Background on recent policy response
The economic policy response to the pandemic in the UK has been swift and varied: HM Treasury has introduced the Job Retention Scheme (now extended to October), providing partial wage support for 7.5 million furloughed workers, income support for the self-employed, deferment of VAT payments and various schemes to support business loans (in excess of £14bn to date); while the Bank of England (BoE) has reduced base rate to 0.1%, increased the size of the Asset Purchase Facility (by £300bn to date and with likely increases to come, given the latest CPI estimate of 0.5%), released bank capital and provided direct lending support (through the Term Funding Scheme and COVID Corporate Financing Facility).
The combined scale of response exceeds that of 2008/9 (and its aftermath); indeed, the fiscal response is expected to reach a size unparalleled since the Second World War, despite which it is predicted that the decline in real GDP this year will approach 13%. Few would disagree with the broad fiscal content of the response – measures to support wages and cash flow (as well as the `automatic stabilizers’) are undoubtedly an appropriate attempt to mitigate the decline in demand resulting from the closure of large parts of the economy; however, many are concerned about the medium-/long-term impact of such unprecedented (in peace time) fiscal and monetary intervention.
Are asset purchases direct financing?
In particular, there are concerns that the current policy combination of increased government expenditure and central bank purchases of government debt is the ‘worst of both worlds’, combining the inflation risks of money printing with the problems of large public debt. Amongst economists there is also the issue of erosion of central bank independence, one of the supposed pillars of monetary policy in recent decades. Are such concerns justified?
Firstly, the formal institutional structure in the UK is that of central bank operational independence, with the price of newly-issued government bonds determined on the primary gilt market, while the BoE asset purchases are conducted as a reverse auction between the Bank and private bondholders, as part of the secondary market. Although BoE asset purchases are not quite direct monetary financing of government expenditure, given the increase in asset purchases agreed at a special MPC meeting one week after the budget and that gilts are eligible for purchase by the Asset Purchase Facility one week after they have been issued, the possibility of some degree of co-ordination between the Treasury and BoE in order to ‘backstop’ the gilt market does not seem entirely fantastical.
Given the decision for an additional £100bn of asset purchases at the most recent MPC meeting it seems possible (or even likely) that the APF will pass £1trn within the near future. There is little evidence of demand-side inflationary pressures currently, with a falling rate of consumer price inflation (there might be some evidence of increased prices of some consumer goods, but we believe this would be likely the result of the temporary mismatch between demand and supply of specific goods rather than a general circumstance). Given also that inflation has been at mild levels throughout the period of BoE asset purchases it could be argued that there are no reasons to be concerned about this ‘money printing’ leading to undesirably high inflation.
However, this is not to conclude that there are no risks from quantitative easing (QE). The creation of reserves on such a large scale represents a significant expansion of the base of the financial pyramid. By easing credit conditions and encouraging investment in riskier financial assets quantitative easing is likely to lead to ‘asset price inflation’ (indeed, the evidence from the previous phases of QE shows that the strongest effect of the policy was to boost asset prices), engendering a further mis-allocation of resources towards the City and weakening the real recovery. Related to this, there is some evidence that QE worsens inequality.
The second major concern about the current economic policy is that of the increase in public debt. The approval of the recent fiscal package together with the recession has brought public debt to an estimated level of 100% of GDP. A similar increase in the debt ratio occurred over a period of two years in the aftermath of the financial crisis, which as we know was followed by 10 years of so-called fiscal austerity, with the previous Chancellor still mentioning it in his 2018 speech at the Mansion House.
However, differently than 2009, the cost of the debt is now less of a concern, with most of the gilts yield curve now below 1%, and as soon as the major economies are back on the recovery path, central banks around the world will gradually turn their attention from growth towards inflation. As monetary policy rates eventually rise and the risk premium potentially increases (given the high public debt/GDP ratio), budgets will be likely to be under pressure (again) in the near future.
To repay the debt via government budget surpluses, without causing a recession or the overthrow of the government, will never be possible and thankfully it isn’t necessary. UK debt is almost entirely Sterling-denominated, mostly held by UK investors and the yields on government bonds are close to zero (factors which those who allude to Zimbabwe and Weimar Germany typically neglect), with the consequence that the debt can be rolled-over indefinitely, with the co-operation of the Bank of England if need be. The political risks of a large deficit being used to justify limited public spending, including limited public sector wage growth, are minimal during the crisis phase, but renewed austerity measures are not necessarily off the table for the medium to long term – potentially just in time to tie the hands of any future government, four years from now.
As ever, austerity seems more a political risk, rather than an economic necessity. Some might recognise the signs and argue that we have been here before.
The case of Italy (1976-1980)
An interesting precedent is the case of Italy, before the so-called “divorce” between the Bank of Italy and the Treasury (1981). Between 1976 and 1980 the central bank was obliged (by law) to purchase any government bonds which went unsold on the primary market, at a price fixed by Treasury. During those years, the Italian economy was relying on public spending relatively more than other European countries, with the Italian average debt/GDP ratio around 57% (UK 48%, France 20%). However, over the same period Italy experienced relatively high average rates of real GDP growth (Italy 4%, UK 2%, France 3%) [source: University of Groningen and University of California, Davis, Real GDP at Constant National Prices for Italy [RGDPNAITA666NRUG], retrieved from FRED, Federal Reserve Bank of St. Louis; July 8, 2020], a relatively stable debt/GDP ratio (fluctuating between 55% and 59%), and average annual inflation rates comparable with other industrialised countries (Italy 16%, UK 14%, France 10%) [source: World Bank, Inflation, consumer prices for Italy [FPCPITOTLZGITA], retrieved from FRED, Federal Reserve Bank of St. Louis; July 8, 2020].
This time we are not facing a banking-sector liquidity crisis. This raises some doubts on whether QE is the right type of “helicopter” to be used. Should the independence of the central bank be reconsidered, when aggregate demand is in free fall? The harmlessness of government debt (in the circumstances of the UK) and the lessons from the Italian case might suggest the need to revisit some of the working mechanisms of our policymaking institutions. Perhaps this time should be different.
All articles posted on this blog give the views of the author(s), and not the position of the IPR, nor of the University of Bath.