I recently read a report in the Times (following a link in the comments section, thanks), which details the point very clearly. The first point is that overseas holders of gilts (UK government debt) were net sellers:
To get a sense of the implication of this, below is the distribution of gilt holdings in 2008, sourced from the Bank of England:
A record sell-off of UK government debt by overseas investors is fuelling City anxieties over the Treasury’s ability to fund soaring public borrowing that is set to top £150 billion over this year and next.
The surge in foreign selling of gilt-edged bonds and short-term UK Treasury bills is also reinforcing growing fears over the effectiveness of the Bank of England’s controversial quantitative easing (QE) scheme to pump newly created money through the economy.
Bank of England figures released on Monday highlighted record overseas sales of UK government debt during the three months from March to May.
Foreign investors dumped a total of £22 billion in their holdings of UK gilts and Treasury bills, mainly selling these to the Bank itself, through its QE scheme.
The Times article goes on to say the following:
With the Bank expected to wind up its huge purchases of gilts under QE in the next few months, some economists fear that, without this vast £125 billion asset-buying drive, the scale of foreign dumping of government debt signals that the Treasury might struggle to meet its future funding needs through finding enough buyers for fresh gilt issues.It is a somewhat surprising article, as the implications are very clear. It is only the purchase of gilts by the Bank of England that is supporting the gilts market. As ever, it comes as a surprise that this is not headline news. For those that doubt that the indirect purchase of gilts might be supporting the auction of new gilt issues, this from the Bank of England:
As gilts have made up the bulk of purchases, an important consideration is who typically own gilts and what they are likely to do with the money. Looking at the final seller of the gilts purchased by the Bank could be misleading. For example, some financial institutions may have bought gilts in anticipation of selling them to the Bank.I have highlighted the important point here. When I first wrote about QE, one of the points I made was that this was one of the ways in which QE would indirectly support the issuance of government debt. I can not help but think that the Bank of England is dropping a huge hint here, in the hope that journalists and analysts will pick up on what is going on. I do suspect that the Bank of England is unhappy with the policy of QE, but that they have been put under pressure to undertake the policy. However, there is no way of finding out if this is the case, and it remains speculation.
It is also very interesting to see the reaction to the news that much of the newly printed money is going to overseas purchasers. This is another article from the Times:
He [Spencer Dale of the Bank of England] addressed concerns that most of the funds spent by the Bank on the asset purchases through which it channels the newly-created cash into the economy had gone on buying government bonds (gilts) rather than or corporate bonds or commercial paper.
Business groups and others have urged the Bank to shift the focus of the scheme and buy more corporate debt in an attempt to stimulate corporate lending markets. Mr Dale said that the Bank was continuing “to review actively the case for extending its operations into other corporate credit markets”.
Confronting criticism that the effectiveness of QE is being undercut as foreign holders of gilts sell these assets to the Bank so that the QE funds then flow abroad, rather than into the UK economy, Mr Dale said that even when this was the case the impact was still beneficial.
“Even if that is the case, it does not mean the asset purchases will not have any economic benefit,” he said. “Rather, more of the effect will come through a lower exchange rate.”
On the one hand we have calls from business to redirect the spending into private assets in the UK, and on the other the Bank of England is claiming to be seeking inflationary pressure through currency devaluation. As a net importer, any devaluation will result in higher prices of goods, and that will be inflationary. Once again, you would expect a policy of active devaluation of the £GB would garner headlines, but still it is tucked away in the financial pages. After all, the devaluation of currency results in relative impoverishment of every holder of the devalued currency.
It is worth taking a moment to understand why net overseas sales of bonds will devalue a currency. As soon as the sale of the gilt to the Bank of England has taken place, the overseas seller is left with a pile of sterling, and needs to do something with it. They have a choice of purchasing another UK asset, or alternatively converting the currency into another currency. Having sold the asset, there is a strong likelihood that they will need to sell the currency, as getting out of the UK bond market is likely to be a signal of moving out of exposure to the UK (the Bank of England also considers this to be the case, though express it less directly). When lots of organisations are selling currency, a flood of currency appears on the market, and outstrips demand for the currency, thereby pushing down the price of the currency.
It might be noted that immediate currency movement are more complex than the picture that I have painted, but that this kind of move in the market sets a baseline on the value of the currency, towards which the currency must eventually move.
