There is a new variant of the global virus spreading again after being subdued throughout 2020. This is a very dangerous variant and if it takes hold will guarantee massive human suffering, and, a further, substantial shift in national income towards the top-end-of-town. I refer to the creeping infestation that is starting to pop up claiming that austerity will be required to pay for all the “profligacy” associated with government approach to the pandemic. I have seen this virus in the wild and it is creepy and being spread by those who seem to want to gain attention as time passes them by. Overheating threats, austerity threats – it is all part of the economics establishment trying to remain relevant. A vaccine will not work. They need to be permanently isolated.
In Britain, the austerity mavens are creeping out of the woodwork.
The Prospect Magazine article (January, 26, 2021) – In defence of austerity – written by a “former head of Treasury”
The sub-title begins the twisted framing: “Free money is in vogue—but there’s no such thing” – the only cost of the Bank of England buying all the debt being issued by H.M. Treasury is the wear and tear on the computer keyboards that type in the numbers.
The pandemic has exposed to an increasing number of people that there is ‘free money’. They are realising that numbers just appear in bank accounts.
Perhaps this former official should watch the recent speech and subsequent Q&A from the Reserve Bank of Australia governor, Philip Lowe to the National Press Club in Canberra (February 3, 2020).
He was asked by a journalist in the Q&A:
Could you please explain in the simplest terms, perhaps keeping in mind your audience outside of this room, when the RBA decides to purchase government bonds, as it’s doing, where does the RBA get that money from? Is it simply a matter of printing new money? How does it work?
The Governor replied:
Well, it’s not printing money. People think of it as printing money, because once upon a time if the central bank bought an asset, it might pay for that asset by giving you notes, you know, bank notes. I’d have to run my printing presses to do it. We don’t operate that way anymore, obviously because we live in an electronic world. When we buy a bond from a bank, the way we pay for that is credit. The banks, we’ll use Westpac, who’s the sponsor of today’s event as an example. If we bought a bond from Westpac, we would credit Westpac’s account at the Reserve Bank, and that creates the money electronically. That’s how a modern system works. And then Westpac could use that money hopefully to make some loans to some of its customers. But we can create money electronically, and that’s what we do these days …
The Central Bank is the only one who can do that. That’s the unique feature of a central bank …
Free money folks!
As an aside or diversion to today’s blog post, the Governor was also put on the spot about Modern Monetary Theory (MMT).
A journalist asked him:
Governor, I thought I better throw in about the old Modern Monetary Theory debate, because it rages on. We’ve got this huge amount at the moment, obviously, of bonds being bought last time around during the GFC, perhaps the inflation a lot of people predicted didn’t come, but if it does at some point, obviously a massive or a spike in inflation is a pretty bad thing for an economy. Are you looking at any other warning signs aside from just inflation itself as to whether that’s a threat in the future, given all the government bond buying at the moment?
The Governor in denial (unconvincing) mode replied:
Well, just for clarity, we’re not involved in Modern Monetary Theory, which is the central bank directly financing the government. We don’t do that. We will not do that, it’s not on my radar screen. So you may have heard me before say Modern Monetary Theory – there’s not much monetary, not much modern, not much theory in it. But the more substantive part of your question was is there inflation risk? That’s more serious than the one I’ve been articulating. It’s possible. I think it’s very unlikely again, because to have sustained increases in inflation, we’ve got to have sustained increases in wages. And for the reasons I was talking about before, I just don’t see that on the horizon.
First, his characterisation of MMT reveals his desire to shut down the debate by using a simplistic characterisation of our work. I won’t deal with that here.
Second, it is true that the central banks who are buying up massive quantities of government debt are not “directly financing the government” (left pocket-right pocket stuff) because the bond auction charade is on-going.
Debt is issued in the primary market and the dealers know they have a high probability of off-loading it to the respective central bank via secondary bond market purchases.
So we are just playing with words.
The reality is that the central banks (left pocket) is putting currency into the treasury (right pocket) accounts, which the accounting conventions then allow the treasury to spend.
This is the mainstream taboo.
Third, mainstream theory predicted that as a result of central banks breaking the taboo not to purchase government debt that inflation would accelerate.
So the better question to the Governor is why hasn’t inflation accelerated in the face of the expansion of central bank balance sheets (buying government debt)?
Anyway, back to the former H.M. Treasury official, one – Nick Macpherson – claiming austerity is inevitable for Britain.
The article rehearses all the narratives.
He acknowledges that there is record peacetime debt “set to rise” and the government is issuing 10-year bonds at near zero interest rates and no impacts on the exchange rate.
And “the markets haven’t batted an eyelid.”
And why would they? The level of corporate welfare is also at peacetime records.
So as more people realise that the rising debt is not going to result in disaster – a realisation that Mr Macpherson (the Eton-Oxford education Baron of Earl’s Court) – calls “A cosy consensus has emerged across left and right” – it is getting harder to rehearse the debt phobia narratives.
The ‘Baron’ recognises the empirical world is not supportive of the debt phobia narratives (Japan, low yields everywhere, etc) but hangs onto it anyway.
