Coronavirus, Fiscal Policy, Debt Management And Inflation

Coronavirus, Fiscal Policy, Debt Management And Inflation Presented by: Bill Allen (National Institute of Economic and Social Research) Date: 29th March 2021 Coronavirus And Two World Wars World War I World War II Coronavirus Deficits during Government war/pandemic (% debt/GDP ratio at of a year's GDP) end of war/pandemic (%) Short-term interest- bearing government debt/GDP ratio at end of war/pandemic (%) 144 155 32 26 61 43 (1) 144 247 109 Short-term interestbearing government debt/GDP ratio 5 - 7 years after end of war/pandemic (%) 16 (1925) 32 (1952) 37 (2026), assuming no new QE, and no unwinding. Note: (1) including commercial banks' reserve balances in Bank of England. Sources: Bank of England, A millennium of macroeconomic data for the UK, OBR, author's calculations. Internal Borrowing In And After WW1 £ millions End of March Gilts Treasury bills Ways and Means advances Savings certificates 1914 636.8 13.0 0 1919 4,502.9 (1) 957.2 455.0 1925 5,413.8 (1) 575.6 166.6 0 227.0 368.8 Total internal debt 649.8 6,142.1 6,524.8 Notes: note issues are excluded. (1) £2.0 billion of this was 5% War Loan 1929/47. - Enormous increase in borrowing in 1914-19 (>100% of GDP). - Borrowing was very expensive, partly o/a financial crisis. - Consumer prices doubled during the war. - Post-war boom was ended by high short-term interest rates for a short period. - Post war mopping up of short-term debt, which fell from £1.4bn in 1919 to £0.7bn in 1925. Shares of borrowing in 1914-1919 Gilts Savings certificates Short-term 70% 4% 26% Internal Borrowing During The Pandemic, Actual, Planned And Assumed End of March (£bn) Gilts outstanding o/w held by BOE o/w held in market Deposits in BOЕ Treasury bills Total internal debt 2019 2020 2021 2022 2026 1,512 1,903 2,119 2,460 (1) 423 444 776 875 (1) 875 (1) 1,054 1,068 1,127 1,244 (1) 1,585 (1) 479 500 (1) 852 (1) 951 (1) 951 (1) 26 1,821 31 1,877 29 2,256 31 2,427 31 (1) 2,928 Shares Of Borrowing In 2020-2022 Gilts in market Deposits in BОЕ Treasury bills - £bn +176 +451 0 % 28 71 0 Author's estimate or guess. It is assumed that the current QE program is completed and that there will be no further QE, and no unwinding of QE. - Supply of gilts in market will need to need to rise by~ 40% by 2026 - at least. - Sources: OBR, DMO, Bank of England, author's calculations. Policy And Results After The Three Episodes - Post-WWI - restoring 'the world of yesterday' • Post-war boom checked by high interest rates. • Gold standard: deflation: high interest rates especially during post-war boom. • Balanced budget despite debt interest up by 6%% of GDP: 'Geddes axe' etc. Mopping up short-term government debt. - Post-WWII • Low interest rates (negative real rates) + financial repression. Fear of secular stagnation. Controls and rationing to contain demand. - • Very tight fiscal policy in 1948-1950. • Mopping up short-term government debt began in 1951. Tolerance of inflation. Post - coronavirus (planned) • Low interest rates (assumed). Fear of secular stagnation. • Inflation target retained unchanged. • Budget deficits continue. • Public finances barely sustainable at low interest rates. Fiscal policy After 1918 Tight After 1945 Tight After Coronavirus (planned) Interest rates High Low Low Postwar price surge Yes Yes No Growth Unemployment Prices No Yes Yes High Low Low Financial repression Deflation Not much Inflation Yes Inflation ? target retained Questions About Post-Coronavirus Fiscal Policy - Are the interest rates assumed in the Budget (market rates as at 5 Feb) realistic? • Market rates have gone up since then. • Effect of stopping QE, here or in USA. • Secular stagnation?  Wrongly anticipated after WWII.  Demographics and de-globalization (Goodhart-Pradhan).  Green investment. - Other budget questions - e.g. health, railways, tax receipts (e.g. P. Aldrick, Times 6 March). - Interest-related risks • Sensitivity of forecast budget to interest rates (OBR para 1.11). • Risk to debt sustainability if rates rise. • Retention of 2% inflation target means Bank of England MPC must hike shortterm interest rates if inflation threat increases. A Proposal For Reducing The Interest Rate Risk To The Public Finances - Risk that inflation target will conflict with planned fiscal policy, because interest cost of commercial banks' reserve balances would rise immediately if short-term interest rates rose. - If interest rates rose, unless expected growth rose in parallel, fiscal adjustments (higher taxes or lower public spending) would be needed because of threat to debt sustainability, but would be extremely unpopular. - Risk can be reduced by swap of reserve balances for short-medium gilts with fixed interest rates. Would have to be compulsory: too big for auction. - Risk would be transferred to banks. Banks would be allowed to sell gilts. - Reserve balances are £800 bn and rising. Total issues of gilts would need to be well north of £500 bn. Gilt yields would probably rise but: - • Inflows from other government debt markets. • QE program would provide some support. • B of E could offer to make markets for a period to protect financial stability. Banks' positions under Basel 3 Liquidity Coverage Ratio Requirement would be unaffected. - Revisiting compulsory serial funding operation of 1951, which aimed to mop up surplus liquidity after WWII and protect government from rising debt servicing costs as interest rates rose. - Preferable to ceasing to pay interest on some or all reserve balances. - NIESR policy paper 25, Managing the fiscal risk of higher interest rates, 25 March 2021.