is planning to inflate away some of the nation’s debt. ‘

I don’t think you can infer at all what you are inferring, Left Outside. Quite simply NS&I are removing it because it distorts the market in the competition for retail deposits. All the private sector banks and building societies are trying to lift their retail deposit ratio rather than depend on the wholesale market. We seen how relying on wholesale worked out in 2008. With weak credit demand on one side, paying too high a rate for deposits pressures their net interest margin. Savers are being paid for funds that no one wants to borrow. NS&I further distorts the market because deposits are 100 per cent guaranteed as opposed to 50,000 pounds in the private sector.

On this thread we have the bizarre sight of a former Taxpayers Alliance apparatchik arguing in favour of a state institution, NS&I, distorting the market that costs, er, the taxpayer money.

In the budget they changed final salary pension schemes from RPI to CPI, leaving pensioners worse off. Due to the weightings of their respective basket CPI will always be lower in the long-run than RPI. If, since 1981 when they were introduced, index-linked gilts had been linked to CPI rather than RPI, the taxpayer would have saved many billions. I wonder if Mark Wallace would favour that change?

12:24 pm, July 21, 2010
12. Left Outside

‘ That’s why I added something conspiritorial about Mervyn King, Maybe Cam has struck a deal, tight fiscal/loose monetary in secret. ‘

There is nothing secret about it. That is the policy. Although it all depends on the euro zone recovering. The eurosceptic Tories rejoicing in euro zone woes are in fact cheering the undermining of their own economic plan.

The remit of the MPC at the BoE is to maintain 2% CPI at all times. Not sometimes, but all times. For all intents and purposes they are inflation targeting lite, so of course this has the effect of inflating the 75/76% not index-linked stock of national debt away. Moreover, the debt burden in the wider economy for the indebted becomes lighter if their wages keep pace with inflation, which currently they are not. A stated higher price level target by the BoE, Fed and ECB would help raise economic activity. However, the hard money nutters in the ECB would never agree. The result will be continuing high unemployment.

Interesting. Perhaps they are also planning to inflate away public service pay by combining a higher rate of inflation with the nominal pay freezes that they have imposed.

35. Luis Enrique

I know I’m repeating myself, but my earlier attempts don’t seem to have gained much traction … if the government can tolerate (or even wants) higher inflation, why the buggery is it cutting public spending like crazy?

N.B. despite the fact the inflation hurts savers and that’s a bad thing etc. there’s no way out of this mess without hurting some sections of society and it’s not obvious that “savers” are such a bad choice for a share of the pain.

Woo! Something related to what I’ve spent the last month working on.

Households in the UK, at the median, have no assets apart from their houses and their pension funds. And inflation makes fuck-all difference to either of those.

People who are rich have significant assets beyond houses and pensions. People who are not rich have no assets or actual liabilities beyond houses and pensions.

As a result, inflation is redistributive. Hence why Tories oppose it, and everyone sensible thinks that it’d be a nice idea.

(I’m completely unrepresentative, as I’m young, have a fair amount of cash-in-bank-in-UK, don’t have a mortgage or a pension, and don’t live in the UK. As a result, policies that favoured UK cash savers – specifically, raising interest rates to 20% and telling everyone to go swivel – would suit me admirably. However, I’m a lefty because I’m not a selfish tit, otherwise I’d be a Tory).

Something tells me that dumping on savers is not a recipe for long term happiness, especially given that our current problems stem from a credit boom.

Something also tells me that engineering *just the right amount* of inflation is not quite as easy as it sounds.

And of course if wages do not keep up with higher inflation then of course it won’t just be savers who get hurt.

Something tells me that dumping on savers is not a recipe for long term happiness, especially given that our current problems stem from a credit boom

Luckily, Chinese savers don’t get a vote in UK elections. FAIL.

As a result, inflation is redistributive. Hence why Tories oppose it, and everyone sensible thinks that it’d be a nice idea.

It also absolutely shafts those on fixed incomes, notably those on benefits and pensioners – otherwise known as the poorest and most vulnerable in society. But hey, who cares about them right? As a socking great debtor and in a steady well-paid job I’d do pretty damn well out of a dose of inflation, but then we Tories aren’t as selfish as all that…

40. Luis Enrique

Tim J

Inflation causes tax revenues to inflate, benefits can be index linked.

the question isn’t whether it hurts some people we’d prefer not to hurt – it’s a matter of picking the least bad. Cutting govt spending and raising taxes (esp. VAT) also hurts “those on benefits and pensioners – otherwise known as the poorest and most vulnerable in society”

Chinese savers can however vote with their feet. DOUBLE FAIL.

