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Trapped in the maze

Imagine for a moment that you are Britain’s Chancellor of the Exchequer – the minister charged with overseeing the economy.  Don’t worry if you haven’t got the first idea how an economy runs… he doesn’t either.  Nevertheless, your boss – the man who lives next door to you in Downing Street – has set you something of a conundrum.  With a general election next year, he is demanding that at the very least, the economy doesn’t get any worse.  And ideally, he would like you to somehow engineer the fabled “soft landing” from the current cost-of-living crisis.

Perhaps the most obvious difficulty with this is that you have already outsourced the management of the crisis to the Bank of England, since they claim to know a lot more about the economy than you do.  Which is true, but that is hardly a recommendation, since the Downing Street cat has more of a clue than the officials at the Treasury and the Bank of England combined.  Nevertheless, the Bank of England officials have told you that since the “inflation” looks a lot like the 1970s, the solution is to do what they did back then – raise interest rates until something breaks and prices are forced down again.

This though, flies in the face of the instructions from the man next door, who would like to present the electorate with a recovering economy rather than a repeat of the depression of the early 1980s.  And so, you might be thinking about increasing public spending to make a bad situation more bearable for the voters – like you did last winter, when you paid the essential part of everyone’s energy bills… except that it was exactly this type of stunt which triggered the inflation in the first place.  In any case, because the global banking and financial institutions have become increasingly concerned about the government’s ability to repay its outstanding debt, they are less prepared to lend you the currency to allow you to fund a pre-election giveaway.

For clarity, the way in which currency is created is a little more complicated than the simple Bank of England explanation of how “bank credit” – the numbers in your bank account – is itself a form of currency:

“Money is more than banknotes and coins. If you have a bank account, you can use what’s in it to buy things, typically with a debit card. Because you can buy things with your bank account, we think of this as money even though it’s not cash.

“Therefore, if you borrow £100 from the bank, and it credits your account with the amount, ‘new money’ has been created. It didn’t exist until it was credited to your account.

“This also means as you pay off the loan, the electronic money your bank created is ‘deleted’ – it no longer exists. You haven’t got richer or poorer. You might have less money in your bank account but your debts have gone down too. So essentially, banks create money, not wealth.”

As far as it goes, this is a good explanation of how most of our currency is created.  It is also a useful explanation of the difference between “money” – which is a store of wealth – and “currency” – which is not.  However, it omits the role of the Treasury and the Bank of England as the originators of bank credit to begin with.  This is because banks require deposits before they can extend loans.  And the way in which they obtain these is through the sale of government bonds – known in the UK as Gilt-edged securities or “gilts.”  Selected banks can obtain these gilts through private auctions when the government is seeking to raise currency for public spending.  The banks may then either sell the gilts in exchange for existing currency, or they can sell them back to the Bank of England in exchange for a special kind of currency called “central bank reserves,” which banks also use to settle accounts with each other.  And it is upon these central bank reserves that the Bank of England applies the headline overnight interest rate which the establishment media reports on.

It is important to understand that this is only the way the UK’s currency system works at this moment.  Other forms of currency creation are possible… including simply creating new currency directly without going through the banking system at all (which is something you will no doubt be looking at in the near future).

So, here’s a problem with this way of creating currency.  In an earlier age, the currency would – at least in theory – have been based upon something material, such as the precious metals used by governments to settle their balance of payments – the “pound sterling” originally referred to a pound, in weight, of sterling silver.  The currency of a strong exporting country would also be strong because of its accumulation of precious metals, while a weak importing country would see the value of its currency fall as its metal reserves were depleted.  In the modern world, however, we have a “fiat” (from the Latin, “let it be so”) currency which neither has nor is based upon anything of value except for the perceived ability of future tax-payers to repay the government’s debts with interest.  This, in turn, is essential to government departments and businesses which trade internationally, since they must be able to convert the national currency into Euros or US dollars.

Unfortunately, this gives rise to a problem concerning the use of interest rates in an attempt to lower prices.  One big difference between 1980 and 2023 – in both the UK and to a lesser extent the USA – is that back then we were industrialised exporting countries (although the inflation of the 1970s had seriously impacted our exports).  Today, the UK is heavily dependent on imports – not just for discretionary items, but for essentials like food and energy.  But higher interest rates leave the government less able to pay for the debt it has already run up, still less raise the new borrowing – especially in dollars – to fund its future spending.  And one place where this is likely to show up is in the gilt auctions that we discussed above.

