Alan Manning writes that government should stop worrying about the current deficit, financing it less by issuing debt though being clear that this is a temporary policy for exceptional circumstances. He explains how monetary financing works and the policies the government ought to pursue in order to maintain the level of economic activity in the parts of the economy still open.
In his speech to the virtual Conservative Party Conference on 5 October, Rishi Sunak said that ‘We have a sacred responsibility to future generations to leave the public finances strong, and through careful management of our economy, this Conservative government will always balance the books.’ They are not going to be doing this anytime soon. The IFS in their Green Budget estimate that the public sector deficit in fiscal year 2020/21 will be 17% of GDP, higher than any other year in peacetime and six times higher than planned in March. The cause, of course, is the pandemic.
Yet there seems little doubt that the government’s response to the crisis is being influenced by concerns about what the deficit means for the future. The support packages for individuals and businesses in financial difficulties are less generous than they might be because of concerns about the public finances. And a reluctance to place further restrictions on the economy to restrain the growth of the virus has a similar motivation.
But the government may be making a big mistake in doing this. The mistake stems from the view that there is only one way the government should plan to run a deficit, namely by borrowing. And the debt that results then has to be paid back by future generations, though with current interest rates so low the cost of this can be exaggerated. But there is an alternative, what is popularly known as ‘printing money’, though these days there would be no actual printing – just money in digital accounts. Compared to issuing debt, money financing has the attraction that there is no interest to be paid now or by future generations. But there is a catch, one that has led money financing to be regarded as taboo. If a government pays for a deficit by printing money in a situation where demand is running ahead of supply, it leads to inflation, and, in extreme cases, hyper-inflation. The Weimar Republic and more recently Zimbabwe are classic cases.
The fear that excessive money financing can lead to inflation is a real one, but just because it can happen does not mean it always will. One should always be asking whether, in the current circumstances, money financing would be inflationary. I worry the government is not asking that question, and I think the answer would be ‘no’ if it did. Olivier Blanchard, former Chief Economist at the IMF, argued that we should be more relaxed about monetising deficits.
In fact there is considerable money financing going on through the Bank of England’s ‘quantitative easing’ (QE) policy in which it buys government debt, creating reserves in the process. There are some subtle reasons why this is sometimes argued to be not exactly the same as ‘printing money’, but those are details. By June 2020 more than 30% of UK government debt was held by the Bank of England. There seems to be the intention to sell this debt back into the market at some point but it is not clear how credible or desirable this is; the QE done in the financial crisis has never been undone.
The default position seems to be that deficits should be debt-financed unless there are exceptional circumstances. That may be a sensible position but the risk is that even in exceptional circumstances like now, there remains a reticence to use money financing. Our macroeconomic policy framework in which the government decides on the deficit and the Bank of England decides on how much QE may not be helpful at the present time. According to Monetary Policy Committee member Gertjan Vlieghe, ‘The MPC has decided to expand the Bank of England’s balance sheet, because we believe that if we do not, the economy will weaken further such that we would fall short of our inflation target’. If it came to the decision from a different direction (a subtle yet important difference in framing) – expand the balance sheet unless there is a threat of inflation or comparing the costs to the government of printing money and borrowing as alternative ways to finance the deficit – I suspect we might have seen a higher level of QE. And the government would have been able to run a deficit without such a fear of an increasing national debt.
So, far from being a sacred responsibility, Rishi Sunak’s policy may be an original sin with a cost in both poorer economic and health outcomes as the government becomes reluctant to impose restrictions to restrain the virus because of the economic damage.
The government should stop worrying about the current deficit, financing it less by issuing debt though being clear that this is a temporary policy for exceptional circumstances. With this frame of mind, what policies should it pursue? It should be more generous in its support for people struggling financially because of COVID. This is important not just to provide support for individuals falling on hard times but also to prevent a cascading fall in aggregate demand through the economy. If incomes fall for those who previously worked in the part of the economy now closed, their expenditure on the parts still open will fall, transmitting the fall in activity to those sectors. The aim should be to maintain the level of economic activity in the parts of the economy still open. There is a simple rule of thumb for the level of support required. If you shut 10% of the economy for health reasons, you need that 10% of people to be able to continue to spend 90% of their previous income in the open part. So, people need to be provided with 90% of their previous income. The current levels of support fall far short of that and are planned to get worse.
