Using official forecasts from the Office for Budget Responsibility, economists Dr Jo Michell and Dr Rob Calvert Jump show that small changes in forecasts for future interest rates and growth, and what is counted as government debt, dramatically alter the size of the apparent “hole” in the public finances.

These changes to forecasts and accountancy rules produce hugely bigger effects than the £50bn or more changes in spending and taxes the government is reported to be considering for the Autumn Statement.

Most dramatically, reversing a decision to exclude the Bank of England’s debt from the government’s own debt figure, made in January 2022, completely wipes out the projected “fiscal hole” and, on the official forecasts, leaves the government with an additional £14bn to spend against its own debt targets by 2027.

Examples of minor changes, relative to the government’s current forecasts, are shown in the modelling results below.

1. A small increase in the government’s forecast borrowing costs makes the path of future debt unsustainable, making the target useless.

2. Slight changes in the forecast rate of growth, including a possible recession, mean the government also miss its target, also making the target useless.

3. Changing the accountancy rule used to measure the government debt back to what it was before Autumn Statement 2021 completely removes the “black hole”, putting government debt back on a sustainable footing with £64bn headroom to spare.

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Phoot credit flickr

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Since QE was introduced in 2009, it has saved the government over £110bn in interest payments. This is a non-trivial sum, equivalent to nearly 2% of total tax revenue since QE started. For comparison, total NHS spending in 2019/20 was about £150bn. Without QE, the national debt would be at least 5% higher.

The effect of QE on the public finances has attracted less discussion than other possible outcomes, such as increased wealth inequality and higher house prices. This is partly because financing the government is not one of the official reasons that QE was implemented — both the government and the Bank of England are at pains to avoid the impression that QE provides direct financial support to the government. But the fact that it is not much discussed does not mean that it is not happening.

How has QE saved the government so much money? The answer lies, unfortunately, in the technical details. When the government spends more than it receives in taxes – which is almost always – the difference is covered by selling bonds. These are essentially IOUs which entitle the holder to a series of interest payments.

QE involves the Bank of England buying up these bonds. To do so, the Bank issues a different kind of IOU called “reserves” which, ever since the financial crisis of 2008, have paid a very low rate of interest: reserves currently pay interest at 0.1 per cent.

If the government borrows £1bn by issuing bonds at a 2 per cent rate of interest, the Treasury is then obliged to pay £20m per year to the bond holders. If the Bank of England subsequently buys up these bonds, however, overall interest payments made by the government are dramatically reduced to £1m per year. This is because the Bank makes a tidy profit borrowing at 0.1 per cent to lend at 2 per cent and the Bank’s profits – in this case 1.9 per cent of £1bn or £19m – are returned directly to the Bank’s owner: the Treasury!

Since 2009, total interest payments paid to the holders of government bonds add up to around £590bn. However, the Bank has bought up a large chunk of these bonds while financing these holdings at much lower rates of interest. As a result, the total sum paid in interest to private bond holders by the Treasury and the Bank combined is substantially lower, at around £475bn. The difference between these two sums tells us how much QE has saved the government in interest payments: around £115bn.

In fact, this number almost certainly understates how much has been saved. This is because, in addition to the direct effects described above, QE also reduces the government’s interest costs in more indirect way. When the Bank buys bonds, it reduces the available supply in the market. This pushes up the price of the bonds remaining in the market which in turn reduces their “yield” (the effective rate of interest). This means that any further borrowing by the government will be at a lower rate of interest than would otherwise have been the case.

These figures illustrate the power of QE in to reduce the interest costs arising from government expenditure. As discussion turns to potential interest rate rises in the face of inflationary pressure, some have argued that QE exposes the government to higher interest costs: as the rate paid on reserves increase from the current low of 0.1 per cent, the “profit” of QE may disappear or even turn negative. But this is not inevitable. By introducing a “tiered reserve” system – some reserves pay the higher Bank rate while a substantial chunk remain at a lower rate – the money-saving power of QE can be retained, even as interest rates rise.

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Even a few years ago such views would have been seen as heretical: it was assumed that a return to the system of macroeconomic management that prevailed before the financial crisis was just around the corner. Instead, discussion is now dominated by the tools that central banks should turn to next: helicopter money, deficit monetisation or negative interest rates? Demands are also growing for central banks to join the fight against climate change.

The disintegrating conventional view, that a return to pre-crisis orthodoxy is both possible and desirable, mirrors what Henderson and Keynes called “the fashionable view” of the 1920s: the view that all that was necessary to recover the sunny, predictable comforts of Edwardian empires was a return to the monetary arrangements that obtained before the war.

On the 90th Anniversary of Henderson and Keynes’s “Can Lloyd George Do It?“, which argued against this view, and in favour of Lloyd George’s programme of public spending, we have written a report for the Progressive Economy Forum on the effectiveness of the Bank of England’s monetary policy.

The report argues that a reversion to pre-crisis central banking is neither possible nor desirable. Just as the Bank did not have the capacity to stabilise the pre-crisis economic system — stable inflation during this period was, instead, due to factors outside the Bank’s control — it does not have the capacity now to achieve stabilisation using a broader array of tools. Nor does it have the power, acting alone, to achieve productivity targets or a carbon-neutral transition.

The principal reason why pre-crisis central banking is not possible is that the Bank of England now has a substantial balance sheet which cannot be reduced without adverse consequences for capital markets in Britain. The principal reason why pre-crisis central banking is not desirable is that it was precisely that model of central banking, restricting monetary policy to the management of short-term interest rates, that contributed to the crisis that broke out in 2007 and caught the Bank of England by surprise. The Labour Party’s review of policy offers an opportunity to re-examine how central banks can contribute to stabilising economic activity at high rates of employment.

The report reviews various proposals that have been put forward for enhancing the responsibilities of the Bank of England. Targets for productivity would work in a perverse way and may create unemployment, while credit support for greening the economy requires a much greater investment irrespective of Bank support. The report concludes that the Bank has limited instruments for influencing economic activity, and those instruments should be concentrated on what the Bank can do effectively, which is to contribute to economic growth and prosperity by maintaining financial stability. We therefore argue that the Bank should be given an enhanced financial stability mandate in the form of a target to conduct open market operations to keep the yield curve stable. This should be implemented through a policy of open market operations aimed at keeping rates of interest at different maturities stable at levels that support the solvency of financial institutions, and the availability of finance for investment. This is what the Bank of England can do. Stabilisation of the economic system and regulation of employment and investment is a matter of policy for Government, not the central bank.

The full report can be read here. Photo credit: Flickr/Dun.can.

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