32 – except for those people who bought two houses cheap, and now have a vastly overpriced asset that they can sell (the second home), the increase in house prices is an entirely virtual increase in wealth, since to benefit from it you have to sell up and then – assuming you’re not emigrating or becoming homeless – buy another one at equally inflated prices.

As for pensions… I’m simply not convinced that there are going to be any by the time I get around to retiring in 35-50 years. We’ve actually got a pension advisor coming in to talk to the whole firm I work at (private pensions now being a compulsory offering of businesses to employees, or something?) and I am deeply, deeply skeptical. My whole impression of pensions is that they’re failure-riddled not-quite-ponzi-schemes. So to me, right now, they’re junk.

*shrug*

43. Richard W

35. Luis Enrique

‘ I know I’m repeating myself, but my earlier attempts don’t seem to have gained much traction … if the government can tolerate (or even wants) higher inflation, why the buggery is it cutting public spending like crazy? ‘

Well inflation is determined by monetary policy not fiscal policy as you seem to imply. Luis.

Government borrowing represents future taxes. Conservatives would be opposed to financing a fiscal deficit through borrowing because it represents higher future taxes and they want taxes to be lower.

Moreover, you have to separate the rather fruitcake views of the conservative base from most of the sane conservative politicians and economists. The base just see the government deficit as evil and would on the other hand laud private sector saving in comparison to the profligate government. As we know the sectoral balances of the economy ( government, private sector (households & firms) and foreign ) must sum to zero. Therefore, the fiscal deficit is not government profligacy but is forced on them as the flip side of private sector saving and deleveraging, in the absence of an external (foreign) surplus on the current account.

The present government want to cut spending even in the face of private sector deleveraging because they believe it will allow them to eventually cut taxes. They believe a Ricardian equivalence currently exists in the economy. Therefore, if they cut spending it will lead to a private sector investment boom- leading to an export-led boom- leading to the fiscal budget being balanced and the private sector still being able to increase their savings through the current account surplus. There is absolutely nothing wrong with wanting a balanced fiscal budget and the private sector to increase their savings, but it all depends on demand in the eurozone and the confidence tooth fairy. Moreover, all the eurozone countries want to do the same thing so unless aggregate demand increases the result will be higher unemployment.

“Government borrowing represents future taxes.”

Not necessarily. We currently have 2.5 million unemployed which are not being employed by the private sector. Borrowing to put these people to work will make us richer and mean future taxes can be lower.

I do see inflation as largely monetary because the central bank can move to neutralise any inflation caused by fiscal policy more quickly than vice versa.

Luis,

I’m not sure how they expect to get more inflation without a lot of unconventional monetary policy, but perhaps they really really believe in the confidence fairy.

@all

Inflation can be damaging all policy options currently are. The negative effects of inflation can be ameliorated more easily than those of our other options. Plus inflation is currently useful in itself to boost aggregate demand.

45. Richard W

44. Left Outside

“Government borrowing represents future taxes.”

‘ Not necessarily. We currently have 2.5 million unemployed which are not being employed by the private sector. Borrowing to put these people to work will make us richer and mean future taxes can be lower. ‘

Well yes. Spending money today to cover the shortfall in private sector spending is sensible to all but the puritans. The unemployed especially the young are not left to rot on the dole and acquire work skills. Future GDP is higher which means paying for the borrowing need not increase the overall tax burden. However, the borrowing still represents future taxes, it just means our ability to pay them have also increased. The monetarists believe we can achieve the same thing through monetary policy without the taxes. A ‘ liquidity trap ‘ would work against monetary policy having much traction hard against the zero bound but they reject the idea of a liquidity trap.

To repeat, the whole of the Tories economic plan depends on for success the external sector. If the current account does not move into surplus, the private sector will need to take on more debts for the government to cut their fiscal deficit. If the private sector does not take on more debt the result will be higher unemployment. The sectoral balances always sum to zero.

Towards the end of 2008 the Bank of England Pension Fund moved the majority of its assets into index-linked gilts – at the same time as the BOE were waving the spectre of deflation at us.

It’s called insider dealing when other people do it.