He invokes the ill-fated decision by Britain to enter the “Exchange Rate Mechanism in 1989” only to leave in 1992 as a reason that the “case for fiscal rectitude remains as strong as ever.”
I laughed when I read that.
The British government had initially refused to join the EMS but was clearly divided between the pro-European camp and the Thatcher camp.
The latter correctly saw that membership of the EMU would compromise Britain’s policy sovereignty.
However, with Thatcher’s star on the wane and the elevation of the pro-European John Major to the role of Chancellor to replace Nigel Lawson, the Tories turned towards joining the ERM.
The decision confronted British jingoism (Thatcher’s anti-German sentiment) with the ahistorical ideology of Monetarism, which were both in play during the Thatcher years.
Drawing on the Monetarist influence, Major and Foreign Secretary Douglas Hurd argued that Britain could expunge the high inflation left over from the oil price shocks if it tied the pound to the German mark, which was equivalent to saying that the Bank of England would passively follow Bundesbank interest rate policy.
At the time the Bundesbank was pushing interest rates up beyond the level that would be considered appropriate for a recessed British economy.
Major and Hurd won over Thatcher and Britain joined the ERM on October 8, 1990, while mired in a deep recession with an overvalued currency (2.95 marks per pound).
Once Major took over as Prime Minister in November 1990, following Thatcher’s demise in the same month, the British Government touted Britain’s membership of the ERM and the so-called ‘inflation anchor’ as the a central aspect of Britain’s anti-inflation policy.
It was a very misguided decision.
In the late 1980s, governments were abandoning capital controls, which had previously been the reason currencies were relatively stable in Europe, because of the introduction of the Single European Act 1986 which stipulated that all capital control had to be abolished by July 1, 1990.
The capital controls had protected central banks from speculative attacks on their foreign exchange reserves and allowed nations to focus more effectively on domestic policy targets (economic growth and low unemployment).
Once the controls were eliminated, were eliminated, central banks became vulnerable, as they had to focus policy on defending the nominal exchange rate parities.
By 1992, this vulnerability became acute.
The referendum failure in Denmark on June 2, 1992 brought some reality back into European financial markets by pricking the false bubble of currency stability.
It was obvious that Italian and British competitiveness had been severely eroded by their higher inflation rates and that their currencies were substantially overvalued, particularly against the mark.
The politicians pushing for the EMU saw the dark clouds emerging in the international currency markets as a sign that they had to move more quickly to introduce the single currency and impose harsher fiscal rules on Member States.
The Bundesbank didn’t help matters when it pushed up interest rates on July 16, 1992 because of its concern for rising inflation associated with the reunification.
The increased German interest rates forced Germany’s neighbours to increase their own interest rates beyond the levels deemed prudent given their domestic circumstances.
Monetary policy was locked into ensuring the exchange rates were stable and higher unemployment was the casualty.
The increasing political backlash to the high unemployment raised further doubts in the financial markets as to the commitment by policy makers to maintaining the ‘no realignment’ policy.
The EMS was now on very shaky ground.
And with Italy going into currency crisis and resisting devaluation, their interest rates skyrocketed.
France was also in crisis as it approached the ratification referendum on September 20 (especially after the Danish result).
And in Britain was enduring high unemployment and didn’t want to devalue (national pride type justifications).
It demanded Germany reduce interest rates to ease the speculative pressure on the exchange rate but the Germans refused, pushing the instability on Italy and Britain.
The obvious happened and while tying the pound to the mark lowered inflation, it was at the expense of a deepening recession and worsening unemployment.
By the ‘Summer of ’92’, the pressure on the pound was unbearable.
And then Wednesday, September 16, 1992 dawned, and the ‘skies became darker’ as the day progressed.
As the day unfolded it became obvious that Britain could not tie its currency to the mark and expect to avoid speculative attacks.
Black Wednesday was inevitable for Britain because the Government had been blinded by Monetarist ideology and failed to appreciate what ERM membership meant for domestic policy – sustained high unemployment and on-going austerity.
The decision to enter the ERM was driven, in part, by John Major’s delusion that the sterling would replace the German mark as the region’s anchor currency.
The episode tells us nothing about the need for on-going “fiscal rectitude”.
It only told us that a nation that surrenders its currency sovereignty to join a currency arrangement where a strong industrial exporting economy dominates (Germany) then it has to expect to maintain austerity indefinitely if it wants to keep its currency within the agreed fixed bounds.
But the real lesson was the madness in joining such arrangements.
The 19 Member States of the Eurozone live that madness on a daily basis.
Britain went free on Black Wednesday, 1992.
So that little historical reference doesn’t help his case at all.
The question that the sound finance types refused (and refuse) to ask is why would Britain want to fix its currency. That was the issue.
At least Margaret Thatcher understood that it was not wise to have anything to do with the ERM, especially with Germany as the dominant nation and with the Bundesbank demonstrating a consistent history of refusing to behave according to the rules set, which required symmetric foreign exchange market intervention.
Mr Macpherson then tries another tack – the inflation and market pressure tack.
