I am sharing this press release from an organisation called the Policy Reform Group, of which I admit I know little.
The release refers to a paper by Gerald Holtham, who is Hodge Professor of Regional Economy at Cardiff Metropolitan University, Managing Partner at Cadwyn Capital, and an Associate of Llewellyn Consulting. Prior to that Professor Holtham was a Fellow of Magdalen College, Oxford, Chief Investment Officer at Morley Fund Management, Director of the Institute of Public Policy Research, Chief Economist at Lehman Brothers, and Head of the General Economics Division in the OECD Economics Directorate.
He has this to say:
Government borrowing driven by the COVID-19 pandemic is leading to increasing concern about the growing size of the UK public debt, which topped £2 tr — some 100 per cent of annual GDP — by the end of the fiscal year 2020-21. This brings two issues into focus.
First, with one-third of unexpired UK government bonds currently in the hands of the Bank of England following its purchases under the policy of Quantitative Easing (QE), this portion of government borrowing is a contingent liability rather than straight debt. It is unlikely that much of it will ever be ‘reissued'.
Second, and even more importantly, the particular way that the Bank of England currently conducts monetary policy stands to make the operation of monetary policy unnecessarily ‘costly' in budgetary terms. This is because bond purchases made by the Bank under QE swell reserves of the commercial banks which are held with the Bank of England.
The Bank pays interest on these reserves as a means of controlling interest rates and thereby the amount of bank lending. And that is all very well when reserves are low or when, as at present, interest rates are near-zero.
However, that will not always be the case. At some time in the future the Bank will need to raise interest rates. And then it will face a choice: either sell UK government debt holdings — and thereby incur a loss, given that bond values fall as interest rates rise — or pay large sums to commercial banks in interest on these reserves.
Neither course is attractive; and nor is it evident why the Bank should pay interest on these QE-created reserves. While commercial bank reserves are conventionally counted as a liability of the Bank of England, and hence as part of the public sector debt, the reserves are themselves ‘ultimate' money, and cannot be repaid. Moreover the banks are not doing the Bank of England a favour in lodging their reserves with it: on the contrary, it is rendering them a service by acting as clearer and lender of last resort. There is therefore no reason, legal or moral, why it should pay interest on those reserves. It has done so purely pragmatically as a way of controlling short-term interest rates. But given the now-swollen reserves, a more economical way of influencing short term interest rates to discourage excess borrowing is required.
There is another option. The Bank could sterilise reserves in the system by requiring deposit-taking institutions to make Special Deposits with it at zero interest. This would enable the Bank to set higher interest rates only on marginal, or borrowed, reserves in order to restrain lending. The contingent value of the public sector debt — netting out the authorities' own holding — would then not be 100 per cent of GDP, but more like 70 per cent.
Such policy action would also enable the Bank — without prejudice to its monetary policy independence — to exert monetary control at a lower cost to the Exchequer. The Bank managed to preserve its independence while making large-scale government bond purchases to combat deflation; surely it can maintain that credibility while enabling an indebted government to avoid paying too dearly for an eventual rise in interest rates.
I quote this release because I agree with it. I have long been confused as to why the Bank of England feels itself obliged to pay base rate on the central bank reserve accounts that it has, in effect, created for the UK's clearing banks.
These supposed deposits simply represent the debt owing to the banks for the funds used to repurchase government bonds under the QE programme. The clearing banks can only use them to make payment to the Bank of England, for example when settling tax liabilities due from their customers, or to pay another bank when clearing customer liabilities. The reality is that this only requires balances totalling a few tens of billions, as was the case in 2008 before QE. The rest has been forced on the banks.
Why then pay base rate on them? Simply because before 2008 the balances were so small it did not matter and since then the interest rate has been so small again it did not matter. Near enough £800 billion is held on these accounts now, at an annual cost of £800 million, which in government funding terms is not great (but is, apparently, when allocating funds to pay for children's education).
The concern the Treasury has is that if interest rates rose to say 2 per cent (which would be enough to probably precipitate a major personal debt crisis in the UK) then the cost of serving these central bank reserve accounts might become £16 billion a year - enough to pay for all the catch up education required in the UK.
Sunak is obviously now holding back the money needed for children's education to pay this interest cost to keep banks happy.
But I entirely agree with Prof Holtham that this is completely unnecessary. Simply redesignate the sums as special deposits and require that the banks hold them (which the Bank of England has the power to do, and which it has done in the past) and then pay zero interest rate on them and the problem of interest rate costs is solved.
What is more, effective government debt is reduced by more than 30%.
And maybe £16bn of cost is saved if rates rise by a lot. Enough, then, to cover the cost of children's education, in fact.
And what is more, there is no need for austerity anymore as the debt crisis has been solved (not that there was a debt crisis, or need for austerity, but let's beat them using their own narrative).
In other words, Sunak has no debt problems left, at all.
If he claims he has then he is not telling the truth. And to do that to impose real loss on the children of the UK, to prefer banks instead, would be unforgivable. But that is what he seems to be doing.
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Maybe you are assuming Sunak is brighter than he is – I doubt he has thought about this. He has a specific mindset – one where there is always enough money for his mates / backhanded support for the Tory party, but never enough for the needs of the population at large – as shown by 1% pay rise for NHS and pathetic sums to help deal with the backlog, along with the same approach to education and welfare.