47. Luis Enrique

Richard W

Well inflation is determined by monetary policy not fiscal policy as you seem to imply.

yes… and how does monetary policy work? how does newly printed money get into circulation? answer: via government spending. The central bank increases the quantity of high powered money in circulation by buying government debt. This reduces the quantity of debt the government has to meet out of the fiscal surplus, as well as being inflationary. It means there’s less pressure on the government to cut the deficit. Not to mention the fact that “inflating away debt” (nominal prices, wages and taxes rising, with most debt contracts being written in nominal terms) means there’s less need to cut the deficit too.

47. Luis Enrique

Richard W

Well inflation is determined by monetary policy not fiscal policy as you seem to imply.

‘ yes… and how does monetary policy work? how does newly printed money get into circulation? answer: via government spending. The central bank increases the quantity of high powered money in circulation by buying government debt. This reduces the quantity of debt the government has to meet out of the fiscal surplus, as well as being inflationary. It means there’s less pressure on the government to cut the deficit. Not to mention the fact that “inflating away debt” (nominal prices, wages and taxes rising, with most debt contracts being written in nominal terms) means there’s less need to cut the deficit too. ‘

The BoE are forbidden by the articles of the Maastricht Treaty to finance the government deficit. What you are describing is QE, which has no effect on reducing the amount of debt the government issues to finance their fiscal deficit. The government through the DMO issues gilts usually by auction in the primary market. They sometimes have syndicated sales for ultra-longs. The BoE buys gilts in the secondary market. During QE, they bought by reverse auctions. Other than possibly reduce the yield the government have to pay it has no direct effect on the fiscal deficit. Incidentally, yields are currently lower than they were during QE. The purpose of QE was to raise the money supply and lower spreads between government bonds and corporates.

‘ This reduces the quantity of debt the government has to meet out of the fiscal surplus, as well as being inflationary. ‘

Unless they were redeeming maturing debt not quite sure why they would have to issue debt with a fiscal surplus.

I’m not sure how they expect to get more inflation without a lot of unconventional monetary policy, but perhaps they really really believe in the confidence fairy.

Well, keeping interest rates at 0.5% should do the trick eventually.

50. Luis Enrique

Richard,

this is getting a bit esoteric, perhaps we should continue by email (I think you can get my address by clicking on my name).

Thanks for response; I didn’t know about the Maastrict restrictions. Yes I am describing QE. I don’t agree it “has no effect on reducing the amount of debt the government issues to finance their fiscal deficit”. Rather than buy newly issued gilts, with QE the BoE can buy outstanding gilts held by the private sector … and the private sector then buys news gilts from the DMO. Is that right? If it is, while it might technically look like the BoE isn’t financing the government deficit, it’s sleight of hand. It’s a bit like saying you want to borrow £10 from me, but you also own Harry £10, so I buy the debt off Harry, and sit on it, and Harry lends you £10. Same difference.

“Other than possibly reduce the yield the government have to pay it has no direct effect on the fiscal deficit.” I think that’s wrong too. The net effect is to take government debt off the table, put it on the BoE balance sheet and sit on it. If the goal is to be inflationary, the BoE will just roll that over in perpetuity (i.e. a permanent increase in the money supply) and the govt never has to pay that back out of tax revenues. This is effectively “the govt paying its debts by printing money”, the thing I presume Maastrict tries to ban. Of course the BoE could either sell that debt back into private hands, or take redemption without buying more debt to replace it, both of which would be “reverse” QE, and deflationary. But we’re talking about “if the govt wants to inflate …” aren’t we?

I think what I am describing is more or less how the money supply is increased over time as the economy grows, via seignorage. I’m really just saying that if the govt wants to inflate the economy, then a big burst of seignorage will do the job, and reduce the quantity of debt the govt needs to meet out of tax revenues into the bargain.

no, I wasn’t talking about the govt issuing new debt when it’s running a fiscal surplus

51. Luis Enrique

oh, I see you can’t. it’s luisenrqiueukATgmail

@48: “Well inflation is determined by monetary policy not fiscal policy as you seem to imply.”

Yes – but suppose the extra money injected into the system by the BoE through Quantitative Easing is accumulated in balances held by the banks in extra reserves and in other private sector balances?

“Bank lending to small and medium-sized businesses is showing little sign of improving, according to two new surveys that highlight the problems for government of getting banks to increase their lending.

“A survey to be released on Tuesday by the Institute of Directors finds one in three of its members applying for loans in the first six months of the year was turned down by a bank.

