Debt Games: How Governments Finance Themselves for Free

The ‘magic money machine’

Last week, I explored the Chancellor’s Spring Statement from the perspective of four different stakeholders. One common theme was the evolution of the national debt and the interest burden arising from this at a time of rising interest rates. One reader – Ian – wrote in with a query. He said that if our central bank, the Bank of England, buys new debt issued by the UK government and sits on it, then surely it can just collect interest payments due and credit them back to the government − so effectively, the government can raise new finance to cover the current-year fiscal deficit for free. And therefore, the level of the national debt, typically expressed as a percentage of GDP, is nothing to worry about.

Well, Ian, the answer is yes and no. Please bear with me.

First, the bad news. The UK’s national debt will rise to more than £2.5trn (that’s £2,500bn) in fiscal year 2023-24. The national debt will peak at about 96 percent of GDP this year before starting to fall, assuming growth is sustained and inflation erodes the real-terms size of the debt ‘mountain’. The plan announced last week is for the debt-to-GDP ratio to fall to 83 percent of GDP in five years’ time.

Rampant inflation – which is likely to hit double digits later this year – will drive up the cost of servicing that debt: while three-quarters of outstanding debt has a fixed coupon, about a quarter is index-linked, such that interest payments are tied to the level of the Retail Price Index. True, the bulk of these index-linked bonds will not be redeemed for years, so the full impact will be spread over several years.

The Chancellor said that in 2022-23 the government will spend £83bn on debt interest. That is the highest figure on record, and almost four times the cost of servicing the debt last year. It is more than for any departmental expenditure except for the NHS, education and state pensions. As the Chancellor said in his Statement: “More borrowing is not cost or risk-free”.

But the good news is that, of the approximately £400bn of new government debt issued during the pandemic, the Bank bought about half through its programme of quantitative easing (QE). Government bonds that it bought during the pandemic and before sit on the assets side of its balance sheet. The corresponding liability is outstanding currency – that means pounds sterling that have been magicked into existence by the Bank which, uniquely, can create currency at the stroke of a pen (or rather the click of a mouse).

What that liability entails is written on every ten-pound note. The Cashier of the Bank states: “I promise to pay the bearer [of this note] the sum of Ten Pounds”. So, theoretically, you can turn up at Threadneedle Street carrying a tenner and present it to the Cashier – who will then hand you a crisply minted tenner back. Job done.

If that sounds strange, think about it this way. Money – your ten-pound note – is only worth something because other people believe that it is worth something, in the sense that if they receive it from you in a transaction, they believe that they will be able to spend it on something of equivalent value. So, notes and coins – and their digital counterparts in the form of bank deposits – only have value to the extent that other people think they have value. If people think the currency is feeble, they avoid it and its value falls. Money, like financial markets, is all about human psychology. My Jack Russell terrier, who is otherwise highly intelligent, does not think much of my ten-pound note because it doesn’t smell tasty. That’s dogs for you.

All this gives a central bank extraordinary powers. And these are now exercised beyond the purview of ministers of finance, who are overwhelmingly politicians in the West (some are qualified economists – but many are not).

Now for a qualification. Bond prices (gilts included) rise in value when interest rates fall and fall when interest rates rise. It is an inverse relationship which is central to financial economics. Thus, when interest rates were trending downwards, the mark-to-market value of any gilts bought by the Bank were edging up and the capital gain accruing on those papers could be handed back to the Treasury. The Treasury still had to pay the coupon (interest payment) on the bonds to the Bank, otherwise it would technically go into default.

Theoretically, the Bank could always lend the cost of the interest payment due to the government – that is what banks sometimes do for clients with minimal default risk. Since the cost of the liability is set by the base rate (currently 0.75 percent – up from 0.5 percent and just 0.1 percent previously), if the interest received is greater than the base rate then the Bank can book a profit. Conversely, if the interest coupon is less than the base rate, the Bank will book a loss – which will have to be recovered from elsewhere. Again uniquely, when central banks set interest rates, they also determine their own level of profitability – but they don’t really exist to make money.

But with interest rates rising, the mark-to-market value of those papers is falling, and the Treasury will be expected to cover any loss. Remember, the value of the asset must precisely equal the value of the liability that is funding it on the bank’s balance sheet. In the current fiscal year just ending, the Bank was expected to pay £7.2bn to the Treasury to balance the books. But, according to the OBR, from 2023-24 onwards, the boot will be on the other foot. The Treasury will have to pay the Bank about £400m, rising to £1.1bn in 2024-25 and £2.6bn in 2025-26. So, the funding will not have been ‘free’ after all.

The Bank currently holds about £875bn of UK government debt together with about £20bn of corporate bonds (overwhelmingly of investment status). With the entire QE agenda in retreat given a period of inflation, it is likely that the Bank may seek to unload those assets on the open market. As it does so, those financial assets will be turned into cash and the Bank could choose to cancel out the corresponding currency liability, thus reducing the money supply.

Governments can get away with financing part of their deficits using monetary ‘magic’ for a while; but as ever, there will be consequences.

The whys and wherefores of inflation

While the surge in inflation has boosted tax revenues for now, on the other side of the equation, the cost of government expenditure will rise – not least in the Ministry of Defence where one pound buys less than it did last year (the cost of equipment will rise, together with soldiers’ wages). So, the idea that inflation has given the Chancellor more ‘headroom’ has been over-egged.

