The Age of Entitlement – Part 4

Part 4 – Funny Money And A Perilous Path

With vaccinations underway it may appear that we are now at the ‘beginning of the end’. In a matter of months providing the vaccine protects against infection in the high risk groups we should be able to unlock and return to normal. Or so the plan goes.

However, sadly that is very much not the case. Because while the vaccine may eradicate the virus in the coming months it won’t eradicate the economic consequences of our response. A response that has exacerbated problems that already existed but few were talking about. 

In this blog post I want to layout some of the very real facts about the financial status of the UK (which is similar to much of the western developed world) and explore some of the likely consequences of where we are going and the choices we face. I clearly don’t have a PhD in economics as a health warning. But I did study the subject and I’m hopefully aware enough to take you through it, even if incompletely.

While I’m an optimist I find it hard not to see a perilous path ahead. For the young in particular this makes for sobering reading. I do wonder if more of what I’ll share was known how supportive they would be of the policy approaches being deployed.

To begin I want to share one of the first phrases I remember learning in economics, back as a fresh faced teenager. ‘There is no such thing as a free lunch’. The huge support packages announced by governments and central banks then warrant some attention. Much of our fiscal and monetary policy for the last 50 years does. There really isn’t a magic money tree. Or certainly not one that is costless. As the journalist Paul Mallon wrote in 1942 “Until man acquires the power of creation, someone will always have to pay for the free lunch”. Be that in taxes to pay it back or by eroding your income via inflating away debts. Somewhere, somehow, someone pays.

That we can’t live beyond our means is universally accepted too. In every election all political parties scramble to announce to us all their manifesto are ‘fully costed’. In other words their plans are affordable. That’s because we the voters seem, by and large, to want the house in order. What proposals and policies differences that do exist are usually in a fairly narrow band. A few extra billion here or there with a new headline grabbing tax of small scale or a slight increase of an existing one to pay for it. 

So how are we doing? How have we done at balancing the books? Well, on your behalf the UK government has managed to balance the books in 6 years in the last 50 years. Yes, that’s right, 6 years out of 50. Or just 12% of the time. Given that borrowing is in some shape or form a transfer from the future to the present, that means we’ve been living beyond our means. Consistently.

It should come as no surprise that over the same period our public sector net debt (PSND) to GDP ratio has grown from c40% to over 100% today and it shows no sign of stopping. While this isn’t close to our theoretical debt ceiling, for example Italy (135% 2018) and Japan (235% 2018), demonstrate you can sustain higher levels, it does start to impact adversely on a nation when the cost of servicing the debt (paying the interest let alone paying it down) begins to undermine growth because it directs resources away from investment in important things like infrastructure and education. 

If creditors don’t keep the faith then things can become painful and quite quickly. Just ask Greece. There the government was forced by the EU to make drastic spending cuts to restore fiscal credibility. This has done little to support the Greek economy at a time when unemployment has averaged over 20% for the last decade. 

Just how expensive is our debt in the UK currently? In 2019/20 the Office for Budget (OBR) responsibly estimated our total interest on debt was £42bn. To offer context that is £10bn more than we spend as a country educating 4m primary school children each year. It’s the same as our entire Defence spending per year. That’s right today, before we factor in the cost of coronavirus, we are already spending as much on just the interest of our debt as we do on our armed forces each year.

This is when our debt was 85% of GDP. Or £65,000 for every UK household! Post coronavirus the OBR includes a forecast of a downside scenario (where infections and lockdowns persisted – as seems to be the case given new Tier 4 restrictions) that sees debt to GDP rise to 123%. Levels not seen in peacetime. 

This level of debt predicted by the OBR would be twice that allowable under EU law. Funny isn’t it how some international laws are apparently OK to break! And funny too how some laws get very little attention from the media and politicians alike. What is this law? 