What we now have is a situation in which the government is massively expanding borrowing, and overseas creditors are dumping gilts. This means that the UK needs to fund the borrowing of the government from its own resources, and also absorb the sale of previously issued debt. This raises a significant problem. If you think of the chart that is shown earlier, the major holders of government bonds are overseas investors and insurance/pension funds. However, the problem that arises from this is that the amount of money going into investments is unlikely to be expanding fast enough to soak up the new issuance of government debt. Whilst there has been a significant increase in savings, is this enough?
The original data can be found here. The methodology for the calculation is not very clear, and might actually include pay down of debt as 'savings', as the survey of what people are saving for includes 'Pay off mortgage'. One thing that is certain is that the increase in savings is unlikely to be sufficient to allow for the purchase of the massive new issuance of government debt.
Although incomes fell over the quarter, the survey found that the amount saved as a percentage of income had risen. People saved 6.83pc of their earnings in the spring, up from 6.35pc at the same time last year and from 6.48pc during the winter.The average amount of money kept in savings rose to £18,443, compared with £17,332 in the previous quarter.
Another possible source of internal financing is the pension and life insurance industry. However, in order for these to finance the government borrowing, it must mean a reduction in investment in commercial assets, such as the stock market. As such, if they are purchasing gilts, it is at the cost of investment into the commercial wealth generating sectors. This would defeat one purpose of QE, which is to encourage commercial investment within the UK.
Put in crude terms, if the pension funds and life insurance funds are shifting assets into the expanding gilt market, then the issuance of government debt is crowding out business investment. The same argument applies to the banks.
Whilst the stock markets have seen falls of late, there has been a long period during which government debt was expanding, whilst overseas creditors retreated, and the stock market was rising. As such, the idea that insurance and pension funds are covering the debt issuance over the last six months seems improbable, at least if the upwards move in the stock market is indicative of the balance between government and private investments.
In the case of the banks, there is a further worry. During the economic crisis, the major banks have come under increasing control of the government. That control might come as the cost of pressure to purchase government debt. Furthermore, if the banks that have received bailout money are purchasing gilts, then the situation becomes even more worrying. The government has borrowed money to fund the bailouts, and therefore the banks would be using government borrowed funds to finance government borrowing. This would be akin to a ponzi scheme.
Returning to the Times article, it is difficult to see that the current government borrowing might be financed by anything other than the policy of QE. The policy is soaking up the excess of government debt, and therefore allowing for ongoing success in the issuance of government debt. Whilst the Bank of England might not be purchasing government debt directly, the indirect method of purchase can be the only thing that is currently supporting the gilt market.
It therefore comes as no surprise to see that the Bank of England is putting no end date on the policy of QE or the reversal of the policy:
It is too early for the Bank of England to judge when it will need to start withdrawing the massive stimulus it has delivered to the economy, policymaker Timothy Besley said on Thursday.However, once again the Bank of England is dropping massive hints that it is unhappy with its role of printing money to support government expenditure.
In a speech to a financial regulation conference, Besley also said that it was too early to judge whether the Bank's 125 billion pound quantitative easing programme was helping to boost GDP and avoid deflation.
There needs to be a clear and open debate on fiscal policy, Bank of England policymaker Timothy Besley said on Thursday.The problem being confronted by the Bank of England is summarised in an article in the Wall Street Journal:
The government's unprecedently high borrowing levels to fund a bail-out of the banking sector and pull Britain out of recession have led to fears it will be many years before the public finances are returned to a more stable position.
The dilemma faced by the Bank of England is that, if it stops the purchases, the gilt market will likely collapse. If it continues, then government profligacy will continue. It is becoming increasingly clear that the Bank of England is running out of patience with the government, and that they are increasingly unhappy with what they are undertaking.
As policy makers discuss how to exit from quantitative easing, investors need to position themselves for the government-bond-market turmoil that is likely to follow.
The markets got a taste of what might be in store this week when the Bank of England decided to stop buying two bonds originally included in its £125 billion ($204.68 billion) quantitative-easing program. The prices of those bonds plummeted, suggesting there is big money to be made for investors who get their trading strategy right.
The snag is that some government-bond markets are so potentially distorted by central-bank programs that it is hard to feel confident of where prices should be. Consider the two bonds the BOE will no longer purchase: 5% gilts due 2014 and 8% gilts due 2021. The BOE already owns more than half of both issues. In fact, combined with holdings by the U.K. Debt Management Office, at least two-thirds of both are in public hands, according to Barclays Capital.
