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,


Q to reduce bonds

In the 1970s, the British comedian, Spike Milligan devised the Q series.  This was a surreal comedy show, which when any particular sketch had come to an end without a suitable punchline, the actors would then wander around saying “What are we going to do now?”  UK economic policy seems to have reached the “What are we going to do now?” stage.


On fiscal policy, the coalition government has been and remains totally committed to reducing the budget deficit by a planned, slow but steady austerity approach.  This initially involves an increase in taxes, followed by spending cuts throughout the life of this parliament and now extended well into the next parliament.  Unfortunately, for the UK economy, this well-planned and thoughtful approach has not delivered the budget deficit reductions that were predicted for two main reasons as follows:


  • the eurozone crisis meant that the domestic economy of our nearest and largest trading partner was much weaker than expected as even more severe austerity was introduced there than in the UK.
  • all the economists’ models of how an economy performs at a time of government spending cutbacks woefully underestimated the impact of austerity on the overall economy.  The result has been considerably weaker UK economic performance, and much higher budget deficits than forecast by the government.


None of the Chancellor’s choices on fiscal policy are politically appealing.  Should he choose:


  • to cut spending faster than planned, to try and meet the deficit targets in future years, then even more public sector workers will be put out of work in the run-up to the next Election.
  • to reverse the spending cuts, then he will be accused of admitting that the austerity policy was wrong all along.
  • to do nothing, then he will be accused of having no ideas to boost the economy.  Increasingly, with a little over two years to go until the election, these accusations are likely to come as much from his own MPs as from the Opposition.


With regard to monetary policy, Mervyn King, the current Governor of the Bank of England, has managed to thoroughly confuse everyone. For the last twelve months he has been saying that the policy of Quantitative Easing (in place since April 2009) is becoming progressively less effective and that monetary policy cannot solve all the UK’s economic problems.  This is somewhat at variance with his confidence in the policies when they were initially unveiled.  However, the latest minutes from the Monetary Policy Committee showed him in a minority of 3 (against 6), voting for more QE to stimulate the economy at a time when inflation is expected by the Bank to be above its target throughout the next two and a quarter years.


Further, the Chancellor, has asked the incoming governor to lead a debate to assess what the appropriate target of monetary policy should be.  Taken all together, one gets the distinct impression that those in charge of UK economic policy have run out of ideas.


The investment implications of this uncertainty and indecision have already begun to be seen.   Gilt yields have been rising, and sterling has been falling, evidence that international investors have been reducing holdings of UK government bonds.  A weaker pound is however positive for the profits (in sterling terms) of many of the UK’s largest companies, and so share prices have been rising.  The rise in government bond yields is likely to be mirrored by rising sterling corporate bond yields, and exposure to this asset class should be reduced.

Not so Sterling

All three of the major credit rating agencies, Standard & Poor’s, Moody’s and Fitch, have the UK rated at AAA but with a negative outlook.  A fourth, Dagong, a Chinese-owned rating agency, already has the UK at only A+, four notches below AAA.  They have each warned that a failure to reach the government’s deficit reduction targets in 2013, may lead to a decision to remove the AAA designation.  The worse than expected growth of the UK economy over the last two years has produced less tax revenue than expected and meant that reducing government spending has proved more difficult to achieve.  The government looks increasingly unlikely to meet its deficit targets, and the chances of at least one of the agencies downgrading the UK in 2013 are very high.

For Messrs. Osborne and Cameron, this will undoubtedly be politically embarrassing.  When they first came to power, they laid great store on the credibility of their austerity policy with the financial markets and the credit rating agencies.  Since then, they have often sought to justify the policy by reference to the fact that the AAA rating has been maintained to date, while most Eurozone countries undergoing austerity programmes have seen their ratings reduced.  The Labour Party will be able to score many political points, if and when a downgrade occurs.

For the financial markets, and indeed for the economy, it will, however, be of almost no significance.  Markets are rarely surprised by downgrades to credit ratings, as the agencies telegraph their thinking some months ahead.  Both the US and France have already lost their AAA status with at least one of the agencies, and it has had no obvious effect on yields on their government bonds.  Indeed, French yields have fallen sharply since being downgraded.

For countries such as the UK and US, which have Central Banks who are allowed to print their own currencies, there is in fact no doubt that these governments will always repay their debts.  They always have the power to create the money that is necessary to repay any debt denominated in their own currency.  From the perspective of a domestic investor, there is no risk of not being paid back the nominal value of any government bond, and in that sense they should remain AAA.  That is not of course the same thing as saying that these bonds have no risk, since creating a lot of money to repay government bonds is likely to prove very inflationary.  Being repaid in devalued money can seriously damage an investor’s wealth.