“At some time in the future the Bank will need to raise interest rates. ”
Will. Not. Happen.
People really need to start understanding that QE is not a consequence free ride.
QE used to be in the “Here be Dragons” section of the monetary map and for very good reason.
If you want to inflate a massive asset bubble you just go right ahead but don’t think that once its inflated you can go back to business as usual.
Once its inflated you need to keep it inflated and the only way to do that is :
A) Maintain interest rates near zero.
B) Message the public that you will not raise rates
It is not a coincidence that the Fed has signalled zero rates through 2023. JPow has NO CHOICE.
The Fed & every other Western central bank have firmly painted themselves into a corner.
This is it folks. ZIRP.
Interest rates are not going to rise until the Wests central banks are prepared to throw their asset holders under a bus.
Do not hold your breath.
I agree: 2% would now crash the economy
” I have long been confused as to why the Bank of England feels itself obliged to pay base rate on the central bank reserve accounts that it has, in effect, created for the UK’s clearing banks.”
QE makes it necessary. In normal circumstances (thin reserves) you control the overnight interest rate (OIR) with CB sales to drain reserves to prevent the interest rate falling to zero. But that doesn’t work if the CB is going to be a net purchaser of securities. Now the system has excess reserves (the situation you were trying to prevent with CB sales) and you now have no way to stop the banks lending their excess reserves out to each other & driving the rate to zero. The only way to prevent this is to pay them to hold their excess reserves (IOER).
Here is Randall Wray with a very good, 4 minute explanation. Its the American system but it all applies equally here.
https://www.youtube.com/watch?v=pex89N9Oqog
I disagree
Zero has the same result
The government doesn’t pay IOER for fun or because the banks are their mates. They do it because its the only way to set the interest rate in a non-thin reserve scenario.
You either drain reserves by selling bonds (which pay interest) or you pay the same interest on reserves.
Either way you pay interest. Which is essentially a price maintenance mechanism.
Those are the options.
If you choose to do neither then the interest rate falls to zero because the natural price of money is zero.
For those of you who find this concept alien, consider this: Governments & banks create money at zero cost to themselves. If supply exceeds demand, what happens to price?
Paying zero is a rate
It need not be zero though. It could spray at 0.1%
But it need not be base rate
Can you explain for us Laymen why 2% would suddenly crash the economy ?
Thank you
Many households are massively geared with very large mortgages
The chance of default would increase rapidly with many increase in cost
I think 2% could begging to cause a debt crisis and tip over into banking issues
And Conservatives have an obsession with the price of housing. An increase in rates would devastate the housing market and create mortgage defaults which would be a failure in their eyes.
Increasing BOE base rate would increase mortgage rates, resulting in decreasing house prices and slowing of construction as developers decrease supply because of reduced profits. A much needed correction in house prices effect will reduce GDP, which is why successive governments have successfully tried to prevent falls in house prices at all costs, because housing inflation masks low growth in the real economy. This has been government policy for over 20 years, but it’s highly destruction to society, hence the ongoing housing crisis.
High house prices create the illusion of wealth but it is only really accessible by those with multiple properties, since most require a new property if they sell theirs. This housing asset bubble has prevented ordinary workers from entering the housing market in most of the country. It has increased inequality, regionally and generationally, making buying a home a fantasy for the young unless they have a very highly paid job or access to the bank of mum and dad. The low base rate and saving interest rates have resulted in savings is being poured into the speculative economy of housing, using housing as investment vehicles, as either buy to lets or buy to leaves, forcing up rents and making home ownership even more impossible for most as potential savings are swallowed by rents, and inequality increases as income is taken from poorer rent payers and given to rich second-home owners.
Obviously one way to control the housing bubble it to increase the BOE base rate, but this creates negative equity, defaults and reduced GDP. Rent controls and even house price controls would also reduce inequality with much the same effect. Allowing councils to buy repossessed properties and from landlords are unable to pay their buy-to-let mortgages, to increase the stock of social housing and reduce rents is one option, but the hit on GDP is inevitable.
Properly including housing cost increases in inflation indices is also an option, which should increase wages and reduce the cost of living, but wouldn’t this be consumed by increased rents and house prices, leading to inflation? Inflation will inevitably result in base rate increases. Another option is a wealth tax that creates government money to pay for cheaper truly affordable (living rent) housing, hopefully putting negative pressure on rents and house prices, with an inevitable hit on GDP.
There is no easy solution to the housing crisis, but unfortunately raising the base rate might be part of it.
More houses – green ones at that – is a much better solution
And you do realise house prices have no direct impact on GDP? Because I was not sure you did I had problems with the other comments you made
You are right – there is no debt crisis. You are right about the rate of interest that the BoE pays is in their gift – not some externally given number. You are also right that raising rates to 2% now would be very damaging BUT zero rates is damaging, too, as it is delivering asset price inflation.
We know there are other tools in the tool kit – fiscal policy, tax policy, differential interest rates depending on purpose, credit controls. Couldn’t we do better than the current situation? I think so.
We could….
I was actually writing on this today and got distracted by the G7