Monetary financing – whereby central banks buy government bonds to finance their deficits – is now common, not least in the UK. But for how long can the UK government rely on the magic money tree to pay their bills, asks Victor Hill.
Behold the magic money tree!
So it does exist after all! – even though Mrs May said there wasn’t one. The Tories were once the party of fiscal prudence, robust finances and self-discipline – remember the Cameron-Osborne pantomime horse and their regime of austerity? In fact the Tories won the general election just seven months ago claiming that Mr Corbyn was a spendthrift who could not be trusted with the national purse strings. But now Mr Sunak cannot rise in the House of Commons without pledging a billion here or three billion there as if his job is just to keep shovelling dosh…Once again, the virus has changed everything.
Let’s just consider the extraordinary deterioration in government finances that has unfolded since Prime Minister Johnson declared a national lockdown on 23 March. The 2020-21 fiscal deficit envisaged in Mr Sunak’s first budget of 11 March was around £44 billion – so the books would still not balance but, as a proportion of GDP, the deficit would be down to 2.1 percent – respectable by any international comparison. In the Special Report which I co-wrote with James Faulkner in mid-April, I speculated that the deficit would probably come out at north of £150 billion. That was based on a back-of-a-spreadsheet estimate of the cost of the Job Retention Scheme (the government-funded furlough initiative) plus a guestimate of the reduced tax-take for the year.
But the UK government borrowed £55 billion in May alone – that’s nine times more than in May 2019. The latest estimate by the IFS is that the 2020-21 fiscal deficit will come in at near £350 billion – about 18 percent of GDP, and double the 2008-09 deficit. It will still be £150 billion in 2021-22. The UK’s debt-to-GDP ratio will has ballooned in four months or so from just over 80 percent to a little over 100 percent – and is still rising. That is totally unprecedented, even by comparison with the path of public finances during World War II.
What has happened is that state spending has been ramped up to extraordinary levels – well beyond anything in Messrs Corbyn and McDonnell’s dreams last December – while the tax-take (government income) has shrivelled to a level last seen 40 years ago. And about £200 billion of the expected £300+ billion deficit will be financed it now seems by the Bank of England by means of quantitative easing (QE).
We knew that Mr Johnson regarded austerity as a dirty word. But none of us expected a tsunami of new expenditure on this scale – but then how many people foresaw a pandemic in 2020? The pandemic has not deterred him from ramping up a programme of infrastructure investment; rather he has announced a programme to build, build, build in the spirit of FDR’s New Deal. As if this were the age of the shovel and the tunnel rather than that of AI and robotics.
Then there is the issue of social care – i.e. how we pay for the care of the elderly. A National Care Service may be in the offing – and it will be colossally expensive (and will not work for reasons that I shall explain soon).
Mr Sunak, a Goldman Sachs alumnus, understands monetary and financial economics. But does he understand that new spending is easy while curtailing excess expenditure is usually politically impossible? Nine million workers are still furloughed with the state paying 80 percent of their wages up to £2,500 per month. Once the scheme terminates in October a sizeable number of that nine million will be made redundant and will claim benefits thereafter. Mr Sunak’s job retention bonus of £1,000 payable in January will not be enough to forestall a massive rise in unemployment. We learnt yesterday that UK payroll numbers were already down by 649,000[i]. And the cost of possibly four million people unemployed will be massive and enduring – not including the cost of the attendant social disorder.
The furlough scheme might be seen as a one-off emergency measure; but free school meals in the holidays, once granted, are probably here to stay. Not to mention the additional 1.5 million new benefits claimants since March. Then there is the scheme to pay the wages of up to 300,000 young people on universal credit if businesses employ them for at least six months. Britain has benefitted hugely since the Thatcher era from a flexible labour market. What Britain needs is not government interference in the labour market, but comprehensive re-skilling. (Mr Blair’s policy that all youngsters should go to university – whether academic or not – derailed that – and must be undone.) Mr Sunak is one of the few British politicians who has emerged from the pandemic with his reputation enhanced. But how shall we view him in five years’ time?
What we face (as Messrs Cameron and Osborne understood in 2010) is a structural deficit that will only get larger as time goes by. Given an ageing population, healthcare and pension costs will inevitably rise. By 2037 one quarter of the UK population will be over 65. The OBR projected even before the pandemic hit home that the UK’s debt-to-GDP ratio could reach a staggering 282 percent by 2068 if these issues are not addressed. But no one on either side of the political divide has a plan to shore up our finances.
At Mr Bailey’s pleasure…
Andrew Bailey was appointed as the new Governor of the Bank of England by Mr Sunak’s predecessor, Mr Javid. The word in Tory circles is that Number Ten would much have preferred Andy Haldane, the Bank’s highly respected Chief Economist, in the top chair. Mr Bailey is known to believe that it is not the task of central banks to finance their governments’ profligate spending. Although he presided over the slashing of interest rates to an incredible 0.1 percent (let’s call it zero), he would be disposed to increase rates if inflation gains traction. And, given these levels of government debt, even a base rate of just one percent could explode the government’s finances.
