10:29

Why can't the Bank of England cancel all the Gilts it holds?

The Bank of England is now holding about two thirds of the total issuance of Gilts as a result of QE. So the Treasury pays lots of interest to the Bank of England - part of George Osborne's deficit headache that won't go away. Both are part of the UK Government, so why can't the Bank of England simply cancel the gilts that they hold - maybe closely coordinating that action with other central banks doing the same thing at the same time?

Below is a blog exchange that bats this idea around 

"The UK sits unhappily at the very boundary of what debt burden is acceptable for a AAA rated economy.  If growth continues to disappoint, or if more austerity becomes socially impossible, the UK will be downgraded – and neither of these possibilities look very remote.

At the moment the UK public sector net debt to GDP ratio is about 63%, equivalent to about £1 trillion (these numbers exclude the debt of the part nationalised banks).  Debt servicing costs are over £50 billion per year – a large chunk of our annual deficit.  Additionally our debt position is likely to deteriorate before it improves.

But do we really need to be paying interest to the Bank of England on the £300 billion+ of gilts that it holds as part of the Quantitative Easing programme?  In fact the Bank holds these gilts on behalf of the Treasury anyway, so the Treasury is effectively paying interest to itself on assets that it bought with “free” printed money.  Could we decide that this is a waste of time, that we are unlikely to sell these gilts back to the market in any case, and that we may as well just cancel the gilts we bought for the nation?  Gold bugs and inflationists will at this point be spluttering into cups of tea – what about all of the printed fivers that have been set free into the economy like in a modern day Weimar Republic?  Well, how about this for a potential statement from the authorities on gilt cancellation announcement day:

“Today the Treasury announces the cancellation of £350 billion of gilt-edged stock held by the authorities.  These gilts were bought as part of the Quantitative Easing programme started in the aftermath of the financial crisis.  The purpose of Quantitative Easing was to boost nominal growth after what we thought was a temporary fall in UK output.  Several years later it appears that this fall in output was permanent – the fall in UK GDP remains more severe than that experienced during the Great Depression.  We will therefore make this liquidity injection permanent in order to boost UK growth and reduce unemployment.  The Bank of England of course remains fully committed to its inflation target of 2% – a cornerstone of UK economic policy. Should inflation rise, or be forecast to rise above the target range, the Bank may raise interest rates, or sell Treasury Bills to the market in order to drain excess liquidity from the system and return inflation to its target.  Today’s action also reduces the UK’s debt to GDP ratio from 63% to 41%, and slashes our interest bill from £50 billion £32 billion per year.  This prudent action safeguards the UK’s AAA credit ratings and leaves holders of gilt-edged securities in a stronger position than before.

Note from the Debt Management Office: the gilt cancellation will take place using the same process and precedent set with the cancellation of £9 billion of UK gilt-edged securities acquired from the Post Office pension scheme in April 2012.”

So who would be unhappy with this?  No default has taken place (no CDS trigger, no D from the ratings agencies who are only interested in failure to pay private investors), the UK’s public finances become sustainable, the economy gets a boost from the knowledge that the QE cash injected will stay there for the foreseeable future, and a mechanism exists to remove cash from the economy should inflation return.  Apart from the fact it all feels a bit banana republicy everybody’s a winner.  In fact the genius of this idea is that it doesn’t need to be done at all – if the Bank of England were to start paying gilt coupons and maturing gilt proceeds over to the Treasury automatically you would have an equivalent economic impact, without any of the awkward Zimbabwe comparisons."

Reply 1.

