Why not panic over UK public debt | Daniela gabor

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A A number of journalists, politicians and observers are increasingly concerned about the growing amount of public debt involved in the UK’s response to the coronavirus. These “quantitative vigilantes”, as I like to call them, fear that public debt will increase to levels not seen since the start of the pandemic, rising to 100% of GDP – a level never seen since 1963.

This record peacetime deficit will only increase as the second wave of coronavirus hits jobs, investment and spending in the UK economy. So how bad will it get? For some alarmists, what awaits us is no longer simply the “sacred responsibility”To balance the books of the next generation – that old conservative trope organized to legitimize austerity – but something much worse: a looming currency crisis.

This conclusion is worrying. But to get there, quantitative vigilantes must remain silent about two troublesome factors: interest rates and the institutional arrangement of the bond market. Mention either, and shrill warnings of an impending tax apocalypse quickly lose their force.

To understand why, you need to understand how government borrowing works. The Treasury finances its operations on the bond market. She has an overdraft account at the Bank of England, called “ways and means”, which she does not uses under extraordinary circumstances – and even then in relatively small volumes. The Treasury has an operational agent, the Debt Management Office (DMO), responsible for raising funds on the markets to finance government activity through the issuance of bonds.

The DMO issues bonds, or “gilts”, usually with maturities of five, 10 or 30 years, and also uses short-term treasury instruments. It pays bondholders a fixed interest rate on the amount borrowed which reflects the market interest rate at the time. Gilts also trade in secondary markets, allowing bondholders to sell before maturity. As bond prices change, yields – what investors would earn over the bond’s remaining life if they bought it and held it until it matures – also change, in the opposite direction.

As any first-year macroeconomic textbook will tell you, a rapid increase in the amount – nearly half a trillion pounds of bonds to be issued in fiscal year 2020-2021 due to record government borrowing. – should lead to a fall in bond prices. , and an increase in yields that creditors expect from the UK government.

But that is simply not true for the UK government bond market. At the end of October 2020, 10-year yields were lower than a year earlier, and significantly less than five years ago. At shorter maturities, yields have fallen into negative territory, meaning investors are paying for the privilege of lending to the government. This is not a British anomaly, but a historical trend that dates back at least 15 years. In high-income countries, bond investors welcome an ultra-simple fiscal policy with lower interest rates, or what economist Erik Norland calls “stimulus / debt. paradox”.

This paradox underlies the second blind spot of alarmists: the institutional reality of bond markets. Government bonds have become the cornerstone of modern financial systems. Private financial institutions, from pension funds to insurance companies, hedge funds or banks, hold them for regulatory purposes, demand them for speculative reasons, use them as collateral for cheap leverage and run to them during tough times because government bonds are viewed, rightly or wrongly, as the ultimate risk-free asset.

The hidden financial life of government bonds has also altered the relationship of central banks with government bond markets. As government bonds have become central to financial stability, central banks can no longer afford the “hands off” approach to government bond markets that has prevailed over the past 40 years. Monetarist economists such as Milton Friedman convinced politicians and central bankers that escalating government deficits were consuming resources available to the private sector and, if funded by the printing press, inevitably led to inflation.

In 1979, when Margaret Thatcher came to power, the Bank of England held around 17% exceptional UK government bonds. This share fell to zero in 1988 and remained at zero until the global financial crisis. The crisis changed everything, with the Bank catching up with the institutional reality of modern financial systems. In 2010, the holdings of the Bank of England rose to 20%. Then, in 2015, the Bank announced that it would standardize its direct interventions in the UK government bond market as a new ‘market maker of last resort’ policy tool, aimed at preserving the stability of a system. financial heavily dependent on liquid gilts.

He has used this tool forcefully in response to the pandemic, purchasing half of UK government bonds issued since February 2020. As unprecedented as this monetary financing is, it pales in comparison to the European Central Bank, which bought 70% of the debt issued by European governments during this period, or the Bank of Japan, at 75 %.

In case all of that sounds complicated, here’s what it means: The current level of public debt is not a cause for alarm, as interest rates will remain low and structural demand for bonds is not expected to go away. .

So, will quantitative vigilantes, like any broken clock, end up ringing correctly? For the government’s current borrowing rate to result in a currency crisis, nothing less than a political tsunami would be needed. The UK should radically reform its financial system to reduce structural private demand for government bonds. In the absence of such measures, the Bank of England should be prepared to risk financial stability by raising its highly visible hand from the government bond market.

It may be prepared to do so and increase interest rates quickly if it faces significant inflationary pressures. But here, the reality once again runs counter to fear-mongering predictions: The pandemic has brought deflationary winds to a world where central banks in high-income countries struggle to make sense of the forces that could generate sufficiently high inflation. to justify interest rate hikes. No wonder there is an almost universal consensus in financial markets that the interest rates on the public debt of these countries will remain very low for a very long time.

It’s easy to dismiss the argument that we have too much public debt as an ill-informed view of the state of the UK’s finances. But it is a mistake to do so. After all, what is at stake here is the UK government’s willingness to feed its starving children, fund the NHS and invest in a just transition to a green economy. These are political choices in a high income country that can afford to pay them.

To claim that the rapid growth of public debt is a source of alarming concern is only a Trojan horse for a policy wary of state intervention, especially when it involves some form of debt. redistribution from the rich to the poor.

Daniela Gabor is Professor of Economics and Macrofinance at UWE Bristol

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