Thursday, January 8, 2009

UK Government Borrowing - Where is the Money Coming From?

I have had some very interesting, and challenging comments on my post on free trade, which have provided some requests for clarifications, and also some challenging commentary. Ideally I would like to address these points, but I have been neglecting some recent events, so the replies to the points raised will require another post at another time.

Of particular interest at the moment is the way in which the UK government is making itself ever more central to the economy and how it is achieving this. An article in the Times was a prompt for me to discuss this:
The lowest interest rate in the history of the Bank of England will deter savers from depositing money and further undermine troubled banks, it was claimed yesterday.

Two thirds of savings accounts are set to pay less than 1 per cent after the Bank cut the cost of borrowing to 1.5 per cent yesterday. It has now cut interest rates by 3 percentage points in as many months.

Financial experts warned that the ultra-low rates would not boost the stalled economy.

Essentially, the underlying point of the article is that, without savers depositing money into the banking system, the banks ability to lend will continue to become constrained. However, the article does not follow this train of thoughts as far as it should.

There are several problems here. One of them is that, if savers are not depositing money with the banks, where is the savers' money actually going to go? It is not entirely clear, and I will confess that I do not have an answer.

The other problem is that the government is currently borrowing huge sums of money to support the neo-Keynesian boosting of the economy. In so doing, as I explained a long time ago in my post on government borrowing, they are competing with private companies for the stock of available capital. At its most basic, for every unit of capital borrowed by government, there is one less unit available for private industry, or at least in principle (more on that later).

As such we have two constraints on credit to private business. On the one hand we have the deterrence of deposits into the banking system, and on the other hand we have government borrowing soaking up large amounts of the limited capital available. Put simply, the government has engineered a situation in which there is likely to be a shortage of capital available for lending into business. This is a rather curious outcome to pursue.

However, governments believe that they can get around this capital shortage for business by acting as a lender to troubled businesses, by offering bailouts of businesses which it determines are strategic and so forth. Furthermore, it is becoming the 'capitaliser' of the banking system, with ever more measures in prospect to overcome the problems that the banks do not have enough money to lend into business. As you will note, there is something rather circular in all of this.....

In a 'normal' situation, people deposit money with the bank, the bank then uses that money to lend to business and consumers. Thus money is channeled through the economy. The situation now is that people do not want to deposit money in banks, so the government borrows money from the banks in order to lend money to the banks, and then the banks continue to lend the money to the government. The government then uses the money to provide Keynesian boosts to the economy to support the economy, and bailouts of chosen industries, and supports business through creation of activity in the economy.

At this point, you may be noting that governments are placing themselves in a position in which all economic activity rests upon the role of government as the ultimate creditor. The central problem in this scenario is that governments themselves are net borrowers. How can a net borrower become the main creditor?

It is here that we come to a significant problem. At present, across the whole of the OECD (now including Germany), governments are all borrowing huge sums of money. I do not have figures for the aggregate borrowing, but we can safely assume that, with the US alone projecting a $US 1.2 trillion deficit, we are dealing with some extreme numbers. Where is all of this money coming from?

Are the big creditor nations still financing all of this? There have been many indications of late that they have been pulling back from such lending and, even if they were lending, do they have sufficient finance to support such massive levels of borrowing from so many countries?

The reality is that there is something fundamentally wrong with all of this. I have posted before on the subject of printing money, and the US is openly undertaking this and the UK possible already covertly doing so (see post here). The idea that the Bank of England is thinking of printing money is firmly 'out there', but is it already doing so? This from the Telegraph:

'Other potential moves include using more taxpayers' money to re-capitalise banks, wholesale nationalisation or printing more money to buy up government or commercial debts'

To this end, I sent an email to the Bank of England on 31st December. I do not like conspiracy theory so in light of my concerns about covert money printing, I thought it would be better to end the uncertainty. The email I sent was as follows:

I am an online publisher and have been made aware of a matter of some concern. In particular the latest banking bill saw the following provision:

235 Weekly return
Section 6 of the Bank Charter Act 1844 (Bank to produce weekly account) shall cease to have effect.

The section in question was the following:

6 Weekly account in form in schedule (A.) to be rendered by the Bank of England
… An account of the amount of Bank of England notes issued by the Issue Department of the Bank of England, and of gold coin and of gold and silver bullion respectively, and of securities in the said issue department, and also an account of the capital stock, and the deposits, and of the money and securities belonging to the said governor and company in the banking department of the Bank of England, on some day in every week to be fixed by the [Commissioners for Her Majesty’s Revenue and Customs], shall be transmitted by the said governor and company weekly to the said commissioners, in the form prescribed in the schedule hereto annexed marked (A.), and shall be published by the said commissioners, in the next succeeding London Gazette in which the same may be conveniently inserted.