However it is spun, it is apparent that government borrowing is being funded through the printing of money, the weasel worded 'quantitative easing'. However it is spun, it is fundamentally no different from Zimbabwe, Argentina or the Weimar Republic. Resorting to the printing press is the action of a bankrupt government.
The UK government is bankrupt.
I am still plugging away at the fixed fiat currency question, but am not sure that I have covered all the angles yet. It will come soon. I am also hoping to do something on commodities soon, as I have several reports on the sector that have proved to be interesting.
I note that white supremacists are posting in the comments section again. I do not censor comments, as a follower of Mill's argument in 'On Liberty'. It is nice to see the responses of other commentators, as they demonstrate that Mill was correct. If an argument comes out into the open, then it can be addressed. Thanks, Tiberius.
Lord Keynes (a commentator) is producing some very interesting material. In particular he has linked to a comparison of now and the Depression, which I first picked up on Reddit, where it was very popular.
He also offered an interesting comparison of QE in 1930s Japan, in which hyper-inflation did not follow. As he recognises, the policy was undertaken in a situation where it was possible to reverse the policy:
Of course, the Japanese economy had a productive manufacturing sector.and no large private debt bubble to liquidate in 1931, unlike the US and the UK today.I have not studied this case, and suspect that the answer here is in the ability to rapidly reverse the policy. As I have outlined, there is no such potential in the UK without prompting a collapse in the bond market, as the growing fiscal deficits stretch out over a very long time.
In a later debate with Acca, the subject of devaluation came up. I think that it is worth reiterating that devaluation is a form of impoverishment. As Acca rightly points out, there is a price....devaluation of the currency means that the value of labour in a country falls in relation to the value of labour in other countries. That equals relative impoverishment. I think Lemming has grasped this point:
I'm still having trouble understanding the role of separate currencies in economics.Note 4:
Talking to someone about how some Asian workers slave for £7 a day he replied "Ah yes, but what can £7 buy you in Asia?" and surely he does have a point.
Lord Keynes, you explain how devaluation helped Japan to boost exports. Wouldn't just cutting prices have achieved the same effect? (Or is the aim to get the country's general population to subsidise an effective price cut whether they want to or not?)
How can a currency be over- or under-valued? Isn't this just another variable which obscures economic fundamentals and prevents the capitalist system, such as it is, from working properly?
Jonny asks whether the Japanese carry trade would see a jump in Japanese GDP. A subtle and interesting question, which I will try to ponder for a while. I am afraid that I do not have a simple answer. Thoughts on this one welcomed.
As a background, the following is my take on the relationship between the carry trade and QE, and why Japan did not suffer from inflation:
The answer is rather odd. As fast as the Japanese central bank pumped out newly printed money, Japanese banks also pumped money out of Japan into Western banks. Having reduced inflation to virtually zero, any holdings of the currency were moved into countries with higher interest rates in what was known as 'the carry trade'. In other words, the lack of the ability to earn interest in Japan drove Japan into diverting lending outside of Japan.So did the carry trade raise GDP? My thoughts are that it would do so through increased aggregate wealth, but I need to think on this more for the full picture. As I said, comments welcomed.
In this trade, what was happening was that you could borrow at no cost in Japan, drop the money into a Western economy, and be paid interest on money that you borrowed for nothing. In doing so, even though the money was being devalued by the government printing more money, you could offset the devaluation by the interest you gained through investing it in Western countries. The following is a (grossly) simplified explanation:
If you are printing money such that the base money supply increases by 5% per year, and interest rates are zero, you can borrow that money, invest in a country offering 7% interest, and actually make a currency whose value should be falling, increase in value. In investing the money overseas, you are actually creating an improvement to your current account that offsets the impact of the increase in units of your currency. You are creating greater foreign reserves as a result of the return on that overseas lending, such that you are accumulating ever more foreign reserves, thereby strengthening your currency. If you look at a chart for the value of the JPY against the $US, you will see that the rate fluctuated but has only recently fallen significantly.
The story is not as simple as I paint it here, as Japan also has a large trade surplus and considerable savings, other countries were inflating their money supply and so forth.... The reason for pointing this out is that we have in principle is a system in which it is possible for a central bank to print money, flood that currency into another market, and still retain the relative value of the currency. It is quite an extraordinary notion and I therefore find it hard to believe myself and, as such, comments on this are welcome.
There have been many other interesting coments, and my apologies for not responding to them all.