“The report also shows that many businesses are being asked to stump up hefty collateral for loans, even when their borrowing is guaranteed by the government” [dated 12 July]
http://www.ft.com/cms/s/0/63cb806a-8de5-11df-9153-00144feab49a.html

According to the BoE’s Monthly Trends for July:

“The flow of net lending to UK businesses remained negative in May, and was more so than in April.”
http://www.bankofengland.co.uk/publications/other/monetary/TrendsJuly10.pdf

So far, QE doesn’t seem to be doing much to boost the economy by supporting additional business investment. There’s an evident irony about this plaintive headline in the Telegraph:

“Help the private sector to save the economy”
http://www.telegraph.co.uk/comment/telegraph-view/7882507/Help-the-private-sector-to-save-the-economy.html

50. Luis Enrique

Richard,

‘ Thanks for response; I didn’t know about the Maastrict restrictions. Yes I am describing QE. I don’t agree it “has no effect on reducing the amount of debt the government issues to finance their fiscal deficit”. Rather than buy newly issued gilts, with QE the BoE can buy outstanding gilts held by the private sector … and the private sector then buys news gilts from the DMO. Is that right? If it is, while it might technically look like the BoE isn’t financing the government deficit, it’s sleight of hand. It’s a bit like saying you want to borrow £10 from me, but you also own Harry £10, so I buy the debt off Harry, and sit on it, and Harry lends you £10. Same difference. ‘

The mistake you are making is assuming that it was the same institutions who were buyers at DMO auctions and also sellers to the Bank. Gilt auctions are always oversubscribed and how oversubscribed is the bid-to-cover ratio. A high ratio signals strong demand and means the government can sell the issue cheaper. The bid-to-cover is always noted by buyers because it contains useful information for future auctions. The government have about twelve investment banks who are primary dealers who must bid at an auction. Obviously if they do not want the issue they can submit an uncompetitive bid which will not be successful. Even a competitive bid is not guaranteed to be successful if others are more competitive. Moreover, the DMO like to spread the debt around rather than just giving it all to the lowest bid. Therefore, there was no guarantee in being able to buy debt in the primary market and sell it to the BoE in the secondary market.

When QE first started the hedge funds ever on the lookout for a quick buck bought up debt from the primary dealers and a few days later sold it to the BoE at above market prices because they had correctly worked out the BoE would overpay. Thereafter, the BoE only bought in the secondary market debt with a different maturity to what the DMO were selling to finance the government. Even buying in the secondary market with the intention of selling to the BoE at above market prices was not guaranteed to be successful because the reverse auctions were oversubscribed. This is just a long-winded way of describing the process and explaining the buyers at DMO auctions were different to the sellers at BoE auctions.

Regardless of the scare stories that used to appear in the press about financing the deficit what you need to understand is there is huge demand for fixed income sterling assets. The Singapore sovereign wealth fund issued bonds denominated in sterling just a few days ago. I think Finland was the last foreign government to issue sterling bonds. The demand for them far outstripped supply. Fund managers in the UK have to match their liabilities for all those baby boomers who are retiring with a pension.

‘ I think that’s wrong too. The net effect is to take government debt off the table, put it on the BoE balance sheet and sit on it. If the goal is to be inflationary, the BoE will just roll that over in perpetuity (i.e. a permanent increase in the money supply) and the govt never has to pay that back out of tax revenues. ‘

Not exactly because the Treasury still make full coupon payments to the BoE for the gilts they hold and those payments appear as part of the fiscal deficit.

‘ I think what I am describing is more or less how the money supply is increased over time as the economy grows, via seignorage. I’m really just saying that if the govt wants to inflate the economy, then a big burst of seignorage will do the job, and reduce the quantity of debt the govt needs to meet out of tax revenues into the bargain. ‘

Well yes, anything that increases GDP will reduce debt issuance and increase tax revenue.

“A survey to be released on Tuesday by the Institute of Directors finds one in three of its members applying for loans in the first six months of the year was turned down by a bank.’

The commercial banks say there is weak demand for credit. Businesses say the banks’ are not supplying credit. Who do you believe? I don’t know.

“The report also shows that many businesses are being asked to stump up hefty collateral for loans, even when their borrowing is guaranteed by the government”

It is called repricing of risk. We have had a decade when risk was underpriced and now it is being repriced. People do not like to be told they are a poorer risk than they think they are.

‘ According to the BoE’s Monthly Trends for July:

“The flow of net lending to UK businesses remained negative in May, and was more so than in April.”

Would you invest with the demand signals the government are sending out, Bob?

@54: “Would you invest with the demand signals the government are sending out, Bob?”

Exactly. Given the extent of similar signs and commentary about the fragility of the recovery – not least from the FT – it has become weird that Osborne hasn’t taken in the message.