First included as part of the Maastricht treaty in 1992 and now found under Article 126 of the Treaty on the functioning of the EU (2012) are laws which oblige member states to avoid excessive budget deficits and debt levels. This had two parts. Firstly, not to have a deficit above 3% and secondly to not exceed 60% debt to GDP ratio. The reason for insisting on such a level of debt to GDP is because they determined above a level of around 60% was detrimental to growth. Now you can debate if it is best to be 40% or 80% but it’s hard to argue its good to be too far beyond that. Yet, at the end of 2019, and before the pandemic, 11 of the 28 nations, including the U.K., were in excess of this level. Greece the worst offender still at 180%. Only since 2016 had we managed to achieve 3 years of deficit being under 3%. This now totally undermined by the 19% deficit forecast for 2020. The EU’s general growth prospects do not look good when, not if, these fiscal positions are addressed. More on that later.

(Detail on the EU law is here https://ec.europa.eu/eurostat/web/government-finance-statistics/excessive-deficit-procedure)

Yes, these are exceptional times right now clearly and we do need to support the economy. But we can’t be under any illusion of what’s needed eventually. This needs to be paid for. 

The problem is compounded as we’ve been breaking the rules in the normal times too. Yes, there was a financial crisis in 2008 but we took 8 years to bring the deficit under control. For those who insisted austerity was wrong for the last decade I ask what austerity? In every year we still borrowed more than is sustainable. And we borrowed for 34 years of the previous 4 decades too. This is why the interest on that debt annually is now what we spend on defence. Just the interest.

To give you a sense of just how unsustainable the current situation is we can look at another piece analysis by the OBR called the ‘unchanged policy’ scenario. This analysis projects forward the fiscal position of the country based on expected future economic growth and what spending commitments / policy choices exist today. It also factors in demographic changes. It’s basically an exercise to answer what the public finances would look like in the future if we commit to offer citizens the same level of public services as we do today. Ideally you’d want the long term debt to be proportionally similar as it shows a sustainable balance of growth relative to expected public spending levels. Our trajectory is anything but sustainable.

The OBR predicts our net debt to GDP will rise to 282.8% of GDP by 2067/68. Driven by an ageing population and their associated health and pension costs, combined with lower numbers of working taxpayers. Again, this was before Covid. Without major policy changes it’s a road to ruin. That’s taxes or spending cuts of significant scale or economic growth significantly above the long term average level. When politicians look to raise the pension age you may now understand why. Without actions like this the nation’s fiscal credibility is at stake. Failing to act can create a viscous cycle of higher interest demanded by creditors which then reduces economic growth by diverting money to debt interest and not investment or salaries as mentioned.

Full report from July 2018 here (https://cdn.obr.uk/FSR-July-2018-1.pdf)

Nor is this debt level actually what our real debt level is. It’s the tip of the iceberg. You’re being lied to again. The debt level you hear in the media or used by politicians of debt to gdp is a measure called the public sector net debt (PSND). It’s very narrow indeed. The easiest way to think about it is to see it as similar to your own bank account. If you’re in debt it’s because you’ve borrowed to pay for things already. You’ve got the new sofa and you’ve paid for it via debt. 

But imagine you also had already agreed to pay for other things in the future, like a summer holiday. It won’t be in your debt yet but it’s basically the same thing as you’re committed to it. The same commitments exists for governments too and these are captured in a different measure called the whole of government accounts (WGA).

Top of the pile in this broader view is the current value of future public sector pension payments. These are not included in the PSND figure. Yet, it’s a debt the government has and will pay. How big is it? At the end of 16/17 it was £1,835 billion. 92% of GDP. 

Today therefore when people say we have a debt to gdp ratio of 100% it’s actually double that really once you include just the future pensions we owe public sector workers. But there is more, there is about 16% of gdp provisioned to cover expected, but not certain in value, future costs associated with things like future nuclear decommissioning costs or medical negligence claims. Taken together and including a variety of obligations (remember public finance initiatives? That’s £200bn to 2050) we have a debt to GDP ratio that’s far higher than what you think and hear about. It’s already in reality closer to 300% of GDP. Then we’ve got the ageing population problem to go on top too. 