Part of the problem comes from the nature of the UK’s welfare state, which provides, through Universal Credit, a very low level of income for those without work, something which is the product of a long-run obsession of the government with the deficit. The government has increased the level of Universal Credit by £20 a week but seems reluctant to retain it, probably because they see this as giving extra money to people who were not in work even before the crisis. Yet even with this modest extra, someone moving from work onto benefits will often be faced with a catastrophic fall in income. In most other countries those losing work do not face as big an income fall because, for the initial period of unemployment, benefit levels are linked to previous earnings. The UK government should be moving to this system.
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Alan Manning is Professor of Economics at the LSE and an Associate at LSE’s Centre for Economic Performance.
Photo by Miles Burke on Unsplash.
Interesting blog article, but there are a few things I would respectfully challenge. It’s stated that if 10% of the economy was shut, we must ensure that 10% of people have 90% of their previous wage to spend into those sectors of the economy that remain open. Practically those sectors of the economy which remain open are those selling essential necessities of daily life. Just because you are provided with 90% of your wage during a lock down, your requirement to spend in to the limited sectors that are open doesn’t increase. For example, your car doesn’t suddenly require more maintenance, or your daily food and beverage intake doesn’t increase due to the fact there is a lockdown. Also, if it did surely this would lead to consumer price inflation in the service and retail sectors which are open, as demand increases coupled with global supply chain disruption. Many brits are currently furloughed with many not producing goods or services required to run a healthy economy which will surely lead to inflation, more-so from the lack of those goods and services being supplied to the market than the demand side of the equation. Adding fuel to the fire is money going straight in to the life blood of the economy through furloughing schemes etc. This may not be showing up yet, but surely as the economy opens and the recovery starts with a more positive outlook, there will be a population with healthy bank accounts wanting to buy that car, or take that holiday, and make up for lost time. Specifically speaking of the travel industry, many airlines in particular reduced their fleet size due to the pandemic, retiring aircraft early. With this dynamic of pent up consumer demand and either the same (or likely reduced supply compared to pre-Covid), I would be interested to know how inflation isn’t on the horizon or of little concern.
Alan Manning’s blog is right about the need for government to support businesses’ and individuals’ incomes through the pandemic. The reason Rishi Sunak does not properly support the poor through this crisis is because of pervasive ideas about government debt. There seems to be a reluctance to offer challenges to perceived wisdoms and Vlieghe’s Bank of England paper in April 2020 skirts around debt and monetary financing with confusing semantics.
The reasons we do not fundamentally challenge outdated concepts of debt – the need to balance the books, or be fiscally prudent – are twofold. Politicians of all persuasions attribute moral value to government debt, and secondly, the finance industry that dominates thinking on this matter, and of which the Chancellor is a part, has a stake in the outcome of the debate.
Government debt is a good thing for savers and the finance industry that manages their savings. Gilts provide a necessary, safe, if unspectacular home for private saving, in pensions for example. Such debt could be framed by Rishi Sunak as ‘guaranteed private savings.’ NS&I savings are government debts, but do not have the same negative connotation as other debt.
It is unnecessary to cover government spending through taxation and borrowing. The government, with its debt in its own sovereign currency, could repay it by more monetary financing, if it chose to, or continue to increase the proportion of monetary financing. The balancing factor to prevent inflation is taxation, removing government issued money from the system as demand outstrips supply. We are far from that situation. Monetary financing poses no serious inflationary risk at the present.
From an accounting perspective, monetary financing does not really add to debt. It must be accounted for because the books have to be balanced, but the Treasury and Bank of England are arms of government, and accounting logic says money owed to yourself cancels out. The government seems to know this and has quietly forgotten about the monetary financing of the past decade, but is still using it as part of its moral hazard view of debt by pretending it has to be paid back when it does not. It will never be paid back.
The choices the government takes on these matters are determined by policy preferences and not by laws of nature. Government frames debt as a bad thing, but debt is a number on a balance sheet balanced by savings, around which choices, all with consequences, can be made. Representing government debt as a moral hazard distorts decision-making. Representing monetary financing as debt and ‘a bad thing,’ suits the finance sector who make money from gilts. Misrepresenting debt, as Osborne and then Hammond did through austerity, punishes the poor and insecure, as Alan Manning rightly says, and it is more to do with politics than economics or accounting.
Really interesting blog, two follow up questions. Is QE not just a way to spin money around the financial system rather than the real economy? If so, could banks not print money (Create credit) as Professor Werner argues but crucially ensure that such credit creation is invested, it would need to be directed by a much more enlightened central bank into public investment initially but also into private sector investment particularly into areas such as graphene development, nano technology and green technology. If Output were to rise as a result this could then negate any worries over inflation, particularly If consumer demand remains subdued. Of course it would require a shake up of our Monopoly rent seeking banking sector to be replaced by local and regional not for profit banks, but what an opportunity!