Despite running a large budget deficit in each of the past three years, the net debt of the UK government has barely risen.
The distinction between gross and net debt is central to any consideration of a government’s solvency. Gross debt usually refers to the total stock of current non-contingent financial liabilities of government, principally bonds outstanding, and net debt subtracts liquid financial assets held by government departments, such as foreign exchange reserves or holdings of government bonds.
Net debt is the basis for any calculation of fiscal solvency, as long as the assets held by government are highly liquid. If departments within the government hold gilts, it makes sense to net them off the stock of debt, because the government is making interest and principal payments to itself.
The treatment of quantitative easing in the estimation of the UK government’s net debt is therefore critical to any estimate of the fiscal solvency of the country. QE involves the Bank of England purchasing government debt with newly-created cash. This constitutes a reduction in the net debt of the government. Indeed, given that the Bank holds almost 30 per cent of the total debt outstanding, it almost entirely eliminates the increase in debt caused by budget deficits since the financial crisis.
Sir Mervyn King, Bank of England governor, made clear in his speech on June 14 at the Mansion House in London, that potential losses that the Bank might incur on unconventional policies were fiscal costs. Similarly, the assets and liabilities of the Bank should be consolidated with the rest of the UK government. Under the 1998 Bank of England Act, the Bank was granted operational independence, but it remains wholly owned by the government.
QE involves one branch of government (the Bank of England) buying the debt issued by another department (the Treasury). Gross debt of the government rises, but what matters – net debt – declines. In simple terms, if a government holds its own debt it is economically equivalent to cancelling this debt.
Why does the Office of National Statistics ignore QE in its estimate of the UK’s net debt? The answer hangs on an arcane aspect of central bank balance sheet accounting. For simplicity, assume the Bank of England had purchased its entire gilt holdings by issuing physical notes and coins. Accountants, who are used to assets and liabilities matching, would observe that the Bank’s assets – gilts – have risen. But where are the matching liabilities? For convenience, accountants (and the ONS), treat notes and coins issued by central banks as liabilities. After all, in the days of gold and silver standards, they were: a pound note was a promise to deliver the bearer a pound of silver. But no longer. What does the Bank of England owe you if you show up with a pound note today?
Cash is a unique instrument: it is an asset, because it grants purchasing power to the holder, but it is not a liability, because the issuer owes nothing. So standard accounting does not apply: central banks can create assets without corresponding liabilities. The issue is complicated by the fact that the Bank of England does not finance all its gilt purchases by issuing physical notes and coins, but by creating the electronic equivalent – bank reserves. These also typically treated as “liabilities”, but this again makes no economic sense, if they are nothing other than an electronic version of cash.
There are two objections to this line of reasoning. First, that QE is temporary and will need to be reversed, and second that these policies are inflationary.
We can be very clear about the circumstances in which these policies will not cause inflation, because they prevail currently. Increasing the stock of cash in the economy is not inflationary if the private sector increases its liquidity preference. This is precisely what has happened since the financial crisis in 2008, and has been further exacerbated by the sovereign and banking crisis in the eurozone. Banks now want to hold high ratios of cash to other assets, so rising reserves have coincided with very modest growth in lending, and private firms and households are holding higher amounts of cash and restraining their spending. The stock of cash – physical notes and bank reserves – has risen in the UK, the US and Japan by substantial shares of gross domestic product, without any noticeable impact on the price level.
After a financial crisis, and during a secular deleveraging, it is entirely reasonable to anticipate that the increase in the private sector’s demand for higher reserves is structural, and not temporary. It is of course possible that at some point in the future, private sector demand for credit will increase and threaten a credit boom. At which point, the Bank may want to shrink bank reserves. But there are many other policy tools which would be effective, such as raising interest rates, cutting government expenditure, raising taxes, using prudential controls on borrowing, or raising reserve requirements.
This analysis explains the behaviour of government bond markets. If there was either a big problem of fiscal solvency or of inflation it would make no sense for bond yields in the US, Japan, and the UK to be close to historic lows.
There are also profound implications for macroeconomic policy. Much of the debate across the developed world conflates two distinct issues: the size of the government in the economy; and the size of the budget deficit. The former is an ideological question: do we want a large or small public sector share in GDP. The second is really an issue of salvation or suicide. Given extreme private sector risk aversion and substantial financial panic in the eurozone, salvation suggests combining large budget deficits with QE, until the economy recovers. Tightening fiscal policy makes no sense: why cut the budget deficit if fiscal solvency is improving due to QE?
For those who want to survive, but limit the size of the state, the answer is very simple: combine QE with tax cuts. Or make tax cuts greater than reductions in government expenditure. What is beyond doubt, however, is that there is no imminent fiscal constraint in the UK, or for identical reasons, the US.
In the eurozone, it becomes increasingly obvious that the European Central Bank’s opposition to QE will go down in history as one of the greatest acts of policymaking folly. A simple misunderstanding of their balance sheet may well cause the bankrupting of a continent.