Since he is not known for being totally thick, I can only assume either that he really believes economic developments will improve eventually or that his own political credibility among Conservatives would be irreparably damaged if he changed course and slowed down the pace and scale of cutting public spending.

The decision of Alan Budd to quit the OBR at the very earliest opportunity is looking very sensible.

56. Luis Enrique

sorry Richard, we’re still failing to communicate. I am not assuming that it was the same institutions who were buyers at DMO auctions, I’m thinking about the system as a whole regardless of the identity of the actors and how indirectly the net effect is achieved. I know the Treasury still makes payments to the BoE. I think you are missing the wood from the trees here. Bottom line is that if the BoE prints cash, buys govt debt and sits on it this 1. is inflationary 2. reduces quantity of debt the govt needs to finance out of taxes. The point about seignorage is not it “increases GDP” but that as GDP increase the money supply has to grow in tandem, and that’s done by printing money, buying govt debt and holding it in perpetuity (rolling it over) on the CB books, so the govt is always having some of its debt paid off with new money. To make any more progress on this discussion, I’d have to build a spreadsheet, but I’m not going to do that.

Ominous headline in the Mail on Thursday:

“B&Q sales drop as shoppers’ appetite for big ticket purchases remains weak”

http://www.dailymail.co.uk/money/article-1296790/B-Q-sales-drop-shoppers-appetite-big-ticket-purchases-remains-weak.html?ito=feeds-newsxml#ixzz0uPX4kG2u

58. Richard W

It depends who the CB buys the government debt from. The CB in their open market operations buy and sell government debt all the time from the banking sector. That is why the term ‘ printing money ‘ is so misleading. Maintaining monetary aggregates otherwise disinflation or deflation will occur would be more accurate. If they buy from a bank it does not increase the money supply because the security is already part of the money supply. They only alter the aggregates. The difference between QE and normal open market operations was they were buying from non-banks to raise the money supply because it was falling through the floor. The QE was not really adding to the money supply but only partially replacing the fall.

59. Luis Enrique

Richard

Try a reductio ad absurdum. Why who the BoE buys from doesn’t matter so much. If the BoE bought 100% of the UK government’s outstanding debt, and continued to by new gilts issued by the DMO say 1 year after they’d been bought by somebody else first, and maybe changed hands a few times in the interim, and hung a big sign over them in the vaults saying “we’re never going to want paying back for this – we’ll just keep rolling it over”, I presume you wouldn’t want to argue that this would have no implications for fiscal policy (because it’s just monetary) nor that it wouldn’t constitute funding the deficit. Never mind that it would send inflation to infinity.

QE (or, as you point out, we could just be talking about normal market operations) are just a far more moderate version of that, regardless of the fine details. And if the govt wanted to generate inflation, buying govt debt and putting it in the vaults for keeps to achieve a permanent increase in the money supply, would be a quick way to achieve that goal.

The point about buying gilts held by banks that are “already part of the money supply” is interesting, and would matter if we were discussing the nature of the relationship between BoE market operations and changes the effective money supply. But we’re not.

This stuff is missing from most undergrad macro courses, which tends to leave the impression that there is a stock of outstanding debt, and the CB either buys or sells in this pool to change MS. The CB cannot a achieve long-run, permanent increases in the money supply in this way, cause it would eventually have bought the outstanding stock. The govt has to keep issuing new debt (growing the pie) and the CB must effectively end up buying a slice of the expanding pie – this is seignorage, and seignorage is paying govt debt by printing money, and in doing so it removes some govt debt from the “funded from tax revenues” pile and puts it in the CB vaults for keeps, and it happens all the time. All I’ve ever been arguing is that if the govt wants to create inflation, then a dose of seignorage would 1. do that and 2. remove some debt from the liability of tax payers pile. I really do think you’re getting a bit lost in the detail.

60. Richard W

Luis, I suspect we are just looking at the issue from different perspectives. My perspective is looking at the scenarios from the underlying bond market and how the CB interacts with that market. In your reductio ad absurdum, yes the CB buying up the full stock would see inflation move higher through fiscal policy if the CB were not inflation targeting. However, a central bank who were inflation targeting could still buy up the whole stock and the governments fiscal spending would not be inflationary because the CB would react by neutralising it through open market operations. All that would happen is there would be an indirect financial repression and the stock would end up on the balance sheets of the commercial banks not the CBs balance sheet. In a inflation targeting system fiscal policy will not be inflationary because the CB will react against it.

In no way would I disagree if they wanted to create inflation they could.


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