For countries inside the Eurozone, matters are very different.  By adopting the single currency, they have forsaken the right to be able to create the money to repay their debts and handed the right to the ECB, who hold a very strong conviction that creating money for such reasons is a very bad idea.  It is thus entirely possible for a Eurozone country to find that it does not have enough euros to pay back its lenders, and thus go into default – hence the crises in Greek, Portugese and Spanish debt markets in the last few years.

One investment implication is likely to be a reversal in the strength of sterling that was seen in 2012, when it was the strongest of the major currencies over the year.  Any downgrade itself is not likely to be the cause of sterling weakness, but both would reflect the poor growth performance of the UK economy.   Further, David Cameron’s recent call for an in/out referendum on the UK’s membership of the EU, will create much uncertainty in the minds of global businesses and investors looking to invest in the UK.  The pound looks set for a period of weakness, and investments overseas should benefit from currency gains for UK investors.

Business Investment: The Key to UK Economic Recovery

Sifting through the small print of the Chancellor’s Autumn Statement, which could be summarised as very much a “steady as she goes” story, one finds the breakdown of the UK economic forecasts generated by the Office of Budget Responsibility. It shows that the sector of the economy which is expected to lead the UK economy back towards growth is Business Investment, which further analysis shows is forecast to grow at a compound annual rate of 9.5% from 2014 to 2017.  Over the same period, Household Consumption is forecast to grow at a compound annual rate of just 2.2%.  Of the four key economic sectors that can drive growth, Household Consumption, Business Investment, Government Spending and Exports, only Business Investment is currently in a position in the UK to lead a recovery.  The Household and Government sectors are both suffering from very high levels of debt and pressure on their incomes and are therefore working hard to curtail spending.  The remaining sector is Exports, but with over half of the UK’s exports going to the rest of the Europe, which is expected to fall back into recession in 2013, export-led growth for the UK economy looks a very distant prospect.

The Chancellor announced two new surprise measures in the Autumn Statement to encourage businesses to invest. The first was to cut the rate of Corporation Tax by another 1% to 21% from 2014, leaving it well below the rates set by other western nations, and a tenfold increase in the tax relief granted on investment by small businesses for 2013 and 2014.  This government has consistently sought to reduce the rate of Corporation Tax since it came to power as an incentive for businesses to invest, grow and create employment in the UK.

Though the growth rates have been quite low at 2.9% and 3.8% for 2011 and 2012 respectively, which have not been sufficient to get the economy as a whole moving strongly, Business Investment has in fact been the fastest-growing part of the UK economy.  Businesses themselves cite two factors when asked why they are not investing more.  One is the readiness of the UK banking system to provide loans to finance investment and the other is a lack of confidence in the economic outlook and hence the generation of a sufficient return on any investment. The Chancellor and the Bank of England have worked together to create the recently-launched “Funding for Lending“ scheme, which provides cheap liquidity for banks who will actually use that liquidity for new loans.  In the first two months of the scheme, only £500m has so far been lent out of a possible £80bn, which is disappointing. If this does not improve soon, then the only explanation left for slow investment growth is a lack of confidence from businesses in the outlook for demand.

Most entrepreneurs are natural optimists, always believing and seeking to do more business and make more profit.  In long periods of little or no growth, such as that which is being currently endured, then such optimism can get squashed by consistent economic disappointment. Normally, the dynamics of capitalism mean that in the downturn, loss-making or unsuccessful businesses withdraw from the market.  This shrinks the supply in that industry, so enabling their more efficient competitors to boost their market share and become more profitable.  However, the recent revelation that 1 in 10 UK businesses are zombie companies, which are effectively bankrupt but are being kept alive by ultra-low interest rates and the reluctance of the banks to admit to more bad debts, is disturbing.  This indicates that this normal operation of the free market system in economic downturns is not currently occurring, leaving less scope for more efficient companies to take the opportunities for them to grow.

There are only two strategies that the UK Government can follow to generate growth.  The first is for the Government to use its strong creditworthiness to borrow in the markets and spend the money productively by, for example, building houses and necessary infrastructure projects.  However, if the money were to be spent less productively, it would merely raise the level of public debt that future generations will need to repay.  The second strategy, which is this government’s preference, is to give the private sector every reason to want to invest, and lead the economy back to growth.  To create the required optimism amongst businesses, it would, paradoxically, help if more companies were made to go out of business.  The costs of this though are more jobs lost and more losses for the banks in the short term, before the opportunities for the survivors can improve.

