Is the Bank of England financing the UK government?

Today’s subject does have historical echoes as who can consider this sort of topic without thinking at least once of Weimar Germany with its wheelbarrows full of bank notes and Zimbabwe with its trillion dollar note? These days we need to include Venezuela which cannot even provide a water supply now. There are three good reasons therefore why central bank Governors should tread very carefully around this particular subject. So it was curious to see the Governor of the Bank of England long jump into this particular pit yesterday in a Sky News podcast.

The government would have struggled to fund itself if the Bank of England had not intervened during the market “meltdown” of COVID-19, the Bank’s governor has told Sky News.

In an exclusive interview, Andrew Bailey said that in the early stages of the virus, Britain came within a whisker of not being able to sell its debt – something many would characterise as effective insolvency.

There are elements of the first paragraph which are true but “came within a whisker of not being able to sell its debt” is a curious thing to say and if we are being less kind is in fact outright stupid. We are also guided by Sky News to this.

While there was an uncovered gilt auction in 2009 – in other words, the government was unable to find buyers for all of the debt it was selling to investors – it was widely seen as a one-off.

They are trying to make this sound a big deal but it isn’t really. For example over the past few years I can recall Germany having several uncovered bond or what they call bund auctions. Nobody considered them to be within a whisker of being unable to sell their debt, in fact Germany had a very strong fiscal position. Here as an example id CNBC from the 21st of August last year.

The bund, set to mature in 2050, has a zero coupon, meaning it pays no interest. Germany offered 2 billion euros worth of 30-year bunds, and investors were willing to buy less than half of it, with a yield of minus 0.11%.

What was it about having to pay to own the bond and do so for around 30 years that put investors off? That of course provides the clue here which both Sky and Governor Bailey either have not figured out or are deliberately ignoring. The debt did not sell because of the price at which it was offered was considered too expensive. Germany could have sold its debt if it was willing to pay more,

How did the Bank of England respond?

Mr Bailey warned that the dislocation in markets in March was even more serious, prompting the Bank to intervene with £200bn of quantitative easing – the biggest single cash injection in its history.

Actually it also cut Bank Rate to 0.1% and there is significance in the date which was the 19th of March. That is because the price of our debt was rising which has been summarised by the Governor like this.

The governor said: “We basically had a pretty near meltdown of some of the core financial markets.

“We had a lot of volatility in core markets: the core exchange rate, core government bond markets.

“We were seeing things that were pretty unprecedented, certainly in recent times. And we were facing serious disorder.”

If we look at the UK we were seeing a rise in Gilt yields as the benchmark ten-year yield rose quickly from an all-time low of 0.12% on the 9th of March to 0.87% on the 19th. We have seen much worse in the past and I have worked through some of them! In historical terms we still had very low Gilt yields and so it looks as if we are seeing another case of this from a central bank.

Panic on the streets of London
Panic on the streets of Birmingham
I wonder to myself
Could life ever be sane again? ( The Smiths)

The job of calming down world financial markets was a dollar issue and was dealt with the next day by the US Federal Reserve.

The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing a coordinated action to further enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements.

We will never know now how much things would have improved in response to this as a panic stricken Bank of England fired as many weapons as it could. As a technical factor overseas QE bond buying helps other markets via spread and international bond buyers. Whether that would have been enough is a moot point or as central bankers regularly try to point out, the counterfactual! We do know from experience that it is a powerful force exhibited in say Italy which only saw bond yields rise to 3% and that only briefly recently as opposed to 7% last time around.

Anyway even the relatively minor rise in UK Gilt yields has the Governor claiming this.

Asked what would have happened had the Bank not intervened, Mr Bailey said: “I think the prospects would have been very bad. It would have been very serious.

“I think we would have a situation where in the worst element, the government would have struggled to fund itself in the short run.”

Okay so he is in effect claiming to have funded the government although not long afterwards he claims that he is not.

The Bank’s decision to create so much money and use it to buy government bonds, including an extra £100bn only last week, has prompted some to ask whether it is in effect financing the government’s borrowing. Mr Bailey rejected the accusations of “monetary financing”.

