You’re the Chancellor of the Exchequer. You’ve set yourself some – admittedly fairly arbitrary – targets for the public finances. It looks like you’re going to miss them. You’ve got a big speech, the autumn statement, coming up on 5 December.
What do you do? Admit that things aren’t quite working out as you’d hoped, and brace yourself for the taunts from the opposition? Decide that the answer is more of the same – that we need more cuts, even though they won’t be popular? Or decide that it’s time to use the ongoing slowdown to push for some radical solutions, such as a genuine simplification and overhauling of Britain’s ridiculously complicated tax system?
For George Osborne, it seems the answer is: none of the above. Instead, he has taken a page out of Gordon Brown’s book and decided to ease the pain by cooking the books instead.
Last week, the Treasury quietly broke new ground in the UK’s ongoing monetary policy experiments. Since March 2009, the Bank of England has printed enough money via quantitative easing (QE) to buy up £375bn in gilts. That’s more than a quarter of the UK government’s outstanding IOUs. As a result of holding all these gilts, the Bank will also have racked up £35bn in interest payments on that debt by March next year.
Until now, that cash has been sitting in an account at the Bank, call the Asset Purchase Facility (APF). The idea is that when QE is eventually unwound, and the gilts sold, this interest income will offset the likely capital losses the Bank will experience.
But the Treasury now argues that it makes no sense to pay the Bank interest on the gilts, given that the government has to borrow more money to do so. As Jeremy Warner put it in The Daily Telegraph: it’s “a bit like the government taking out an overdraft to pay money into a savings account – not very sensible given that you pay a lot for the overdraft but get virtually nothing back from the savings account”. So the Treasury has taken this £35bn from the Bank, with the plan to use it to reduce public borrowing.
Conveniently enough, this might also make it that bit easier for Osborne to hit his debt-reduction targets. Indeed, says Michael Saunders of Citigroup, the move “may just be enough” for the Office for Budget Responsibility (OBR) to project that the government “will probably hit its target of falling debt/GDP ratio in 2015/16 whereas previously that appeared out of reach”.
A watershed decision
The Treasury argues this isn’t a big deal. After all, the decision just brings it into line with the way Japan and the US account for interest paid on government debt. And as the taxpayer is ultimately responsible for any losses the APF incurs, it doesn’t matter – the money will be paid back to the Bank in the future if necessary. But that’s not the point.
The danger is that the Treasury has crossed a line here. QE is meant to be a tool that the Bank uses only in extraordinary circumstances to try to force more money into the economy. It’s not meant to be a blank cheque that’s used to fund government spending. Because if the Bank does that, you’re getting into Weimar Republic territory.
This is why it’s important that people remain confident of the Bank’s independence – they need to believe that the Bank will protect the country’s currency even in the face of opposition from the government. And that’s why this decision is such a watershed.
It’s pretty clear that this is all about political expediency. This isn’t the Bank’s decision – it’s the Treasury’s. Osborne was looking for some loose change to dress up his accounts. He found it down the back of the Bank’s sofa, and took it.
To use the jargon, this blurs the line between monetary and fiscal policy badly. It’s worth noting that the TUC is already calling on the government to use this £35bn ‘windfall’ to boost public spending, seemingly oblivious (or uncaring) of the fact that this is exactly the sort of thing that got Zimbabwe into trouble.
What’s worse, perhaps, is that it reveals just how dependent Osborne and the British economy are on QE. The chancellor has taken the first step – and a potentially very controversial one – on a very slippery slope, all in the name of burnishing his figures in the short term.
It’s ironic: during the boom years, the Bank of England (and other central banks) were the biggest creators of moral hazard in the stockmarket – investors were taking more risks than warranted, safe in the knowledge that the Bank would always bail them out with lower interest rates.
The Bank is now creating moral hazard in the public finances. The more the chancellor thinks he can rely on money-printing to ‘solve’ his budget problems, the less likely it is that an already divided coalition government will take tough action to put Britain back onto a sustainable economic growth path.
Britain’s fragile finances
That’s bad news. Because if there’s one thing that Britain needs, it’s a plan for growth. The economy might have bounced back from its double-dip, but it’s hardly firing on all cylinders. GDP is still a good 3% below its pre-recession peak, and it’s very difficult to work out just how much the Olympics artificially boosted both the figures for the economy and employment data. Meanwhile, Britain is still up to its eyeballs in debt.
Officially, our national debt stands at around 68% of GDP. But if you include the impact of the bank bail-outs following the 2008 financial crisis, our debt-to-GDP ratio jumps to nearly 140%. That’s bad enough already, and we haven’t even considered pension obligations or private-sector debt in this figure.
If you take into account total private and public-sector debt, Britain is the most indebted economy in the world, with the possible exception of Japan.
One of the biggest problems for growth in recent years has been “unexpectedly stubborn inflation”, said the OBR last month. Wages have failed to keep up with the cost of living, meaning that many people have suffered a wage cut in real terms (accounting for inflation). With credit tight too, that means consumer spending has been reined in. This doesn’t look set to improve in the near future.
The UK’s most recent consumer price index (CPI) inflation figure came in at 2.7% – well above expectations – but the Bank of England shows no sign of being the slightest bit worried. In its latest inflation report it issued the usual glib assurance that inflation would come down to meet its target at some point in the future, and at the same time noted that it would be quite happy to consider printing more money in future if necessary.
But the other issue is that Britain’s big growth driver – the financial sector – is now in long-term decline. With regulators cracking down, competition mounting from overseas, and new rules being introduced both on how much capital banks have to hold, and potentially on how they are structured, the City can’t be expected to continue to drive Britain’s economic growth in the future. The trouble is, there’s no obvious replacement industry.