Hello Governor

In choosing Mark Carney as the next Governor of the Bank of England, George Osborne appears to have adopted the strategy employed by Roman Abramovitch, the owner of Chelsea Football Club, when selecting managers.

Mr Osborne scoured the world for someone who (i) was respected as a monetary policy expert in order to be effective as Chairman of the Monetary Policy Committee, (ii) understood the global banking industry to maintain and develop the role of London as a major force in the world’s financial structure and (iii) was a very effective executive to deal with what has been identified as a very inflexible culture and hierarchical structure in the Bank of England.

In Mr Carney, he appears to have found the man that best meets those criteria.  However, he is not British, though he does have a British wife and he says he will take on British nationality, and he is expensive.  These concerns, which would have counted against him very strongly in previous times, are outweighed by his reputation in the global markets and the application of more money.  Mr Carney’s basic salary will be almost 60% higher than Lord King’s and with other elements could end up being more than double what the current incumbent earns.

Mr Carney’s time at the Bank of Canada is lauded.  He was at the helm when the Canadian economy went through the financial crisis and under him it returned to a reasonable level of growth, without a banking sector meltdown, and without resorting to zero per cent interest rates or Quantitative Easing.

However, it is also true to say that much of Mr Carney’s success at the Bank of Canada is down to the work of his predecessors.  The Canadian banking system was much more tightly controlled in the lead up to the global crisis (having gone through its own meltdown in the early 1990s), with the result that neither the banks nor the Canadian consumers became over-leveraged as was the case throughout most of the rest of the G7.  Mr Carney took over at the Bank of Canada a few months before the crisis occurred, so no blame could be attached to him, and the problems he faced were far less severe than those found in the UK or the US.  He did not need to take the aggressive easing measures required elsewhere, and when Obama embarked on the huge fiscal stimulus in the US in 2009 and 2010, the Canadian economy was a natural beneficiary of the extra demand this generated.

Napoleon famously remarked that he preferred lucky Generals over clever Generals, and Mr Osborne would doubtless agree with Napoleon. Mr Carney has, it could be argued, been a little lucky.  The Governor of the Bank of England’s newly expanded role is a huge job, requiring economic policy dexterity to deal with a weak economy dependent upon an over-sized banking system that is undergoing major structural change in an institution with an out-of-date culture.  He is the best man for the job, but it will be a hugely difficult one – perhaps like managing Chelsea?


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.

UK Economic Policy – Sticking to Plan A (plus a bit)

Last week as investors worried about the Greek elections, the Spanish bank bailout and the Federal Reserve meeting, George Osborne and Mervyn King made significant announcements about UK economic policy. Since coming to power, the UK’s approach to managing the economy can be described as a slow but steady tightening of fiscal policy over the medium term, to avoid an austerity-driven recession as seen in parts of Europe, combined with an extremely easy monetary policy.

The complicating factor to this logical response to the UK’s problems was capital requirements that had been placed on UK banks following the banking crisis – much more exacting prudential requirements with regard both to capital and to liquidity risks had forced the banks into buying large amounts of gilts (UK government bonds). Whilst one side of this coin meant that banks’ balance sheets were better protected, the other side of that coin is a reduced emphasis on the attractions of lending to small and medium sized businesses, which is a vital but nonetheless risky activity for banks.

Mr. Osborne announced a scheme to offer both government guarantees and cheap funding for banks that lend to the domestic personal and small business sectors – at £80bn this is approximately 5% of total existing lending to these sectors. Mr. King announced that going forward banks would not have to hold such large amounts of liquid gilts on their balance sheets, and thus would be able to make more loans (which are less-liquid assets) to business. There are few details yet but assessments of how much this might mean are around £150bn.

These announcements are clearly aimed at allowing the QE policy to work more effectively, which until now has worked to inject lots of money into the financial system. However, little of it has found its way into the real economy – thus financial asset prices (in particular the price of gilts) have been supported but with only a small impact on growth. The banks are receiving very strong guidance that they should be lending.