It always descends into this.
So he knows “the Bank of England can buy Britain’s debt.”
But it won’t do that “indefinitely” because it “took many years to win its independence”. The ‘win’ was not an operational shift just a piece of political window dressing that legislative change could alter any time the Government chooses.
But why would the Bank suddenly stop buying government debt?
Well apparently because “concerns about inflation are likely to revive”.
The purchase of the debt does not alter the inflation risk built into the spending that the debt issuance matched (note: did not fund).
The Bank of England could just type zero against its British government debt holdings and nothing material would happen.
The inflation risk was in the spending and that has flowed into the economy and is doing its thing. And I haven’t seen any signs of inflation or inflationary expectations as a result.
He also claims that the UK is different to Japan, which by implication means he is conceding that there should be no concerns about Japan’s deficits and debt situation.
The difference, apparently is that:
… the UK doesn’t have an effective “captive market” of savers. The British people, and the governments they elect, have always favoured consumption over investment. That means the UK has to rely on the kindness of strangers, as former governor Mark Carney once put it, to finance deficits. Foreign investors own a little under 30 per cent of Britain’s debt. Lose their confidence and we have a problem.
Kindness is not involved. Bond markets are not about kindness or generosity.
It is true that the Overseas Holdings of Central Government liabilities amount to 27 per cent of total as at the September-quarter 2020.
You can find all the data on British government debt from the UK Debt Management Office – Gilt Market Page.
The Bank of England’s share is now 30 per cent and rising.
The following graph is very interesting.
It shows total Central Government liabilities and the debt held by Overseas Holdings and the Bank of England.
The rising purchases by the Bank of England since the GFC have tracked the Overseas Holdings.
You could construct this as saying that the British government is not exposed at all to foreign purchases of its debt.
But that would be falling into the trap that their purchases mattered in the first place.
Remember, the DMO auctions the gilts and the auction clears every time because the bid-to-cover ratios are typically high.
So if the foreigners withdrew from the auction perhaps the yields would rise a little until the Bank of England used its currency capacity to suppress them again.
It is a nonsense to think that British government spending is at the best of these ‘kind’ strangers.
If they “lose their confidence”, then the UK doesn’t have a problem, they do. They lose their dollop of corporate welfare and the British government doesn’t blink an eye.
Which then makes the next historical reference by Macpherson rather ludicrous.
One might easily just say – Not this again?
The UK crises of 1976 and 1992, and the global one in 2008, involved a slow build-up of risk, followed by an inflection point as investors lost confidence and the dam burst. The government should be careful.
1992 – see above – situation is not applicable to Britain’s floating currency.
1976 – The government lied to the people that it needed to borrow currency from the IMF. It just want to shift the blame for their growing interest in austerity as Dennis Healey became infested with Monetarism onto an external force so they could keep sweet with the unions under the social contract in place at the time.
Here are some analyses of that period:
1. British trade unions in the early 1970s (March 31, 2016)
2. Distributional conflict and inflation – Britain in the early 1970s (April 7, 2016)
3. The British Labour Party path to Monetarism (April 13, 2016).
4. Britain approaches the 1976 currency crisis (April 21, 2016).
5. The 1976 currency crisis (April 26, 2016).
6. The Bacon-Eltis intervention – Britain 1976 (May 11, 2016).
7. The British Cabinet divides over the IMF negotiations in 1976 (June 8, 2016).
8. The 1976 British austerity shift – a triumph of perception over reality (June 13, 2016).
9. The conspiracy to bring British Labour to heel 1976 (June 15, 2016).
2008: The major shifts in the gilts market came from the collapse of financial institutions share and the rise in the Bank of England’s share of total debt.
Here is a graph showing monthly bond yields for 10-year British government bonds from February 2008 to February 2021.
Spot the private bond markets losing confidence? You might be better counting the fairies on a pinhead!
Yields didn’t particularly go wildly up and the trend has been firmly downwards. The private investors can’t get enough gilts.
And in closing we get the ‘if’, ‘might’, ‘could’ sort of fear mongering.
Sure, interest rates might go through the roof as inflation accelerates out of control. And then the sky falls in.
Okay, probability very low.
And if, perchance, things turned ugly, the government could just alter the institutional arrangements governing the gilts market and legislate for the Bank of England to take care of things
And in the final sentence you realise Macpherson is of the old Monetarist persuasion and hasn’t kept up with the literature.
He wrote, as if to terminate discussion:
But in the end, expenditure has to be paid for.
Yes it does.
And when the productive resources (and goods and services) respond to the government spending injection, it is at that point that the spending is ‘paid for’.
It is obvious the British government in liaison with its central bank can spend whatever amounts it wants until the end of time. Financially, there is no question about that.
They can put whatever elaborate administrative and accounting hurdles in place as they like, but they cannot alter their intrinsic capacity as the currency-issuer.
What they cannot control, as easily, is the availability of real resources that it needs to conduct its socio-economic policy program.
That is enough for today!
(c) Copyright 2021 William Mitchell. All Rights Reserved.