This is something which has no doubt given your officials sleepless nights over the weekend.  Because, in addition to selling new gilts to finance public spending, the Bank of England has been trying to sell off the gilts which it bought back (via quantitative easing) from insolvent banks between 2009 and 2022.  It was already understood that these gilts would sell at a loss, but as Elliot Smith at CNBC reported last week:

“Both the Treasury and the BOE knew when the APF [asset purchasing facility] was implemented that its early profits (£123.8 billion as of September last year) would become losses as interest rates rose.

“However, the pace at which the central bank has had to tighten monetary policy in a bid to tame inflation means the costs have risen more sharply than anticipated. Higher rates have driven down the value of the purchased government bonds — known as gilts — just as the BOE began selling them at a loss.”

The Treasury had to transfer £14.3bn in July alone to cover losses.  But, within the current system, the alternative – of having to pay ever higher interest on the £900bn or so of central bank reserves created to buy the gilts in the first place is no less palatable.  And this may only be the beginning.  Because in the highly likely event that the Bank of England economists are wrong – just like every other time – and instead of the promised soft landing, we get a combined housing and business failure crisis, then you have zero chance of raising the foreign currency you depend upon without losing control of interest rates.  That is, in the likely event that we face a major crash when all of those business loans and mortgages have to be rolled over, lowering interest rates will no longer be an option because international investors are not going to believe that future UK tax income will cover the debt.  At worst, the UK might face an investor flight, with nobody outside the UK wanting to take on UK debt.  At best, the Bank of England is going to have to offer an even higher interest rate to attract the few international investors prepared to take the risk.

The obvious – and dangerous – response would be to “monetise” the debt.  That is, to create government currency directly to vaporise outstanding debt.  If the UK was an exporting country, this might work to some extent.  But since it would serve to lower the value of the pound against other currencies, the result would be import-inflation.  And since imports – components and finished goods – account for more than 70 percent of the current cost-of-living crisis, monetisation would only make matters worse.

The same goes for the two approaches favoured by “left” and “right” – infrastructure spending and tax cuts.  Both are supposed to stimulate economic growth (although have only ever worked in periods where there is surplus energy to take up the slack).  In the current economic environment, either or both will simply add to the strain on an already weak currency.  Lower taxes – like Truss and Kwarteng attempted last year – and you risk an even bigger response from the bond markets than they did because you further weaken the UK government’s ability to repay its outstanding debt.  And while infrastructure investment at least promises some payback, the cost – interest – is going to be eye-wateringly high.  Moreover, given the inability of government contractors to deliver on-time and on-budget, this merely looks like adding more debt on top of the existing mountain with no obvious means of repaying it.

As Chancellor, you are trapped.  While there are a few things you might do around the edges – like freezing the pay of public employees earning more than the median wage, or re-balancing VAT by removing it from essentials like energy while increasing it on high-end discretionary goods – these merely change who is most impacted by the crisis, they won’t prevent the crisis itself.  Indeed, all of the big policy levers you might pull, risk making matters worse.  And so, perhaps the best advice came from one of your predecessors, who quipped that “when you are in a hole, stop digging” – something, by the way, that you might suggest next time you meet the Governor of the Bank of England.

Ordinarily, the best advice would be to try to blame the previous government for the mess we are now in… except that you are the previous government, and the man next door is responsible for signing-off on most of the things which caused the current crisis.  Having shut down the economy without even considering the potential harm this would cause, he spent two years spending money like a drunken sailor, so that we had enough pent-up savings by the autumn of 2021 to guarantee an inflation – although this turned out to be exacerbated by the supply chain shock resulting from most of the G20 countries also shutting down their economies.  And then there’s the not inconsiderable shock to the UK gilt market from your government going further than ever before in the application of sanctions, by actually stealing the assets of Russian oligarchs – something which may have assuaged a lot of hurt feelings, but which has caused London to lose its reputation as a safe place for foreign investors to park their wealth.

The one saving grace – although I doubt that Sunak would dare to mention it – is that all of the decisions which have now fed into the biggest economic crisis since the 1970s (and possibly since the 1930s) were enthusiastically embraced by the opposition Labour Party.  Pointing this out might help you to hold onto a few more seats next year but will require a lot of – maybe too much – mea culpa on your part.

Which leaves you with one final alternative – blame everything on the Bank of England officials.  It’s unlikely to help in the election, but it may draw attention away from the bigger part that your government – which, let’s face it, has been messing the economy up since 2010 – has played in creating the conditions for a new Great Depression.

As you made it to the end…

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