A sensible marriage (of politics & economics)

On Friday 9th November in a letter to the Governor of the Bank of England, the Chancellor of the Exchequer changed the rules of the game for the Bank of England's Quantitative Easing programme (QE). (Yes, I know that the day before the MPC decided not to continue with QE - I'll come to that in a minute.)

QE involves the Bank of England purchasing and holding gilts (UK government debt) on the open market through its Asset Purchase Facility (APF). Gilts are interest-bearing securities, so the Government pays interest on the Bank of England's holdings of gilts. Up till now, the Bank of England has kept that interest on deposit. But now, the Chancellor has decided that the Bank of England should return those interest payments to the Treasury.

This is an eminently sensible decision. As the UK has a fiscal deficit, the Government has to borrow money to pay the interest on existing government debt. It does this by issuing more gilts or treasury bills to make coupon payments on gilts in circulation. If you think this is a Ponzi scheme, you are right. Obviously there is no alternative regarding gilts held by the private sector (other than eliminating the fiscal deficit so that interest can be paid from tax revenues). But it is frankly ridiculous that the Government is borrowing money so that the Bank of England can hoard it. Other national central banks (the Fed, the Bank of Japan) already remit coupon payments back to their respective treasuries.

So, if remitting these coupon payments back to the Treasury is a) eminently sensible b) consistent with how other countries behave, what is the issue? Why has there been such a kerfuffle about it, with claims that this is an accounting "fudge" and will cost the country more in the long run?

Firstly, there is a great deal of confusion about the accounting. There is no net profit or loss to either the Exchequer or the BoE from coupon payments on QE. It is purely a matter of cash flows between two components of the public sector. The Bank of England is wholly owned by the Treasury and its accounts are consolidated in the Whole Government Accounts (WGA). Both the BoE's holdings of gilts and the interest it receives on them are eliminated against Government debt in the consolidated accounts. An internal transfer between the Bank of England and the Treasury will make no difference whatsoever to public sector finances.  It's a wash.

The pricing is a wash, too. Basically the Government has now redefined all gilts held by the Bank of England under the APF as zero-coupon, whereas the price the Bank paid for them would have included expectation of coupon payments. In theory, therefore, the Bank should suffer an immediate (unrealised) capital loss. But these gilts will still be marked to market as interest-bearing securities. Unless the price of gilts drops as a consequence of this decision - for which there would be no rational reason, since the Government will continue to pay coupons on private sector holdings - there can be no capital loss in reality. And even if there were, the expectation is that the Bank would eventually sell the gilts back to the private sector at the coupon-inclusive price. As I said, it's a wash.

Unrealised mark-to-market profits are excluded from the proposed transfers, which are to happen quarterly. But Osborne allows the Bank to retain cash from the coupon payments to cover unrealised mark-to-market losses. This is slightly odd, since the effect of QE is to raise the gilt price: I suppose he is concerned about a future speculative attack on gilts. Allowing the Bank to retain cash to cover unrealised losses would protect its balance sheet.

The argument against the Bank returning its coupon payments rests on the idea that the market price of gilts would have dropped by the time they are sold. This is likely, as unwinding QE would be done in a growing economy in which interest rates would be at a more normal level. So the Bank of England would indeed suffer real losses on its holdings of gilts and could reasonably expect the Government to indemnify them for these losses - which as both Osborne and King note, would effectively mean return of the coupon payments. The pessimistic OBR assumes that this would have to be covered by new gilt issuance. But as Britmouse points out, an economy in better shape would have better tax revenues. Any loss incurred by the BoE would be offset to an unknown extent by increased Government income. So the Treasury might not have to issue debt to compensate the BoE for trading losses on its gilts portfolio. It could be yet another wash.

In fact there's nothing to look at here, really. Except for one little snippet in King's reply to Osborne that makes me wonder if King is losing his marbles. Osborne says:
"net coupon income transferred from the APF to HM Treasury should be used solely to benefit the public finances and to reduce debt". 
So, no fiscal easing then. But in his reply, Mervyn reinterprets this:
"your intention is to use any funds transferred to the Exchequer to reduce the stock of outstanding government debt."
Er, no, this can't be right. The UK has a fiscal deficit. Total outstanding debt CANNOT be reduced. All that can be done with this money is either fiscal easing (which Osborne rules out) or deficit reduction. Now admittedly Osborne has not made his meaning entirely clear - "reduce debt" must mean issue less debt, not reduce existing debt - but really King should know better.

King then concludes on this basis that remitting this interest is equivalent to a small monetary easing, because the private sector will hold less government debt and more money. And in deciding to end the QE programme, the MPC seems to have bought King's view that gilt coupon remittance amounts to monetary easing. So are they right?

Well, if Osborne does use the money to reduce the fiscal deficit, yes they are right - there would be a small monetary easing. Not because any of the EXISTING stock of debt would be reduced, but because less would be issued in future, so the private sector would be forced to hold more cash or make riskier investments - which is the same effect as QE. Fiscal easing - increasing government spending and/or cutting taxes - which is Osborne's other option, would also release this money into the economy, but without reducing debt issuance.

And this brings me to my final point. The timing of this announcement is remarkable. Osborne is in danger of missing his fiscal reduction targets because of the poor state of the UK economy and collapsing tax revenues. This money is a political windfall to him, enabling him to claim that he has reduced the fiscal deficit despite difficult economic circumstances. And he can follow this up at a later stage with a fiscal boost just nicely in time for the 2015 General Election. This little piece of chicanery is from the same stable as his cutting of the top rate of tax earlier this year, which as I pointed out at the time was purely aimed at improving the Conservatives' chances of re-election in 2015.

However, it is still sensible economics. For once, Osborne's political instincts and the needs of the UK economy make a happy marriage. We should not criticise this move.


  1. Why? Perhaps because Rule Of Law in the UK is presently misguided, or even too weak (note: asking for the remembering of legal principles for a more proper Rule Of Law doesn't necessarily need or involve the creation of new Law). Take, for example, this comment: "Government needs to be prepared to step in to head off judge-led law if necessary" - that comment, reported in the FT yesterday (http://www.ft.com/cms/s/0/0aa29526-2caf-11e2-9211-00144feabdc0.html#ixzz2C1X7m6WU) singlehandedly represents so distinctly the trashing of what must be one of the UKs most sophisticated and globally respected institutions - the common law system, and comes from one Mr Cridland - a government employee who is evidently very misguided (a poor functioning legal sphere will sooner or later repel capital, after all, and the UK presumably wants to attract capital right now in order to try and meet its interest repayments). Alas, if only all government employees were as even handed and sensible as Frances.

  2. Thanks for explaining this purportedly complex arrangement relatively clearly. A commentator via twitter opined that this is the first sign of GO turning into GB. Good economics yes but convenient politics too and terrible PR!

  3. Democratic fascists should more properly be called corporatists, since it is the merger of state and corporate power ~ Benito Mussolini. A Ponzi? You almost sound like this investor!


  4. An excellent explanation and the right conclusions. Thank you.


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