“At no point have we thought that our job was just to finance whatever debts the government issue,” he said, pointing out that the objective was to ensure economic stability.

Ah so not inflation targeting then?

Comment

The situation here was explained back in the day in an episode of Yes Prime Minister and the emphasis is mine.

We believe that it is about time that the Bank ( of England) had a Governor who is known to be both intelligent and competent. Although an innovation it should certainly be tried.  ( Treasury Permanent Secretary Sir Frank)

As you can see this was a topic in the 1980s and it still is. The present Governor was in such a rush to indulge in “open mouth operations” to boast about his role in the crisis that he not only overstepped the mark he made some factual errors. The UK government could have funded itself but it would have to have paid more for the debt. It could have activated the Ways and Means account earlier than it did as well if needed ( we looked at this on the 9th of April). So we see several of my themes at play. The Bank of England is implicitly but not explicitly funding the UK government right now just like the Bank of Japan, ECB and US Federal Reserve,something I pointed out on the 6th of April.

Let me finish off on the subject of monetary financing. The simple truth is that we have an implicit form of it right now.

This means that it is about as independent as a poodle (another theme). It tends to panic in a crisis and new Governor’s tend to reward their appointment with an interest-rate cut. I cannot take full credit for the latter as that was in Yes Prime Minister as well.

Also in the podcast was a reference to this.

The governor signalled that the government may need to consider finding a vehicle to resolve the many bad debts left by companies that fail over the COVID-19 period.

“If (a bad bank) were to be contemplated, it would be as a sort of an an asset management vehicle: how do we manage small firms through a problem that they would get as a result of the loans that they’ve taken on to deal with the crisis?”

Somebody needs to tell him the UK taxpayer has one of those and it is called Royal Bank of Scotland with a share price of £1.24 as opposed to the Fiver we “invested” at.

Let me finish by giving Governor Bailey some credit for a burst of much needed honesty.

“We’ve been mis-forecasting the labour market for some time because the traditional models just didn’t seem to hold.

We can add that to his apparent enthusiasm for changing policy on the subject of any QT in a direction I have been recommending since September 2013.

Podcast

 

 

25 thoughts on “Is the Bank of England financing the UK government?

  1. It never fails to amaze me the way governors, with arrogance and misplaced pride brag about their ability to do large swathes of QE and interest rate cuts, what should really be a source of great shame and much concern is delivered to the markets and the citizenry as a triumph of their intellectual superiority to overcome almost impossible problems, problems which they have created by excessive credit creation and lending leading to grotesque asset bubbles. The natural correction of which is being prevented by repeating the same policies that got us into this mess.

    • Yes i remember after the EU referendum when Carnage was lowering interest rates, printing more via QE and dishing out free money to the banks and homeowners via TFS; he was described by remainers as being a “safe pair of hands” and “the only grown up in the room”.

      These “educated” simpletons failed to see it was this corruption that led to the epic inequalities which is one of the reasons the plebs voted to leave the EU.

      • So anyone who voted to leave the EU is a pleb? An offensive remark in my opinion.
        I assume you do not consider yourself a “pleb” ?

        • I voted to leave the EU. Yes im a pleb.

          Everything is offensive these days, and people are constantly on the lookout to be offended and play the victim. I could not care less about such people.

  2. it is always the non-govt sector that ‘finances’ the govt sector. The central bank and the banking system can intermediate that financing, but it is always the non-bank private sector (plus the foreign sector) that ends up holding the net financial assets that are the counter of any government sector liability. Looked at another way, you can say that the govt sector issues its own liabilities and thus has a debt, so that the private sector and foreign sector can hold net £ financial assets.

    Govt sector liabilities can only be:

    coins and banknotes, usually held by domestic households, approx £80bn
    reserve balances, only held by banks, with the banks having offsetting customer deposits, £675bn
    NS&I savings products, usually held by domestic households, £175bn
    Gilts, usually held by pension funds and insurance companies and foreign entities, £1,070bn

    The above numbers are rough, taken from memory, but add up to ‘the national debt’ of £2trn.

