The Great Repression

Economic policy is about to take a turn for the weird. UK government borrowing in April 2020 was as high as in the whole of fiscal year 2019-20, at over £62bn, whilst the Bank of England is now seriously considering reducing interest rates into negative territory. Such is the precarious state of the economy as measures to combat Covid-19 take effect that all of the things we previously took for granted are about to be turned upside down.

The fiscal position

Dealing first with fiscal issues, the Office for Budget Responsibility reckons that UK public borrowing will reach 15% of GDP in fiscal 2020-21 which would represent the biggest peacetime deficit on record (chart below). Governments have no choice but to pull out all the stops given that they have imposed measures which impact on people’s livelihoods. With governments having shut down large parts of the economy, those affected by the measures need some form of support as a quid pro quo. The question remains as to how we will pay for it. In the short-term governments have no choice but to borrow more. Although the UK did not enter this crisis with a great deal of fiscal headroom, it does have some. The ratio of net debt to GDP ended fiscal year 2019-20 at 93.3% but as a result of the surge in borrowing in the first month of the fiscal year it jumped to 97.7% in April – the highest since 1963 - and it seems only a matter of time before it exceeds 100%. 

A decade ago, Carmen Reinhart and Ken Rogoff, in their famous 2010 paper, Growth in a Time of Debt, argued that a debt ratio in excess of 90% has major adverse consequences for economic growth since an increasing amount of resources is then devoted to debt servicing. The low level of interest rates today means that debt servicing costs are at their lowest in history so the 90% threshold may be less binding than in the past (if indeed it ever was, as there remains a lot of controversy regarding this figure). Ironically, on data back to 1700 the UK’s average debt ratio is 99% (chart below). Evidently imperial expansion and the financing of wars did not come cheap. But at the beginning of this century, the debt ratio was around 30% of GDP and whilst the financial crisis of 2008 did a lot of damage, it is notable that the debt ratio has continued to climb during the Conservative government’s term of office. Having spent the past decade telling the electorate that the deterioration in public finances was all the fault of the previous Labour government, even before the Covid crisis, the Tories have not exactly had a great record on managing public finances.

That said, even a net debt ratio of 100% is likely to be easily fundable. Despite what the ratings agencies may say, the UK has a long track record of not defaulting on its debt and it issues in its own currency. Nonetheless, no government will be comfortable with debt ratios at current levels and this partly explains why many policy makers want to reopen the economy as soon as possible in order to get some tax revenues flowing into the Treasury’s coffers.

The monetary response

Whilst I have long been an advocate of a more activist fiscal policy, it is equally clear that fiscal policy alone cannot do everything and needs to be backed up by monetary policy. It is presumably for this reason that the BoE is discussing the merits of cutting policy rates into negative territory. Although there are some circumstances in which they might be useful, I have never been persuaded of the merits of negative rates (a view summarised here).  In very simple terms, they are designed to persuade households and firms to bring forward activity and represent an attempt by central banks to alter the time preferences of economic agents. For those with an eye on their retirement funds, the idea of negative rates is anathema and the impact on savers is one of the reasons why a case has been brought before the German Constitutional Court.

As I have mentioned numerous times before, one of the problems with the negative interest rate policy is that it operates only on the supply side of the credit equation. Reluctant borrowers cannot be forced to take out loans and in the current environment, where uncertainty is at a maximum, households and corporates will not borrow under any circumstances. A bigger concern is that once rates fall into negative territory, they will stay there for a long time. That has certainly been the experience in Japan and the euro zone. Indeed, the experience of the last decade has been that central banks never seem to believe that the economy is strong enough to support monetary tightening. Consequently if interest rates do fall into negative territory, I fear they would not quickly rebound. As the respected head of the BIS research department, Claudio Borio, noted last year, “A growing number of investors are paying for the privilege of parting with their money. Even at the height of the Great Financial Crisis (GFC) of 2007-09, this would have been unthinkable. There is something vaguely troubling when the unthinkable becomes routine.”

As to whether a policy of negative interest rates has much economic effect, the jury is still out. Evidence from ECB researchers suggests that negative rates have boosted economic growth in the euro zone, although Italy might beg to differ. But no central bank is ever going to produce evidence that says its signature policy is not having the desired effect so we should treat the results with some caution. However, it does have a real impact on the banking sector. I do not expect the vast majority of the public to shed any tears for banks, which emerged from the 2008 crisis in better shape than they dared hope, but negative rates will squeeze margins. At a time when the BoE is exhorting banks to continue lending because “it is in their interest to do so”,  a policy which makes banks think more carefully about who they lend to is inconsistent with this strategy. Evidence from Sweden suggests that initial moves into negative territory do get transmitted to lending rates but subsequent moves do not. In other words, the monetary transmission mechanism can break down quite quickly. 

We should be under no illusions that policymakers will have to take all available measures to get the economy back on its feet. Given the huge surge in sovereign debt, governments and central banks are about to embark on a prolonged period of financial repression in order to reduce the cost of debt servicing. By doing so, governments will be able to reduce the extent of fiscal austerity required to control public finances when the economy finally recovers. If this means a period of negative interest rates, so be it. However, there is nothing to be gained from doing so for a prolonged period although if asset bubbles, screwing future generations of pensioners and failure to use the market mechanism to discipline risk taking are your thing, be my guest.