I have two questions regarding the abolition of this provision, as follows:

1. Can you explain why this provision was abolished. For example, although the London Gazette is no longer an appropriate publication, why did you not change the provision to the BoE website?
2. Can you confirm that you will continue the policy of full disclosure implied in the 1844 Act, including full disclosure of measures that are resultant from quantitative easing?

Thank you in advance for a clear and direct answer, and please note that your response may be published in full.
As you will guess, I have not been given a reply. It is quite possible that, as an unimportant blogger, they simply do not want to bother to reply. On the other hand, it is quite possible that they simply do not want to reply on the basis that an honest answer is not possible. I have no certainty as to which would be the correct interpretation, and that is the benefit for the BoE in giving no reply at all.

An interesting perspective on this is provided in a BBC news article (thanks to the commentator who provided the link). It can be noted in the comments by Alastair Darling that there is a denial of 'printing money'. It is quite possible to deny 'printing money', as nobody is proposing that the BoE will be churning out physical bank notes. However, this is not the denial of a policy of quantitative easing, which is a policy with an identical outcome, just without the physical printing press. In this confusion of terminology there are plenty of places to hide. This is what was said by Alistair Darling:

"Nobody is talking about printing money," he said.

"There's a debate to be had about what you do to support the economy as interest rates approach zero, as they are in the United States, but for us that is an entirely hypothetical debate.

"We are looking at a range of measures to support the economy, to support business and to help people, but nobody is talking about printing money."'

In short, he does not discuss quantitative easing.

The essential problem is this. It is quite possible that depositors are not depositing money in the banks. We know that the UK government is spending like a drunk. We know that worldwide there is a massive demand for finance. We know that, with a falling £GB, low interest rates, the UK will not look at all attractive as an investment opportunity. This from Bloomberg on January 7:

Britain may overwhelm bond investors with a record number of quarterly debt sales, risking the first failed auctions since 2002 as the economy sinks into the worst recession since World War II.

“I’m not predicting that we will have failed auctions, but I can’t rule that out,” Robert Stheeman, chief executive officer of the U.K. Debt Management Office, or DMO, said in an interview last month. “It’s a big amount of debt to be sold. We are in a very different world than we were six months or a year ago. But I believe it’s a challenge that both we as an organization and the market will be able to meet.”

The DMO, which oversees auctions of so-called gilts for the Treasury, today held the first of 20 sales earmarked for January through March, selling 2 billion pounds ($2.98 billion) of 4.75 percent bonds due 2038. The U.K. said it plans an unprecedented 146.4 billion pounds of debt sales in the fiscal year ending March 31 as Prime Minister Gordon Brown’s government seeks to finance bank bailouts and revive the shrinking economy amid a decline in tax revenue.

Somehow, the government is managing to borrow enough money to serve as the centre of the economy as creditor in chief. If deposits are not being made in the banks (a big if), and if there is less opportunity to raise international finance (a relatively small if), then what is the source of the money that the government is spending?

The question that is being raised in my mind is one for which I do not have a clear answer.


  1. Excellent post. If quantitative easing leads to inflation investors would be crazy to buy government bonds.

  2. Yes I, too, noticed Alistair Darling's weaselly words last night.

    Mark you say "In a 'normal' situation, people deposit money with the bank, the bank then uses that money to lend to business and consumers. Thus money is channeled through the economy."

    Revealing my ignorance and confusion: as I understand it, the money that people deposit with the banks has previously been created temporarily by that bank, or other banks, as loans (fractional reserve banking and all that) and almost all money in circulation exists only temporarily in this way. These loans have to be repaid over time, whereupon the money vanishes under FRB. Apparently this system, in itself, is considered 'sound' i.e. when an economy is growing, at least partly via this mechanism, with low price inflation, the exchange rate of the currency does not reduce and the amount of money in circulation is considered to be appropriate to the amount of economic activity taking place. (Yes, I know that such an apparent equlibrium may just be an illusion!)

    However, I see no difference in principle between the commercial banks printing temporary money, and the government effectively printing temporary money *except* that under normal circumstances there is a demand for a loan from a private citizen or organisation, rather than a government decree that money should be spent on something. However, as we know, there is no law that says that commercial banks or private citizens and organisations have a monopoly on wisdom - an imaginary government might possess much more wisdom than its electorate.

    Yes, I know they'll cock it up, and we're starting from a fundamentally bad position, but economically what is the big objection *in principle* to a government printing temporary money and spending it in the economy, as long as they get it to the 'right' places?

  3. Dear Cynicus,

    I differ with you on some of your conclusions here.

    “...if savers are not depositing money with the banks, where is the savers' money actually going to go?”

