Roger Bootle
This is going to be one of those weeks when the economic statistics could cause a rumble in the financial markets and beyond. On Wednesday we get the latest inflation figures. Simply because of the drop in petrol prices, the headline rate should fall from 8.7pc to about 8.2pc. (Famous last words!) But more important will be the core rate, which excludes energy and food prices. This may edge lower from 7.1pc to 7pc. Not only would this not be much to write home about but even this tiny reduction is far from being in the bag.
If the core rate were to rise, this would be very bad news for interest rate prospects and hence for the finances of both households and the Government. Many readers have written to me recently, worried at the state of the public finances and outraged about the way that the policy of Quantitative Easing (QE), under which the Bank of England bought government debt, appears to have made our predicament worse. They ask me to unravel what is going on. I will try. But these are deep waters: you will need a supply of hot towels at the ready. For a start, the term “National Debt” is a misnomer. This debt isn’t “national” at all. It is the debt of the state to all creditors. And most of these creditors are themselves UK residents – mainly investing institutions. The indebtedness of the country as a whole – encompassing firms, households and government – to outsiders is a very different thing. (Mind you, that isn’t a pretty story either. A subject for another day.)
On Friday we get the latest figures for the public deficit. They will not be pretty. Borrowing may come in at about £22bn for the month of June, putting us on course for something like £140bn for the financial year, amounting to over 5pc of GDP. This would be well down from the peak of 15pc in 2020/21 but it needs to come comfortably below 3pc to be consistent with a falling debt ratio. This may be achieved in 3 or 4 years’ time. Has QE made the public finances worse? It is too early to give a definitive answer to that question.
But we do know that its effects have followed a distinct pattern. In QE’s early days during the Global Financial Crisis, the Bank was buying gilts in the market yielding 3.5pc, financed with deposits held by the banks which paid interest at Bank Rate. At the low point then, that rate was only 0.5pc, giving the Bank a tidy running profit. (Subsequently, Bank Rate fell to 0.1pc but gilt yields then were also much lower.) The profits made by the Bank on these purchases were transmitted to the Treasury. In effect the Government was able to borrow at rates not much above zero. This was extremely useful given that it had boatloads of gilts to sell each year. Indeed, the period of very low interest rates flattered the underlying state of the public finances. But this was always only a short-term fix.
As interest rates rose, then the amount that the Bank had to pay out to banks on their deposits with it would rise and at some point, this cost would match or even exceed the income being received by the Bank on the gilts that it had bought. This point has been reached. The Bank is now making a running loss on most of the gilts that it holds. What’s more, the Bank is also making a capital loss on the gilts it bought at higher prices than those ruling in the market today. Mind you, I wouldn’t get too excited about this since the Bank is not obliged to crystalise this loss. If it just holds onto the gilts then, provided it bought them below par, when the gilts mature it will make a profit. Of course, the objective behind the policy of QE was not to make a profit but rather to boost aggregate demand. As it turns out, after the pandemic it rather over delivered in that regard.
Nevertheless, I don’t subscribe to the view that the current inflation is wholly due to the policy of QE. I place more emphasis on the effects of ultra-low interest rates, interacting with the surge in global cost pressures, particularly energy. But whatever the correct balance between the various factors that have contributed to the inflation surge, the inflation itself has had a major effect on the public finances. Allowing higher inflation is the time-honoured way of reducing the debt ratio. And that factor has been at work recently. But it no longer works so well these days because of the amount of index-linked debt, whose redemption value and interest payments rise as inflation proceeds, and the need to refinance the continuing deficit and maturing debt at higher interest rates.
The markets have got wise to the workings of inflation and they demand compensation in the form of higher yields. Is everything clear now? Or are you just as confused as before but at a higher level? The bottom line is that the dynamics of public debt can be scary. There is an acute danger of a vicious circle as fears about debt sustainability prompt higher interest rates in the markets and that worsens the public finances – and so on and so forth. So the Government has been right to work towards getting the debt ratio lower. Yet we are not at panic stations. Indeed, public debt and deficits should not be the main focus of concern about the UK economy. As I like to remind people, for much of the UK’s ascendancy in the early 19th century, the debt ratio was higher than it is now. The really worrying thing about the current situation is the absence of economic growth. Solve that and the debt problem would be much more manageable.
The China Daily