What economists, historians and politicians will argue about for years to come is: who was responsible for the great inflationary wave of the early 2020s? There will be a lobby who will argue that the aggressive programmes of QE pursued to sustain and stimulate demand, combined with near-zero interest rates since the financial crisis, was inherently inflationary. But if that is true, then the question becomes: why did inflation not kick off earlier?

One view is that globalisation (offshoring – that is, buying your trainers from Vietnam and your semiconductors from China) disguised the underlying trend in monetary economics by artificially depressing the cost of consumer goods, while depressing wages and productivity in developed countries such as the UK. Trade frictions arising from the Brexit settlement did not help.

Globalisation also rendered economies like the UK’s more vulnerable to externalities. When DP World bought P&O Ferries in 2006, beating a bid from Singapore’s port authority, this was hailed by New Labour as “a vote of confidence in the UK”. Now, with several of P&O’s ferry routes paralysed, the sale of strategic assets to foreign oligarchs – be they Russian or Arab – seems like folly.

Finally, it was the coronavirus pandemic, and its consequent supply-side shock, with shipping rates rocketing and supply lines in disarray, which finally allowed the inflationary genie to escape its tightly corked bottle. Then the crisis was compounded by geopolitics and the spike in the price of hydrocarbons, which started with Russian machinations last autumn, well before the invasion of Ukraine.

But if you think that the West’s decoupling from Russia is disruptive, I’ll consider soon the extraordinary dislocation that will follow the West’s forthcoming extrication from China.

French leave

I have just returned from a week in France – my first visit since before the pandemic struck home. I was planning to write something about the French presidential election this week – but I might have risked boring my readers, as there is no element of suspense.

The overwhelming consensus is that Emmanuel Macron will be reelected in April – the question is by what margin. The right-wingers, Marine Le Pen and Eric Zemmour, have been wrong-footed by Putin’s brutal invasion of Ukraine. Both have said flattering things in the past about the man that President Joe Biden now calls “a butcher”. Le Pen’s last presidential campaign in 2017 was bankrolled by the Russians (and unlike Trump’s 2016 campaign, that is documented). Valérie Pécresse, the candidate of the Republican Party (roughly equivalent to the UK Conservative Party), despite a promising start, has failed to gain momentum. She described herself at the outset as a combination of Margaret Thatcher and Angela Merkel. But the French never warmed to Thatcher, and they are now in despair about Merkel’s catastrophic legacy. Left-wing candidates are trailing with low-single-digit support in the opinion polls.

In contrast, Macron’s low-key but confident campaign has secured defections to his cause from both left and right. The French economy has been Europe’s star performer since the pandemic began and inflation is below the European average. The hike in energy costs has been transferred to the energy companies and their shareholders, and not so much to households. And as corporation taxes rise in the UK, they are going down in France. Macron will most certainly lead by a wide margin in the first round on 10 April; and he will most likely do another ‘dance-off’ with Le Pen on 24 April. He will demolish her in the gladiatorial TV grilling before the second round – just as he did last time.

Yes, there is a question as to whether the French electorate will turn out to vote en masse. Many confess to pollsters their ennui et morosité (nothing new there). And the gilets jaunes are still in evidence – we passed a posse of fist-clenching yellow vests as we sped out of Toulouse towards le Gers for lunch last Saturday. They were wielding a banner which read “On ne lâche rien” (“We shall concede nothing”). Good luck with Reform Programme 2.0, Emmanuel. Bonne chance!

I think I’ll go back in May to see how the president, still only 44 (nearly half Biden’s age) is facing up to his second five-year term.

But I’m not a fan of his. He is antipathetic to the UK; he favours a European army which the UK, Poland, Hungary and the Baltics fear will undermine NATO; he pushed sanctions on Hungary and Poland at a moment when they are coping heroically with millions of Ukrainian refugees, overwhelmingly women and children. He abandoned Mali – and therefore all sub-Saharan Africa − to Russian mercenaries (the Wagner Group) despite British offers of military help. French arms producers such as Thales and Safran, in which the French government has controlling stakes, continued to provide weapons to Putin’s Russia after the annexation of Crimea in 2014 − and during his presidency. French intelligence has been proven to be inferior to the Anglosphere’s ‘Five Eyes’. He passionately believes that the solution to all Europe’s woes is more Europe – under French leadership, of course. He has only partially reformed France’s Byzantine pensions system in his first term. And the eurozone’s monetary woes in an era of inflation have only just begun.

But we shall have to deal with him for some time to come. Plus ça change – plus c’est la même chose.

PS

France is now a land of zero Covid hassle, thankfully. You just flash your digital vaccination certificate as you get off the aircraft. No mandatory testing. No masks required in restaurants, and certainly no ghastly Perspex dividers. One just saunters in, sits down and orders aperitifs, as if the pandemic never happened.

There was just one thing that slightly depressed me. I used to breeze through passport control at Blagnac by waving my passport at the man in the little ‘Tardis’, who then waved back. This time, he took my passport, considered it gravely and then, with a flourish, stamped it with a symbol of the Republic.

Oh dear. What could we possibly have done?