We are dangerously close to repeating the austerity errors of 2010

Sunak - BEN STANSALL/AFP
Sunak - BEN STANSALL/AFP

Let us put to rest a beguiling illusion. The Bank of England cannot wave a magic wand and make our national debts disappear, unless it opts for revolutionary methods.

It cannot soak up the extra costs of the pandemic permanently.

It cannot “print” money to cover a fiscal deficit of 19pc of GDP this year, or to cover the £560bn of accumulated damage expected over the next five years.

It cannot buy gilts “à outrance” and keep rolling them over forever, to be stored away as certificates and forgotten.

Or at least it cannot do these things under the mechanism of quantitative easing deployed over the last decade.

We have to come clean about the fiscal costs of the pandemic. That is sobering, but it does not justify premature tightening or a return to post-Lehman austerity.

That episode, justified by the false creed of “expansionary fiscal contractions”, was self-defeating on its own terms. It led to a higher public debt ratio and a smaller GDP than would otherwise have been the case, leaving aside the damage done to Western societies.

Unfortunately, we risk repeating this error in Britain, in gridlock America and in Europe, where politicians have a totemic belief in the healing powers of their modest Recovery Fund.

“We’re going down the austerity road again,” said Dario Perkins, global strategist at TS Lombard. “It is as if we learned nothing from the last decade. Bond yields are at a 700-year low and it’s screaming at us that we have got fiscal policy wrong. There is a consensus among economists that we should never let austerity happen again, but the politicians won’t spend.”

The former fiscal hawks at the International Monetary Fund are now the loudest in warning of a “global liquidity trap” and impotent central banks. They warn that fiscal contraction too soon would be criminal.

“There must be no premature withdrawal,” says IMF chief Kristalina Georgieva.

Yet the Chancellor’s Spending Review borders on contractionary. The Government is bringing forward retrenchment to the early phase of this Parliament in order to play the electoral cycle.

But we are not in an ordinary cycle. If the IMF is right, we are on a deflationary cliff-edge.

Rishi Sunak aims to cut the structural budget deficit by freezing public sector pay and holding down spending in “unprotected departments”, cutting borrowing to 4.4pc of GDP as soon as 2022-2023.

“Large fiscal drag has been planned for the next two years,” said Robert Wood from Bank of America.

All pandemic relief will expire at the end of March. Furlough support and top-ups will be axed just as unemployment peaks.

The broad verdict of analysts is that Mr Sunak will be forced to backtrack again, repeating the stop-go policies that have characterised the UK’s economic response to Covid-19 for months, with a corrosive effect on business investment.

The Chancellor’s gamble may pay off if vaccines are rolled out quickly and a V-shaped recovery unleashes a flood of pent-up capex spending, in turn leading to a virtuous circle. But his premature squeeze may equally smother recovery and condemn us to a low-growth trap.

Mt Sunak is not George Osborne. His plan has a fundamentally different mix from the UK’s post-Lehman austerity, which saw a cut in public investment to 1.4pc of GDP, because it was the easiest item to cut. The Treasury ignored pleas that infrastructure projects and maintenance have a multiplier well above 1.0 during downturns and pay for themselves handsomely through higher growth.

The Chancellor is aiming for a £600bn blitz on capital spending over four years – a figure inflated by drawing in private funds. Genuine public investment will average 3pc of GDP, in his words the “highest sustained levels of public investment in more than 40 years”.

This lifts the UK to the OECD average. It should raise the long-term speed limit of the economy and therefore work to reduce the debt ratio through the denominator effect.

The Office for Budget Responsibility says net public debt will hit 105pc of GDP by the mid-2020s under its central scenario. This is not egregiously high in the global beauty contest. The IMF’s country estimates of net debt by 2024 are: 105pc in Spain, 109pc in Belgium, 111pc in the US, 113pc in France, 142pc in Italy, and 179pc in Japan.

The UK’s average debt maturity is over fifteen years, the longest of the G7 bloc. Borrowing costs on five-year gilts are currently sub-zero, rising to 0.67pc for 50-year gilts. The UK is locking in pandemic debt costs at negative real rates.

A free lunch? Not entirely. The Bank of England is absorbing the entire debt issuance of the Treasury – thankfully – but this is a disguised market liability.

There is a Faustian Pact twist to the construction of QE. Hard money advocates might say “I told you so” or turn to Goethe’s Mephistopheles, who famously told the emperor to issue promissory notes: “Such paper’s convenient, for rather than a lot of gold and silver, you know what you’ve got. You’ve no need of bartering and exchanging. Just drown your needs in wine and love-making.”

Global central banks played down this catch in the early days.

“The US government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at no cost,” said the Federal Reserve’s Ben Bernanke.

The Bank of England suggested in early reports that buying bonds with electronic money is the same as buying them with printed banknotes, only simpler.

This was never true. It conducts QE purchases though commercial banks and this creates reserves as a “by-product”. It pays the banks interest on these reserves at Bank Rate. The cost rises as inflation returns and Bank Rate goes up, and this cost is passed on to the Treasury.

Ergo, the tariff on the existing stock of QE bonds held by the Bank – near 40pc of GDP – increases with recovery, to the point where it may quickly become cheaper to feed the bonds back onto the open market.

The Bank of England could of course refuse to raise Bank Rate once inflation bites or stop paying interest on reserves, but that would subvert its current monetary regime. Bond vigilantes might conclude that Threadneedle Street had been captured and was embarked on Latin American monetisation. They might deem it an attempt to let rip on inflation, and to default via debasement.

The Bank of England - Simon Belcher/ Alamy
The Bank of England - Simon Belcher/ Alamy

The Bank of England has been at pains to explain that QE never was what people imagined.

“QE doesn’t involve ‘printing money’. The policy is more accurately seen as a maturity swap,” says Deputy Governor Ben Broadbent.

Mr Broadbent says it is very hard to inflate away public debt even if you try, and QE has made it harder yet. Markets will preempt the move. It works only if inflation jumps suddenly, as in the Seventies when bondholders saw a 35pc haircut. But it created other forms of economic havoc.

One can exaggerate the perils of this QE "sting-in-the-tail" and, indeed, it is already being touted by deficit-hawks in the push for early austerity. It will become an issue only if reflationary takes off, in which case the gains of rising nominal GDP should overwhelm the rising costs on excess reserves.

Nor is inflation a done-deal. The IMF and the Nobel fraternity are more worried that the global economy will slip into a protracted slump as defaults increase and long economic Covid does its worst. If so, there will be pressure on central banks to tear up the rule book and opt for helicopter money or something akin to Modern Monetary Theory (MMT), in which case debate on the technicalities of today’s QE becomes irrelevant.

It is significant that Ben Bernanke is calling for a “coordination mechanism” between the Fed and Congress, pointing the way to joined-up fiscal and monetary policy. He has suggested the nuclear option of helicopter money to fund the federal deficit and inject money into the veins of the economy.

Central bank independence as we knew it has become a shibboleth. Lord Adair Turner from the Institute for New Economic Thinking proposes a fiscal twin to the Monetary Policy Committee that could calibrate the dosage of monetisation in order to prevent electoral prime-pumping by politicians.

It would be dangerous for the UK to go it alone, but there is herd immunity from the markets if all the big central banks move in concert.

The world is not yet ready for such a radical departure. But when you have the IMF warning that the global economy is in a liquidity trap, it may not be so far away either.