Labour's Strait-Jacket. Gerald Holtham

Labour’s voluntary strait-jacket

The new Labour administration is in a financial strait-jacket. It faces a budgetary situation that inhibits essential investments and implies further cuts to already mutilated public services. It is important to understand, however, that the strait-jacket is voluntary. The government might have reasons to remain in bondage, but it cannot claim it has no choice.

Currently the Bank of England is paying tens of billions of pounds a year in a subsidy to commercial banks. And the government is picking up the tab. The Bank pays interest on the balances that commercial banks hold with it as a way of controlling the interest rates they charge customers. Economists like Paul Tucker and Paul de Grauwe and economic journalists like the FT’s Chris Giles have pointed out, however, that not all the expenditure is necessary . A modification to the system, used in many other countries, could reduce the enormous subsidy to commercial organisations that the present system entails.

The Bank of England never paid interest on commercial banks’ reserve balances before 2006. It began to do so at a time when the balances were tiny as a convenient way to put a floor under interest rates. It continued through the period of very low interest rates after 2008. But this method of managing interest rates is now costing some £40 billion a year as the BoE pays over 5 per cent on balances swollen to £700 billion a year by Quantitative Easing.

To prevent commercial banks swamping the money markets with spare cash and driving interest rates down, the Bank of England needs to pay interest at the margin but does not need to pay on all reserve deposits. A tranche of the deposits can be remunerated and any reduction in a commercial bank’s reserves would be deemed to come from the remunerated portion. The Bank rate would then still act as a floor for interest rates. Not only would that arrangement reduce public spending it could also result in a huge drop in government debt.

To see why that is so consider the Bank of England’s balance sheet. Currently some £700 billion of government bonds are held as assets of the Bank of England. It bought the bonds with cash it created as part of the programme of Quantitative Easing. That is debt the state owes itself! Under current accounting conventions the Bank requires these assets to balance its liabilities – the reserve balances of commercial banks. The liability, however, is optional. Those balances cannot be reimbursed because they are already the ultimate form of cash in our system. A debt is settled by money; if an institution has the money, it no longer has a claim to be settled. The reserve balances are only “liabilities” of the Bank of England because it has chosen to pay interest on them. If the Bank of England now ceases to pay interest on, say, two-thirds of the balances, it can similarly cancel two-thirds of its assets. It can still influence interest rates and yet cancel two-thirds of the government bonds it holds. £400 billion of national debt will disappear, some 15 per cent of the total national debt. And no private bond-holders will be affected. Their holdings could in fact appreciate in value as the prospect of extraordinary bond sales by the BoE (so-called QT) recedes.

Rachel Reeves’ promise to reduce the debt to GDP ratio can therefore be accomplished very easily.

That’s not all. Responsible governments in all countries aim to limit the extent of government debt so that interest payments do not impose an excessive burden on current and future taxpayers. Most governments do not worry about debt that is serviced from marketable investments or commercial revenues because it is not, in principle, a charge on future tax- payers. The usual fiscal target is the General Government balance, excluding the debt of publicly owned corporations. The UK is unusual in making a target of the Public Sector Borrowing Requirement, including the borrowing of such enterprises.

So why should the public debt target include the debt of institutions like the rail network or the new British Energy company which is supposed to pay its way? The conventional answer is that if the commercial activity is in the public sector, the government as shareholder bears the ultimate risk if there is a commercial failure. That is of course true. So how would an actuary assess that contingent liability or how much would an insurer charge to indemnify the state against losses on bonds of the energy company? The answer would be a minor percentage of the debt stock. The government could let the enterprise borrow on its own account and put just the contingent liability on its own books – rather than lumping the whole debt into a PSBR and starving the enterprise of capital.

The steps needed to ease the budgetary constraint, therefore, are:
• Stop paying for the Bank of England’s losses and encourage it to cease paying interest on a large tranche of commercial banks’ reserve deposits at the Bank
• Cancel an associated tranche of government debt held by the Bank of England
• Exclude public trading institutions from the government’s budgetary target and from government debt and account properly for the state’s contingent liabilities.

Changing long-standing conventions, even irrational ones, always triggers criticism, particularly from anyone adversely affected. Changing conventions that restrict the possibility of public action reliably provokes lobbies anxious to limit such action. Special pleading and specious cries of foul can be predicted. Nonetheless, if the government submits to those influences it cannot claim force majeure. It has a choice.

Gerald Holtham
30:vii.2024