    The way that government financing works is that if, say, parliament approved a payment of £1m to me, Treasury would instruct my bank, Barclays, to credit my account with £1m and the BofE to credit Barclays reserve account by £1m. One of the exchequer accounts at the BofE would be debited by £1m. If it was zero, the balance of the Exchequer would now be negative £1m. At this point the government has created its own liability, a debt, of £1m. It hasn’t borrowed anything. It just has a negative balance of £1m. The BofE and Barclays both have a negative £1m and positive £1m balance and I have a positive £1m balance. The exchequer account has a liability, I have an equal and offsetting financial asset. Barclays and the BofE are both intermediating between us, with positions that net out.

    The govt could sell a bond to Barclays, in which case the BofE steps out and is no longer intermediating, but Barclays still is. The Govt could sell a bond (or an NS&I savings product) directly to me, in which case both the BofE and Barclays would step out and no longer be intermediating, with me holding a liability of the Treasury directly. I could exchange my £1m bank deposit for £1m in fifties, in which case Barclays steps out, but the BofE is still intermediating between me and the Treasury.

    Whatever happens, if the Govt sector has a liability, somebody in the private sector has the offsetting financial asset. it is that person who is ‘financing’ the government. It doesn’t actually matter that much if that person holds banknotes or coins, a bank deposit with his bank holding reserves, holds NS&I savings products or holds Gilts. They’re all just liabilities of the govt sector, financial assets of the non-govt sector.

    • Gosh, it’s actually quite simple, when you put it like that!
      Many thanks, I have a much better picture of it now.

      • if the private sector owned liabilities of the govt sector with a negative interest rate, that would cause a gradual drain of net financial assets from the private sector. A positive interest rate causes a gradual add of net financial assets to the private sector.

        Interest on govt debt is no different to any other govt transfer. If it is the govt sector paying the private sector, that’s an add of reserve balances (initially) and any payment from the private sector to the govt sector is a drain of reserve balances

        • OK. so in this description in the EZ its still the nations, ie the entities who collect tax and issue Gilts etc who produce the assets . Even though its issued in Euro deniminations, there is a difference between say French Euros and German Euros. Its still the nations CBs who are one of the intermediaries, but so is the ECB, what role does that really play?
          In the US the federal state issues the assets, the Fed is an intermediary, but both the Fed govt and State govts collect tax in varying ways.

          • if a government is the issuer of the currency, it has to spend first and tax after (and sell bonds after, but selling bonds isn’t strictly necessary)

            If a government is not the issuer of the currency (such as a EZ govt or a State government in the US) then it has to tax first (or otherwise gain revenue) or borrow first before it can spend.

            Anyone in the EZ can hold a EUR denominated financial asset (an IOU). To do so, somebody else has to write that IOU. This can be one of the EZ governments, but in this respect they are no different to any household or corporate that can also do so.

            The only truly 100% safe EUR financial asset is a liability of the Eurosystem of central banks (lets just call it the ECB), which are banknotes, coins or reserves. Whilst the ECB could simply issue these (and be technically insolvent which wouldn’t impede it any way), it does so by acquiring financial assets, which are mainly liabilities of the EZ member governments (but also companies and banks and households (indirectly via mortgage backed bonds))

    • ” At this point the government has created its own liability, a debt, of £1m. It hasn’t borrowed anything.”

      exactly , it came from no where at all , from thin air.

      normally not a problem , so long as it can be paid back ( even over a term of 100’s years , and the interest of course ). When other countries, banks and other institutions do no longer believe that or need that currency then there’s a problem for the issuing country.

      Forbin

      • All financial instruments come from nothing and return to nothing. They are all a variation of the simple IOU. They are created out of nothing, with a writer or issuer that assumes a liability or obligation, and a holder who has a claim over the issuer.

        The net value of all financial instruments always starts out at zero, remains zero, and returns to zero when cashed in or redeemed.