Few economists expect a rate rise in the short-term; but many, not least Tim Congdon, believe that inflationary pressures are likely to build up medium-term. There is already a bout of demand-pull inflation in the UK. As people flock back to the hair salons they are finding that prices have gone up substantially. That is partly because hair salon owners have had to invest in protective equipment, and partly because they have had to cover their fixed costs while generating zero revenues for nearly four months. It’s the same story in the hospitality industry.
More significantly, there is the monetary impetus towards higher inflation. In the first ten years of QE in the UK the Bank of England pumped around £450 billion into the UK economy. But since Lockdown March the Old Lady has spewed another £745 billion into the economy. In “normal” economic conditions that would power a surge in inflation. But then we have not been living in “normal” conditions since about 2006.
Across the eurozone-EU, the USA, Japan and even conservative Sweden central banks are printing money to lend to governments with peculiar results. About one fifth of the total global stock of government debt now carries a negative yield. That means that investors are paying governments for the privilege of lending them their cash. That threatens the viability of institutional investors such as pension funds and insurers, long-term.
And supposing Mr Bailey were to decide that enough is enough – and refuse, point-blank, to purchase any more newly issued gilts? And what if the pension funds were to go on a gilts strike? That would be the moment that the government would have to raise taxes sharply in a hurry. No doubt people who incline to the Left would welcome higher spending and higher taxes – perhaps wealth taxes on “the rich” (which the super-rich will escape and which will be borne by the poor, long-suffering middle classes who already pay wealth taxes in the form of inheritance tax). And would wealth taxes encompass housing and pension assets? But is that what the Tory government was elected to do? Next time round, if you want socialism, you’ll be able to vote for Sir Keir Starmer rather than the Tory Keynesians.
The fiscal expert Sir Edward Troup considers that, sooner or later, substantial tax rises are inevitable[ii]. At the moment, given the fragility of the economy, raising taxes is out of the question as by so doing any recovery could be throttled. Capital gains tax, Sir Edward says, needs to be reformed; but that will not be enough. At some point the “big” taxes – income tax, national insurance and VAT – will have to be hiked. A rise in income tax of just one penny in the pound would raise about £5 billion – though even that is chicken feed when you’re running a deficit of £300 billion. And at present average wages are falling for the first time in six years so the marginal revenue associated with a rise in income tax is diminishing.
When taxes rise every economically active household will be affected, with the young more adversely impacted than the old. The IFS reckons that 40 percent of under-25s are either furloughed or unemployed as compared to 25 percent of 35-54 year-olds. That is another reason to end Mr Osborne’s “triple lock” on the state retirement pension.
At the moment, according to the latest IMF Fiscal Monitor, the tax burden in the UK comes in at 36.6 percent of GDP – as compared with 52.8 percent in France. In Hong Kong and Singapore it is about 20 percent. We can be sure that Labour will argue that higher taxes are both feasible and desirable.
The only way to dig the country out of this debt-and-depression pit is to foster dynamic economic growth. This, in turn, can only be achieved if Britain’s productivity, which has been mediocre since the financial crisis, is addressed. There will be some opportunities to do that post-31 December. But will the Johnson government seize them?
There is a school of thought that inflation is good because it reduces the debt burden in real terms. But higher inflation would also mean higher interest rates and thus much higher debt service costs. And about one third of outstanding gilts are index-linked anyway, making inflation irrelevant. We shall probably be living with eye-watering levels of debt for the foreseeable future.
Winter is coming
Public finances are for now out of control. Sterling is not a reserve currency and the UK is running a huge trade deficit to match its fiscal one. We are probably about to start trading on WTO terms with the EU and a comprehensive trade deal with the USA looks unlikely (apparently, Mr Gove, who is de facto Deputy PM, is against one). China is turning nasty. (The Beijing regime was always nasty but the Westminster elite pretended otherwise.)
The UK right now looks lonely – especially given that the most Anglophile President of my lifetime is fighting for his political life. The obvious grand strategy would be to re-unite the English-speaking democracies which acknowledge HM The Queen as their Head of State in a common economic zone. Secretary of State for Trade Ms Truss aspired to something along those lines – but, apparently, she is on the way out, having fallen foul of Mr Cummings.
And the onset of winter – just four months from now – is filling policy-makers with apprehension. A report released this week by the UK Academy of Medical Sciences warned that a second wave of Covid-19, combined with an outbreak of seasonal flu, could result in a further 120,000 deaths in the UK. There may or may not be a vaccine readily available by Q1 2021 – although there was some encouraging news on that front this week with pharma stocks gaining accordingly. That notwithstanding, we should brace ourselves for more bad news.
I’ll be exploring the topic of the new monetary policy further and in a global context in the August edition of the MI magazine. I’ll explain how, just as we have sustained zombie corporates through near-zero interest rates, we are entering the era of zombie states: debt-strapped nations which are quite unable to grow and which are going nowhere. In fact, they already exist.
On another theme, those who malign President Trump for his handling of the pandemic in the USA might reflect that (as we now know, thanks to his aggrieved niece, Mary) his own grandfather died of the Spanish flu in 1919, forcing his father, Frederick, to become head of the family aged 12. It’s very interesting that the President has never mentioned that.
This week, the President shook up his campaign team as polls revealed he is trailing Mr Biden by double digits. Some believe he has already lost. I’ll spell out the downside risks of a Biden presidency for all investors shortly.