Forgive us our debts!

An open letter to Messrs. Osborne and Balls

Dear George and Ed,

Are you seeking a policy that you can surprise markets with on the first day after the General Election, just as Gordon Brown managed when he made the Bank of England independent in 1997, that you cannot talk about ahead of the election, but has no cost and will probably boost your chances of winning the 2020 election?

Well here it is – tell the Bank of England to cancel all the government bonds it has bought through its QE policy intervention in financial markets. I am sure your advisers have already produced papers looking into this for you. Obviously if one of you announces it before the election, the other will denounce it as dangerous and totally irresponsible but I think it works for whichever of you is Chancellor in May.

The Bank of England bought £375bn of gilts in their quest to support the UK economy between 2009 and 2012, which represents about 25% of the total gilts outstanding and about 23% of UK GDP. Since the Bank of England is an arm of the UK government (though acts independently when setting monetary policy) then these gilts represent debt that the UK owes to itself – each year the government pays interest on these gilts to the Bank of England, which books the interest as income and can be used to pay a dividend back to the government. On the national balance sheet, the gilts are an asset of the Bank of England but a liability of the government, and so cancel each other out. Although when QE was originally announced in 2009, it was expected to be temporary and would be unwound (ie the gilts sold back into the secondary market) when policy was to be tightened again, it is now clear that this remains a long way away and policy tightening will initially be implemented through interest rate increases. These gilts will be held for a long time.

The advantage to you in cancelling these gilts is that the ratio of debt to GDP falls from around 90% of GDP to around 70% of GDP and the UK balance sheet suddenly looks much healthier in absolute terms and compared with the major European countries as well as the US and Japan. The pressure from being an economy with too much debt disappears and gives you as politicians much more flexibility in how rapidly you need to deal with the debt. Further, ahead of the 2020 election you will have lots of very attractive charts showing that the UK has much less debt than all those around – what a sound economy the UK will seem to be!

What are the downsides? – well, the Bank of England will technically be bankrupt since the value of the bulk of its assets fall to zero, but that doesn’t matter because it can then print the money it needs to rebuild its capital base. This will enable to others to say that it represents pure money printing on a permanent basis, which may be argued to be hugely inflationary and risky. But this has been the case for almost 6 years now with QE and there are still no signs of these inflationary risks – all that is happening is that the pretence that QE will be reversed has been taken away. Also it does rather suggest that the Bank of England is not actually independent of the government – however, since the financial crisis it is very clear that governments and central banks around the world have been working together rather than independently of each other – central bank independence is a convenient illusion.

A bold act to start the next government which costs nothing to implement and provides lots of advantages to you ahead of the next election – what’s not to like?

Kind regards,


Why most economic forecasts have been so wrong in recent years

In its recent six-monthly World Economic Outlook report, the IMF included a section examining why it, and just about all other economic forecasters, had been consistently too optimistic in its forecasts of economic growth over the last three years. This has been particularly painful for those governments undergoing austerity programmes, where the shortfall in growth relative to forecasts has meant larger deficits and the need for further austerity programmes.

The very clear conclusion is that their estimates of the fiscal policy multipliers have been far too low. The fiscal policy multiplier measures the degree to which the economy is impacted by a change in fiscal policy (either a tightening of policy created by raising taxes or cutting spending, or an easing of policy created by cutting taxes or boosting spending). For the 30 years up to 2007, economists had identified this multiplier to have a value of about 0.5, so that a fiscal tightening equivalent to 1% of GDP, could be expected to reduce the growth rate of the economy as a whole by about 0.5%. However since 2008 this previously stable relationship has changed and the multipliers now appear to range between 0.9 and 1.7. Further, it was  those economies which underwent greater austerity which saw the higher multipliers on final economic demand.

For the UK, this is unfortunate news for Mr Osborne, since this is exactly what his Labour opponent, Mr Balls, has been saying for some time. It means that the steady approach to austerity at about a 1% rate of tightening per annum, that he adopted is having a greater effect on the overall economic growth than he envisaged.

The higher multipliers identified where there is greater austerity is probably due to an economic confidence effect, as the deep cuts in government spending and large increases in taxes will lead everyone to believe that recession is imminent and thus curtail their spending immediately. For Greece, Spain and Portugal this goes some way to understanding why their previous austerity plans have not worked – those who are bailing them out have demanded that they get their fiscal houses in order in a short space of time and this has resulted in even weaker economies and larger than expected budget deficits.

At the same time as the fiscal policy multipliers have risen, so the monetary policy multipliers appear to have fallen. Cutting interest rates from 6% to 5% has a far more dramatic effect on the economy than cutting the from 1% to 0% and Quantitative Easing policies are generally agreed to work best the first time they are used and have less effect with each repeated use. Keynes is often attributed with describing such policies as “pushing on a string”. Central Banks are now having to make significant monetary policy changes to have any effect on the economy.

So the world finds itself in a real policy bind. The area of policy being tightened (fiscal) is working too effectively on growth, and the area of policy being eased (monetary) is not working at all effectively on growth. This approach does help to provide an understanding of why economic growth is consistently disappointing the economic forecasters. The policy implications are at odds with conventional wisdom – governments should adopt a slow but sure approach to austerity, and a more effective form of Quantitative Easing needs to be adopted with the concept of the Modern Debt Jubilee (espoused here), appearing to be an increasingly interesting idea.