There remain though both demand and supply problems with this new approach, which are likely to mean that it will have only limited success. First, with regard to the demand for bank loans, the banks consistently report subdued demand to borrow. Certainly the housing market is slow (apart from Central London, which is beset with Greek, Russian and Middle Eastern investors seeking a safe home for part of their wealth) – falling house prices is not an incentive to borrow heavily and a lack of confidence in employment prospects or future pay increases is endemic. Similarly the subdued state of demand that many small businesses face will mean that very few are seeking to borrow to expand. Where there is demand to borrow from small businesses, it is usually to cover slow trading (or poorer credit risks). On the supply side, the credit boom conditions of 2002-2007 is now over and banks are not prepared to lend on the optimism-fuelled terms that were available then. Instead, they are reverting to lending terms similar to those on before 2002, which feel now much more restrictive to businesses.

Osborne and King are sticking with Plan A, but trying to make sure more liquidity gets into the real economy. It will help at the margin to boost private sector growth as the public sector continues to be cut back, but the general desire of most people and companies is to reduce their debt rather than increase it. This combined with the major uncertainties within the European economies, will prevent a rapid recovery. There are risks to gilt prices since the banks are being told that they do not need to own so many gilts, but the prospects for UK equity prices are positive given their very low valuations and the (minor) benefits to growth of this adjustment in policy.

Both Osborne and Cameron can count themselves a little unlucky- December 2011

As with football managers, the ability of politicians to keep their jobs can be defined by the formula – Success = Outcome minus Expectations.

A year ago, George Osborne set out his plans for getting the UK public finances onto a more secure footing. To counteract the Treasury’s longstanding record of over-optimism in forecasting trends in the UK economy, he set up the Office of Budget Responsibility, as an independent body to give greater credibility to his plans, believing that they would adopt a less rosy view of the world. Then he went further and gave himself a target of eliminating the structural budget deficit in 5 years, but his actual plans were forecast to achieve this in 4 years. His aim in all this was to maximise the expectation of the pain required in his deficit reduction plan and so minimise his chances of his plan not achieving their goals by the time of the next election. He was trying very hard to ensure that the economy and the reduction in the budget deficit actually came in better than expected in the later years of this Parliament, leaving him some scope for reining back on spending cuts or cutting taxes just before the May 2015 election.

The last year has not been kind to him. First the performance of the global economy has been much worse than was expected a year ago – this is not just the result of the mess in Europe, but also much weaker growth in the US and high food price inflation in many developing economies forcing them to slow their economies by raising interest rates – and this has contributed to a weaker than expected UK economy, making the job of reducing the deficit even m ore difficult. Secondly, the OBR made some key assumptions in its work that in hindsight were still too optimistic – they took the view that much of the reduction in tax revenues suffered in 2009 and 2010 was cyclical and thus short term rather than structural and so long term. Thus, they had tax revenues recovering quite sharply once growth got going again. This year’s deficit forecast is close to target, because there was little growth expected but the deficit forecasts for the next few years have had to be increased to account for weaker world growth and the OBR’s recognition that tax revenues from the banking system will not bounce back as fast due to the ongoing crisis and that weak productivity growth is likely to mean a slower rate of reduction in the unemployment rate.

In his first year then, Mr Osborne has not been seen as a success because he has had to reset expectations to an even lower level. From here though, it might just work out well for him. First, both he and Mervyn King have explicitly stated that all forecasts are dependent on the eurozone crisis being resolved fairly quickly, which is not unreasonable, and secondly that this time round it could well be that the OBR’s assumptions are too pessimistic in that they now assume that the loss of tax revenues were structural and long term and not at all cyclical and short term. Mr Osborne now has more pessimistic forecasts, for which he is criticised today, but which give him a greater capacity to produce a positive surprise, for which he can take credit, in a few years time.

For David Cameron, the bad luck may not be so easy to turn around. A successful resolution of the eurozone crisis requires much greater co-ordination of fiscal policy across the Eurozone. This will require tighter rules and international bodies with real power – in other words deeper political union amongst the Eurozone as Mrs Merkel has been saying for some time. The UK’s economic interests are clearly best served by a resolution of the crisis, but such a resolution is not, from a Conservative perspective, in the UK’s foreign policy interests. A deeper political union amongst the eurozone members, will lead to far larger and more powerful area, which will make policies affecting the UK but over which the UK will have little influence. It re-opens the European faultline within the Conservative Party, which Mr Cameron has worked so hard to paper over. The UK will have to make a fundamental reassessment of its policy towards Europe if the euro survives and a deeper, political union results. Such a debate has always proved to be very damaging for the Conservative Party.