‘Oh but the interest rate is at record lows. We should take advantage of this period’. That was the basis of much of the Labour Party manifesto in 2019. Despite the fact our debt level has been growing they wanted more and were happy to say we could afford it. After Covid and it’s cost you can abandon any hopes of such investment. Indeed it’s precisely because of ‘known unknowns’ events like Covid it is arrogant and dangerous to propose borrowing like Labour did. We already have too much debt and Covid has come along. Imagine if it had come after a Corbyn victory and years of spending increases. Disaster. 

There is also a potentially dangerous reason why interest rates are low too. Quantative easing (QE). What began as a non-standard (read experimental) response to the credit crunch has changed beyond all recognition to become a potential monster. Interests rates are in part low because of this very mechanism. But it’s a cheat. Another ‘free lunch’ that sooner or later needs to be paid for. 

To understand why we need to remind ourselves of what it is and why it came to be. Back in 2008 we had a credit crunch. Ben Bernanke, then Head of the Federal Reserve, reacted to this sudden economic crisis by cutting the interest rate to record lows. But they also deployed QE. Unable to lower the interest rate lower and encourage spending they needed more. Something Bernanke himself said could have been called credit easing. That’s right, faced with a crisis brought about by too much debt we began facilitating more of it and at record low costs.

QE works as follows. The Bank of England in the UK (central banks elsewhere in the world) magic up money – which they can do – and deposit it in their own bank account. In the olden days this was called printing money as it literally was just that. Today, like most things, it’s gone digital. Armed with this new money the bank goes out to the market and buys assets (mainly gilts [governemnt debt]) held by banks, pension funds and other entities that own financial assets. This helps drive down interest rates on these assets by raising their price as ‘more demand’ is invented in the market for them. 

There is then a wider impact in that the banks armed with all this new cheap money they’ve received can lend more directly to business and consumers at lower cost stimulating more economic activity. Or so the theory goes. Also, as they are encouraged to buy other assets, with higher yields, they increase their price too. This can include corporate debt and shares. This helps create a ‘wealth affect’. More money chasing assets, like stocks and houses, increases their price. Owners of these assets ‘profit’ and may spend more as a result. 

You can read an overview here. https://commonslibrary.parliament.uk/research-briefings/cdp-2016-0166/

It shouldn’t be overlooked then that a known consequence of this policy is that it will increase the price of assets. Given those are held predominantly by people who were already wealthy, by increasing their price it will inevitably increase wealth inequality. To young people trying to save for a house, unlucky. Not only are your wages not growing but the housing stock you’re hoping to buy is accelerating away from you! This isn’t a secret as I’ve said. The Bank of England’s own analysis of QE tells you. And unbelievably in its assessment of the impact it leaves out the impact of raising the cost of future housing. You can read about it here.

https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2018/the-distributional-impact-of-monetary-policy-easing-in-the-uk-between-2008-and-2014.pdf

A far greater issue on the horizon though is something called ‘fiscal dominance’. To understand this it’s important to understand the central bank in the UK and other major nations are meant to be independent. They control monetary policy with what should be clear goal of price stability, not economic growth and certainly not managing government debt.

The Bank of England was made independent under Tony Blair’s first term government in 1997. The purpose was to place monetary policy in the hands of an independent body, the monetary policy committee (MPC), with a clear focus on price stability – an inflation target of 2%. Price stability is vital to the economy and public well-being. In inflationary periods the poorest are hurt greatly. Their income goes less far and jobs are lost as businesses retrench in investment or get it wrong as price signals are distorted. Equally, periods of deflation are to be avoided too. When prices are expected to fall consumers hold back spending in anticipation of cheaper goods and services. This in-turn can mean businesses invest less too. The result is a dangerous downward spiral in the economy. 

