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.

Download pdf here

Phoot credit flickr

The post The Dangerous Fiction of the “Fiscal Black Hole” appeared first on The Progressive Economy Forum.

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.

The post Without Quantitative Easing the national debt would be more than £100bn higher appeared first on The Progressive Economy Forum.

In April 2019 the UK government announced an increase in the British Business Bank’s funding by £200 million, with the apparent purpose of replacing the EIB funding. But in its current form, the BBB is incapable of lending at the scale of the EIB or any of the other major NIBs. In comparison, Labour Party plans for a National Investment Bank imply around £25 billion of lending and loan guarantees every year for 10 years. Such an institution might help plug the ‘patient finance’ gap that has afflicted the British economy for decades.

In a new guest paper for IIPP we outline the extent to which a National Investment Bank would affect the public debt and be affected by EU state aid rules — two important questions which have not been considered in depth.”

Public finances

As a future National Investment Bank will be owned by the government, it will — unsurprisingly — be classified as a public sector institution by the Office for National Statistics. As a result, its net debt will count towards the total public sector net debt. Given that the Bank’s assets will be relatively illiquid, this effectively means that the Bank’s lending will add around £25 billion to the public sector net debt every year.

This addition to the public sector debt, however, is unlikely to pose a serious problem. There are two reasons for this. First, the ONS already publishes net debt figures including and excluding public sector banks, with the latter figure generally used as the baseline measure of public borrowing. As the National Investment Bank will almost certainly be classified as a public sector bank, its lending will therefore leave the baseline figure unaffected.

Second, an annual increment of £25 billion to the public sector net debt is actually a relatively small amount. This is illustrated in figure 1, which approximates the effect of a National Investment Bank on current OBR forecasts. The Bank’s liabilities total £125bn by the end of the 5 year forecast horizon, raising the 2023 forecast of public sector net debt from £2179bn to £2304bn — an increase of around 6%. As the OBR’s forecast for nominal GDP in 2023 is £2561bn, the 2023 forecast of public sector net debt as a percentage of GDP increases from 85% to 90%.

State aid rules

While the effects of a National Investment Bank on the public finances are relatively straightforward, its relationship to EU state aid rules is more complicated. These rules are intended to prevent governments from providing subsidies (including grants, interest and tax relief, guarantees, government holdings, etc.) to specific companies or sectors that could distort competition and affect trade in the single market.

At the level of broad generalities, current state aid rules do leave sufficient room for the UK to establish and operate a National Investment Bank. A number of member states already have large and active NIBs, including Germany, France, Italy and Spain. In the post-crisis environment, NIBs are seen by the European Commission as key partners for its Juncker Plan (2014–20), and future InvestEu plan (2021–27), and among large member states the UK is the exception in not having a serious National Investment Bank.

EU state aid rules do, however, limit the range of activities that NIBs can undertake. Broadly speaking, state aid rules allow NIBs to conduct horizontal industrial policies which claim to provide public goods that benefit all industries equally, but not vertical or selective ones that focus on promoting or upgrading specific sectors or firms. The General Block Exemption Regulation (GBER) designates a number of categories where horizontal aid is allowed, including for underdeveloped regions, SMEs, research and development and innovation, and environmental protection.

Fortunately, the distinction between horizontal and vertical industrial policies is not as problematic as it initially appears. In practice, as horizontal and vertical industrial policies are very hard to distinguish, many vertical policies can in fact be legally conducted under current horizontal state aid framework. For example, renewable energies can be promoted under the environment GBER, while advanced manufacturing sectors like aerospace can be promoted under the R&D and innovation GBER. If they do not fall under the GBERs, sector specific programs can still be compliant with state aid rules if they are notified and the EC agrees that there is a legitimate market failure.

What if a National Investment Bank does need to move beyond horizontal policy? We argue that this would be best achieved by remaining in the European Union. For example, a Labour government could call for progressive reform of state aid rules to allow for more targeted industrial policy, as well as a more flexible set of rules for less-developed member states to allow them to catch-up. Importantly, EU industrial policy itself is moving in a more openly vertical direction, with the German and French governments calling for amendments to the state subsidies and competition rules to enable them to create ‘European champions’. If the UK were to retain a special trading relationship with the EU after Brexit, it would need to abide by state aid rules in any case, but without having any influence in shaping them.

In summary, the financial and legal barriers to an ambitiously sized British NIB are not as challenging as might have been thought. Given this, whatever happens in regard to Brexit, it would seem the time is right to create such an institution to support British industry and help create a more investment-led growth model.

You can also read this post on the UCL IIPP blog here. You can read the ‘Financial and legal barriers to the creation and operation of a British national investment bank’ report at UCL IIPP here.

Photo credit: Flickr / TeaMeister.

The post Financial and legal barriers to the creation and operation of a National Investment Bank appeared first on The Progressive Economy Forum.