        This is true of state issued money (currency), bank issued money (deposits), govt bonds, corporate bonds, equity. They are all created out of nothing. They are all a variation of the simple IOU that promises the holder something, which the issuer has to deliver.

        When the state issues its money, there’s nothing further to be ‘paid back’. The money issued by the state should be thought of as tax vouchers. The private sector uses them to settle the tax bills sent out periodically by the state. It is the tax bills that create demand for the state issued money and give it value. Once the tax vouchers get established as a useful means of exchange and/or a store of value amongst the private sector, the government has to issue more than it takes back in settlement of tax bills. That which is left in circulation (which the state might offer to swap for a different form of liability, such as a bond) is the net financial assets held by the private sector. Provided there is always the expectation that the government will continue to send out tax bills, there will always be demand for these tax vouchers.

        The debt of the govt sector, which is exactly equal to the net savings of the non-govt sector, should be thought of as tax vouchers issued, but not yet collected back.

        They can always be collected back. It’s trivially easy. But that doesn’t mean they should all be collected back. Otherwise our net savings go to zero and what would we use a s high level means of exchange?

    • Thanks for that! It’s nice to have the flow of money and the balance sheet effect explained to a non banking layman

  3. Great blog and great podcast as usual, Shaun.
    Tiff Macklem, the new governor of the Bank of Canada, gave his first speech as governor yesterday, and unlike Andrew Bailey he did make it clear from the start that meeting the inflation target remained the first priority even at a time of coronavirus-induced recession. He also gave a statement of the federal government’s role in formulating monetary policy that couldn’t be clearer: “It’s important to note that our framework is set out in an agreement established with the government and renewed every five years. This sends an important signal that the democratically elected government and the Bank agree on our policy goal.” It may not have been entirely appreciated by our government, who often like to pretend that things like our new higher target for the “true” rate of inflation from the 2016 renewal agreement are the central bank’s doing and have nothing to do with them.
    By the way, Tiff served with the Department of Finance during the financial crisis, and of course Carney also had a senior position in DOF, so we have our questions about the independence of our central bank too. I suppose in the final analysis in a democracy no central bank can or should be fully independent. If it is, as Lincoln would say, the people have ceased to be their own masters.
    Bonne Fête nationale du Québec! (It’s actually tomorrow, June 24.)

    • Hi Andrew and thank you

      Your reply made me look up the track record of the new Governor and he looks an establishment man which is not a compliment. As you say he has bounced between the central bank and the department of finance in his career. Still as far as I know he has avoided the accusations of political ambitions which so dogged Mark Carney in Canada.

      As to the remit I prefer your five-year version to the UK annual renewal as these things are supposed to be for the medium-term. Anyway enjoy Quebec Day.

  4. In other news, the PM announces that social distancing was all a sham: the range at which people are, or are not, infectious does not change with the R number.
    Note the ubiquitous term, “Economic Reset.”
    THAT is what all this has been about, what was planned in Davos in late January, and which 400,000 gave their lives.
    Still, 350,000 of them were old and decrepit, so no great loss, & it’s not as bad as a war, which is what the bastards usually do to us when they fuck up.

  5. No great surprise to see this come up as many people, especially those fond of spending, seem to think a magic money tree exists and we can spend what we like, provided the BoE prints the readies to buy the bonds. While it is true that debt will sell if you offer the right return (a few quid was made from some very high yield Greek bonds), it is that spectre of default that lingers in the background. Hence, central bank efforts to keep rates down by printing money as the reality for Greece and Italy has been a bit scary (the Quitaly party in Rome now has one MP, who was slung out of the 5-Star party). While we regularly expect Argentina to default and Russian broke LTCM, the worries are lapping st London’s door and it will be this problem as Sunak tries to cut consumption taxes under the threat of a Sterling crisis that is going to force a rate rise. Especially if there is a no-deal with the EU.

    • Hi Dave
      I remember the days when UK long-dated Gilts yielded 15% which they did very early in my career. So time for panic was maybe back then rather than now. As you say though in the modern era the “independent” central banks will not permit it. The problem with predicting currency falls is that everyone is at the QE game…..

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