The MPC ordinarily controlled monetary policy and influences inflation through control of the interest rate on sterling. Rates are cut to stimulate economic activity which in turn should generate potential inflation as demand increases prices. This inflationary expectation is then managed by raising rates to avoid the economy growing too quickly creating a sharp rise in inflation. But with those rates cut to record levels to help stimulate the economy after the credit crunch they turned to QE. 

As a non-standard measure it was meant to be temporary and short-term in nature. The first country to use it was Japan in 2001. But the programme ended by March 2006. The Bank of England started in 2008. By 2012 it was already £395bn. It is now £895bn. A policy introduced as a temporary response to the credit crisis of 2008/09 has been deployed more since 2012. This looks anything but temporary or limited any more.

And that’s a problem. This year the government debt is being assisted to the tune of £250bn by QE. We are in danger of a cross-over. Where far from being independent and focused on price stability the Bank of England is seen to be instead facilitating government borrowing. This situation is described as the ‘the most slippery of slopes’ for the credibility of monetary policy by Andy Haldane, the Bank of England’s Chief Economist. You can read an excellent speech he gave on the monetary policy debate in 2015 here.

https://www.bankofengland.co.uk/-/media/boe/files/speech/2015/how-low-can-you-can-go.pdf?la=en&hash=93EDF79B04880BB0CA393854FB4C4F6A0EDAB4CC

Now I trust the monetary bodies to act independently. The problem for the economy is that when they do they will have to in a way that most likely increases the cost of government debt by raising interest rates. This clearly marking that their priority is to not allow a government to inflate away their debt. This is particularly important to the UK where foreign investors hold an ever larger share of government debt now. They now hold 27% of all debt versus 11% in 1987 (38% of all debt if you exclude gilts held by the Bank of England). It is this that keeps the chancellor awake at night. Any changes in our rate of interest upwards and the impact to our cost of debt is significant. 

All of this means tough times lie ahead. Debts must be paid and we also face constrained economic times. We have also used the fiscal and monetary devices that could have helped spur economic growth. It is far from certain what a sensible policy path would be if the economy needs help. Worse to balance the books will require taxes and they typically hinder growth.

LOUIS XIV’s finance minister, Jean-Baptiste Colbert, famously declared that “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.” There is, like most things, a balance to strike. Take too much and you can cause damage to overall society through harming the incentives to succeed – to invest, trade, create and learn. After all, if a free lunch is actually on offer then why try? 

For example, contrary to what certain political parties may say, the U.K. has undergone a significant shift in its taxation over the last two decades. The top 1% of earners pay almost 30% of all income tax compared to c20% in 2000. Over the same period the lowest 50% of earners have seen their share of income tax fall to only 10%. Indeed, 43% of individuals paid no income tax at all in 2019 according to HMRC. 

Now, income tax isn’t the main source of taxation revenues for government. That’s taxes on consumption like VAT, NI contribution, fuel duties and other indirect taxes. Taxes that are regressive. They don’t make any allowance for your income or wealth status. We all pay the same rate as each other. Yes, consume more and you pay more tax. But the rate is the same on each purchase, rich or poor. 

It doesn’t require a rocket scientist to see that to help balance the books that income tax and corporation tax is unlikely to be the best place to go. Instead taxes like VAT or fuel duties offer the best way to increase the tax take. These increase prices. Cost push inflation.  In response employees may start demanding pay rises to offset this inflation. This could be made worse by wealth taxes that need to be paid for out of income, which employees will see as further justification for demanding higher wages. A dangerous spiral awaits.

It is not spoken about enough but we look to be on the verge of a period of stagflation. The worst of all worlds. Rising prices despite higher unemployment. To avoid it policy makers will have to choose between trying to combat inflation by increasing unemployment or accepting inflation in order to solve for government debt that is driving the need for additional taxes. 

This fear may go some way to explain why Bitcoin has recently hit a high. Bitcoin is now seen as a store of value and a way to protect against the coming inflation.

There is some comfort in that a difficult but achievable path lies ahead for the UK. In the Eurozone the situation is far worse. There far from inflation it is deflation that is setting in. A story for another day.