Aren’t things as bad in the US?
Aren’t we being unfair on Britain here? Doesn’t the US face similar issues? It does, but comparing the two countries throws into relief just how much worse Britain’s position is. The most obvious difference is in our energy outlook.
The US is on the verge of becoming the world’s biggest oil producer. New production techniques mean it is sitting on a gold mine of cheap energy. That makes the US more competitive, and it will also prop up the US dollar, even in the face of determined money printing by Federal Reserve chief Ben Bernanke.
The UK, on the other hand, faces an energy crunch. North Sea oil output is steadily declining, our policies on green energy are hopelessly muddled, and we seem more inclined to attack companies for hiking our energy bills, rather than tackle the underlying problems.
Then there’s the property market. It doesn’t really matter whether or not you believe that the current rebound in the US housing market is sustainable. The point is, prices have crashed and the market is now beyond the worst. Arguably, US consumers could withstand higher interest rates without suffering a catastrophic wave of home repossessions and surging bank bad-debts.
The UK is different. The structure of our mortgage market means that, unlike in the US, the Bank of England’s rapid action in cutting interest rates to near-zero levels immediately drove the cost of mortgages down. In turn, there has been less pressure to sell. As a result, while prices (outside London) have still fallen, prices are still far higher than they otherwise would have been.
This has left the housing market paralysed, as banks, worried about the potential for future bad debts from their existing property exposure, freeze lending. An illiquid housing market is also bad news for labour mobility, as people are less inclined to move.
Politicians should get a grip
It doesn’t have to be like this. Yes, banking crises take a long time to recover from. But the government could help things along by pushing through sensible structural reforms to make Britain more competitive and encourage more productive investment.
As Allister Heath notes in The Daily Telegraph, our current tax system is “mad and indefensible… we need revolutionary change, rather than yet more useless tinkering”. He’s talking about corporation tax specifically, but the view is applicable to the whole system.
Favourable tax treatment of debt, for example, leads to all sorts of distortions: from private-equity firms hollowing out perfectly healthy companies and leaving them on the verge of bankruptcy, to complex corporate structures aimed at artificially reducing taxable profits.
It might not please the lobby groups for industries whose business model relies on this tax treatment, but as Tim Morgan of Tullett Prebon puts it: “The reality is that Britain will not remain one of the world’s wealthiest countries unless unpalatable decisions are taken.”
But this sort of reform requires political courage. And that’s in short supply right now. Just look at the mess the government has made of its changes to child benefit, for example.
As my colleague Merryn Somerset Webb pointed out on her blog recently, in trying to avoid penalising the ‘squeezed middle’ too much and drawing angry headlines, the coalition has turned a simple, universal benefit into a hideously complicated system.
The tapering of relief leaves the system rife with potential for avoidance, and adds another half a million people to the list of those who need to fill in self-assessment forms for the taxman to pore over. Hardly an example of cutting red tape, or making the economy more dynamic.
This sort of ‘government by headline’ will only get worse the closer to election year we come. Meanwhile, as Heath puts it, “the disastrous anti-business atmosphere resulting from the current backlash, with CEOs who create jobs in the UK being hauled in front of MPs, is already telling the world Britain is closed for business”.
It’s little wonder that Osborne would rather rely on money-printing to tide the economy over in the hope that something will eventually turn up. It feels painless at the time, and if markets fail to react, he might even be tempted to use some of the printed money to fund a few giveaways in the future. But if he does, there can be only one outcome – and it’s not pretty.
Says Tim Morgan: “The only difference between QE and printing money is the claimed intention of reversing it at some point… The next sequential stage – which probably lies in the very near future – is the realisation that the claimed reversibility of QE is nonsense… do we really believe that the Bank of England can ever reverse £375bn of money creation? And that, logically, is where the tragedy ends – in money-printing, hyperinflation, and collapse.”
Let’s hope it doesn’t lead to that. But just in case, we have a few suggestions about where you should put your money to protect your wealth below.
The investments you should buy into now
As regular readers know, we don’t like gilts. In historical terms, they have rarely been more expensive. For as long as the Bank of England continues to print money to buy gilts, yields are unlikely to rise much (that is, prices are unlikely to fall). But it’s hard to see how they can fall much further from here. So we’d avoid them.
We’d also look to get exposure to currencies other than the pound. If investors start to worry that the Bank is printing money simply to fund government spending, it’s sterling, rather than gilts, that will feel the pain first.
If you want to spread bet, you could, but this is very much a short-term speculation. Instead, we’d suggest buying assets overseas that are already attractive, such as cheap European markets – Italy is our favourite of the troubled peripheral countries; one way to get exposure to the market is via the iShares FTSE MIB ETF (LSE: IMIB) – or Japan.
If you’d rather stick to UK stocks, you can get overseas currency exposure by investing in those which get a large portion of their sales and profits outside the UK. Handily enough, in many cases, these companies are often the big, defensive, dividend-paying giants that we’ve been recommending for a while now.
At a time when central banks the world over want to keep inflation moderately high and interest rates low, assets that provide any sort of reasonably safe yield will be in demand, and it’s hard to see that coming to an end in the near future.
However, do be on the look out for potential tax changes: as Merryn points out on her blog: “Governments are broke and corporates are solvent. Governments would prefer it the other way around. That’s a risk.”
You should, of course, hold some gold. If the pound collapses, gold will hold its value well. You can buy physical gold from a bullion dealer, or buy online and have it stored for you at a company such as BullionVault, or alternatively buy a physically backed gold exchange-traded fund (ETF) such as ETFS Physical Gold (LSE: PHAU).