By Ewen Stewart – 6 minute read
IT USED TO BE that governments understood that economic prosperity was hard won and a result of nurturing the private sector, encouraging enterprise and spending and taxing prudently.
They understood that some deficit financing (spending a bit more than the tax receipts raised) might be appropriate occasionally but broadly the budget had to be balanced and savers and borrowers deserved a ‘fair rate’ of interest to compensate them from inflation and as an inducement, in a finite life, not to spend today. Why would one save if there was no reward? That fair rate, the interest rate, rewarded savers and was generally 2-3% above the rate of inflation.
That was then.
Since the financial crisis (2009 onwards) Governments have acted like King Canute’s dealing with the tide in an attempt to re-float the sinking ship of state, tame nature and abolish the cycle. While this article examines the UK response, in truth most Governments have acted in the same highly novel and unprecedented way.
Now they face the moment of maximum risk as the very credibility of that policy is on the line. If inflation does not go away, and I doubt it will, how do they explain near zero interest rates? But if they put them up how do they afford their spending and avoid recession?
No, they will continue to say it’s a blip don’t worry chaps and do very little. Perhaps a 25bp interest rate rise to ‘show they are serious’ but don’t expect much more. We are in for an interesting ride!
The EU experience is possibly even more extreme. Take Germany, the linchpin of the Eurozone, one pays for the privilege of holding German Government debt. As an example at the time of writing the 10-year German Bunds yields negative 24bp. In other words lend the German Government €1m and pay them an additional €2400 each year for the privilege. This is despite Germany acting as effective lender of the last resort to the entire Eurozone, a shift leftwards with presumably even greater borrowing and an inflation rate of currently at 4.5%. One does not need a degree in economics to see this is clearly perverse.
Since 2009 the primary tool used across most economies was monetary to re-float a failed financial system. In the UK case interest rates were slashed and a programme called Quantitative Easing launched, effectively with the UK central bank buying £425bn of its own gilts at the press of a money creation button.
While public debt mushroomed there was at least an attempt to control spending and try and unwind the public sector deficit. After a decade the public finances had stabilised, although monetary policy had not, with existing QE remaining on the balance sheet and interest rates close to zero. At least however there was some fiscal sanity and a clear strategy to try and return to normality.
However, policy makers patted themselves on the back and believed their monetary policy brilliance had saved the day. To an extent they were right, albeit at a massive price of huge economic dislocation, asset price inflation and misallocation.
The impact was partially hidden by the rise of China and the deflationary impact that had on ‘things.’ So CPI (consumer price index) seemed low, but asset prices, which are not picked up by CPI, surged.
This emboldened policymakers. If they could apply that magic once why not when any little difficulty came along or indeed at any point if things got a bit tricky?
Then came Covid-19 – an event several times the magnitude of the financial crisis. Governments locked-down economies for months on end resulting in, almost two years later, a global economy operating way short of normality. In the UK case it offered open-ended employment protection and spent close to four hundred billion pounds on an inferior service where basic public services were either unavailable or severely curtailed.
This on the face of it destroyed the basis of the public finances.
What had been £500bn accumulated debt in 2005, just before the financial crisis, had become £1100bn by 2010, which grew into £2000bn by 2020 and will be in excess of £2500 by 2025, a fivefold increase in a short generation. Worse, the politicians and bankers said it didn’t matter – ‘we could afford it’.
Again there was a grain of truth in this. If interest tares were 0.1% one could afford quite a lot. Why not just borrow, as effectively money is free? How splendid. Let’s party. Save it was the government that chose to party, not the people who had built up savings, largely due to lockdown restricting consumption despite every monetary inducement to spend.
The Government party went on really useful things like £39bn on track and trace, or £120bn and more on HS2, despite demand for railways collapsing, or furlough, or on sending money vainly to reduce a health waiting list the direct result of Government lockdown. These useful things cost around £400bn.
But that was not a problem because during the financial crisis they had discovered you could print money and it wasn’t a problem because they had shown it wasn’t inflationary. So the central bank prints more, taking the stock of quantitative easing to £900bn, well over 40% of GDP. Indeed the entire increase in Covid-19 spending was funded not through pension funds and banks buying gilts but through the central bank buying its own debt.
This time however, there has been no attempt to rein-in public spending, instead the economy has been running on hot with much of the excess public spending embedded, despite lamentable productivity. Effectively, this Government chose to divert capital away from the higher-returning private sector to the grossly inefficient and hibernating public sector. The same is happening elsewhere, although perhaps not on quite the British scale.
Unsurprisingly, given the scale of monetary creation in the UK and far beyond, the supply shocks for global lockdown, pent-up saving and huge labour market disruption and re-appraisal – inflation has emerged.
The response of the Bank of England is to double down. Inflation is just a blip, don’t worry they say. More so, they talk up their hawkishness trying to convince markets they are serious about the inflationary risks, but do nothing.
The Government has gotten itself on a treadmill it can’t easily get off. It’s borrowing over £200bn this year and I would wager a similar amount next. Put up interest rates and the cost of Government borrowing increases while the economy slows. The Government thus talks a monetarily responsible line but actually does nothing.
Now the Treasury has a problem. US inflation is 6%, German and British over 4% but interest rates are 0.25%, zero and 0.1% respectively. But it is said not to be a problem because inflation is only a blip. It will quickly come down.
But what if the politicians are wrong, as I think they are. What if people start to lose confidence in the basis of money as there is no reward for holding it? The signs are there. People are chasing yield, any yield and driving stocks higher. Real estate rises to all-time highs as the inverse of a near zero cost of borrowing and investors buy speculative assets like fine wine and fast cars for fun but also as a hedge.
Now oil and commodity prices are rising and we have global shortages which should not be a surprise if a global economy is in lockdown for such a long period. Inflation is starting to impact the basic things. But don’t worry it’s a ‘blip’. In our post-truth politics where governments like to have total control it is only a blip, for if they raise rates they might need to control their spending as there would be a real price for all their public borrowing and that would rather spoil the party.
But let’s be clear this is a problem of their own making from their own short sighted hubris. It’s a problem years in the making but significantly compounded by lockdown and the subsequent spend, spend, spend response.
By abandoning the basic laws of economics, by abandoning a normalised monetary policy, trying to abolish the cycle as the political lens and attention span gets ever shorter and now, despite the public sector being 53% of the entire economy, spending in a fashion that even Corbyn would have blushed, we face the real prospect of a loss of confidence in the very basis of currency.
These are highly unpredictable and untested times; but don’t be surprised if short term it drives asset prices yet higher. Longer term however, beware – this is not based on sound economics but monetary puff and political expediency.
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Ewen Stewart is a City economist whose career has spanned over 30 years. He is director of Global Britain and a co-founder of Brexit-Watch.org.
Photo of ‘The Lament for Icarus’ painted by Herbert James Draper (1863-1920), Courtesy of the Lady Lever Art Gallery, Bebington, England via the Art Renewal Center.