"I’m really glad that you, as a professional investment manager, addressed that point because I’ve asked that same question a number of times on several forums about a year ago with no response – what if all the gilts bought via QE were simply cancelled – what would be the downside? Your post aptly points out the upsides and the downsides are not obvious.
It wouldn’t necessarily be any more inflationary than QE has been already – if the government were to adhere to gently reducing the remaining debt through tax receipts without embarking on a huge fiscal splurge, but maybe a gentle easing of fiscal policy – a VAT cut? more tax cuts for the poor? And to corporates to encourage investment or job creation?
The only downside I could see – and one I think the Bank of England would most vigorously argue – is that it would represent a new form of moral hazard, something governments would resort to when things got tough. They might also say that it would challenge the whole orthodoxy of sound money effectively that money was freely created with no cost to anyone, at least fresh gilts carry coupons that need to be paid by the taxpayer. I suppose the very thought of the possibility of that occurring could unnerve investors – imagine if the idea caught on in the US and Eurozone (where the potential for moral hazard is enormous because the real problem is one of competitiveness not of just bailing out banks and restarting the economy).
But still it’s not an idea to be dismissed and might be a sensible solution if done within some fiscal and monetary boundaries. After all we’re not living in normal times and even QE was once deeply unorthodox – now it’s orthodoxy."

Reply 2.

"Look at it from the perspective of a book-keeper well-versed in the art of double-entry accounting:

When the Bank of England bought gilts for the QE programme, it paid for them.  Its balance sheet showed it acquired assets (the gilts) and the same value of liabilities (maybe called reserves).  In fact, the Bank’s balance sheet is now much larger – on both sides – than it was before it started QE.
  
If I understand you correctly, you propose that those assets should be acquired by the Treasury without payment.  That would leave the Bank with huge liabilities and few assets:  the result would be insolvency.  Who would then bail out the Bank?  Its shareholder would – the Treasury.

Bear in mind that, outside the ivory tower of the City + Canary Wharf, live some 60 million UK citizens and voters who use the Bank’s banknotes daily (or their Scottish or NI equivalent) and they have absolute faith in the Bank’s ‘promise to pay the bearer’.  A bankrupt Bank would not be trusted; and without full trust, it could not create money nor issue banknotes.

Maybe I misunderstand you, and you propose that the Treasury should pay for the Bank’s QE assets.  But what would be the point?  That wouldn’t reduce the National Debt.

Take another look at your proposal:  suppose for a moment it did work painlessly.  It would then be a good idea to run it again, and again, until all the National Debt had been eliminated.  Maybe it could continue , and build us a National Savings.  Then money would be growing on trees, pigs would be flying and England’s footballers would be permanent world champions.

You may well be right that it’d be worth having a conversation about the extent to which the size of the QE programme has compromised the Bank’s independence (the Treasury indemnifies the Bank for its QE purchases).  The current QE process is that the Treasury issues gilts which the Bank then buys with money it creates.  Can this process continue infinitely?  If this process continued beyond the current £350bn, would there be a point at which the Bank’s credibility became stretched?  Could anybody recognise that point before it was passed?  

If we ever approached the point where the Bank’s ability to create good money was questioned, we might, as you suggest, end up looking to banana republics for lessons in how to manage an economy."

Reply 3.

"QE isn’t inflationary so long as it is a credibly reversible policy, with the “new money” that was used to fund the BoE’s gilt purchases being siphoned back out of the economy, even if this occurs over the long term. In  the normal course of events, all those gilts currently parked on the BoE’s balance sheet will have to be repaid by the Treasury, using taxes receipts extracted from the economy. That’s the long term mechanism by which QE will be reversed, with the “new money” being cancelled out of existence. ie. no long term inflationary impact, since there is no permanent expansion of the money supply. 

Your proposal breaks that “promise” and makes the money supply expansion permanent. In simple terms, that’s open monetary financing, and thus a clear sterling devaluation and hence inflationary. Whether it’s Weimar-esque depends on the size of the numbers, but that’s the path you’ve stepped onto as soon as the money printing becomes a non-reversible policy.  and 

Do I think it’s possible? Most definitely. Politicians and central planners will like the sound of the easy option, and the sound of the consequences being born by others in the future, not on their watch.

That’s why, despite the immense deflationary pressures that the great deleveraging is bringing to bear I believe the eventual end-game will be significantly inflationary. Thus like Mervyn, I’ve a portfolio carrying a wodge of index-linked stuff, UK and beyond, to ride out the long term dénouement. John Hussman knows the score: 2nd half of this decade = major inflation."

 

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