    I would suggest the larger savers will either convert to real physical assets, such as property, precious metals etc. Smaller holdings would probably look for transfers to the largest, most secure banks, probably international/foreign banks.

    “...on government borrowing, they are competing with private companies for the stock of available capital.”

    I disagree. In attempting to borrow our way out of the crisis, the Government is acting as guarantor of the debt on behalf of the real borrowers in the economy. For instance, if a person is fresh out of university, and has a limited or even poor credit score, they might find it hard to secure a mortgage, or even rental agreement. In this case, a lender may offer the loan if say, the person’s perants were willing to act as guarantor of the debt. If the person therefore could not support the debt, the lender would have right to reclaim funds from the perants, who would have a much better credit score and/or, have real assets to back up the loan.

    It is my opinion, the government is acting in this capacity. They are not competing for the loans. They are facilitating loans to businesses/banks/individuals that are being declined loans because they are now seen as a greater credit risk.

    “...In a 'normal' situation, people deposit money with the bank, the bank then uses that money to lend to business and consumers.”

    This is not exactly as I understand the mechanism. Yes, the banks do use the reserves as a basis for lending. However, the banks actually use the reserves as margin for leveraged lending. In simpler terms, they create “new money” in the form of new loans by amplifying the reserves according to the fractional reserve lending criteria. So for example, if a bank holds £10 in saved deposits, it then can create a further £90 worth of loans. These loans then become “real money” in the economy flowing out through business and individuals who borrowed and then deposit it into more banks that repeat the exercise until you reach a maximum amount that can be created from that first £10.

    “...people do not want to deposit money in banks, so the government borrows money from the banks in order to lend money to the banks, and then the banks continue to lend the money to the government.”

    The bank that sits on top of this heap, the so-called “lender of last resort”, is the central bank of the nation (BoE to us) which is a private organisation given a legal monopoly to create “legal tender” fiat money for the UK. This bank doesn’t actually have any money to lend. It creates money when required based on debt obligations received from the government (gilts). It then offers to lend this money to the retail banking sector. Without going further into the workings of the system, the point is that I believe, they are always “printing money” as the cash the central bank gives us is not backed by any physically limited commodity.

    The problem that has now occurred is that the retail banks are over extended and cannot pay up the interest without cutting back lending, and liquidating peoples assets. If they do this, the result will be homes repossessed, businesses going bust, and people without jobs. That is the asset reclamation phase, i.e. the recession/depression – or the nasty side of the business cycle.

    Understandably, to prevent this political nightmare, the government is offering to be guarantor of those bad debts, and so rather than cause a nasty recession to pay off the over-extended boom time growth, they are in effect, taking on those debts on behalf of the economy. However, why should the government be able to do this? Why would the BoE lend to government?

    Well, again in my opinion, it is because the government is the Bank’s most valuable client, and has a higher net worth than any business or individual in the economy. It has guaranteed income from tax by law, the highest income in the country apart from the Bank itself. But, as we can see, the BoE is not convinced the government could take on so much more debt without major tax increases. So what guarantee does the Bank have that in the event of non-payment, it will still get something back?

    Well, in the 70’s when the British Government had a similar problem, they took out massive loans from the Bank (the IMF at that point) to sort out the immediate economic downturn. After this, the next government came to power on a mandate to sort out the economy. During the 80’s Thatcher government, Britain appeared to completely sell off many government owned (public) assets and this continued through the 90’s with subsequent leaders. An economic miracle in the form of the rise of the Financial Services industry diverted attention from the consistent asset stripping from public to private hands. Whatever companies bought these assets or took controlling share, the money to do so came from banks, and just like any mortgage, ultimately the banks own it until it is completely paid off.

    Strangely enough, in the last 10 years the Blair/Brown continuum has also been selling assets in the name of privatisation. I believe a large quantity of gold reserve was sold off when the market was at its lowest, the Royal Mail has slowly been moving to complete privatisation into foreign hands, the nuclear energy industry is now in the hands of the French (public company) EDF. I’m sure others can name more examples.

    I believe the latest “fiscal stimulus” measures are going to be collateralised against whatever remains in public hands. The BoE itself is thought of as a public government institution since 1946, but there is much belief that it ceased to be so shortly after the 1976 economic crisis mentioned before. And it has slowly been transformed during these Labour years and is now no longer even a government department, and its legal obligations to account have been stealthily neutralised (i.e. the money printing change of disclosure), and it has independence over monetary policy, and is so becoming very similar to the format of the US Fed, ECB and international IMF that is composed of all these independent central banks.

    I think we shouldn’t be too surprised if in a few years once we are “booming” again, we find the Government, whichever party, suggests it would be more “efficient” to sell off the NHS hospital by hospital, surgery by surgery to private interests who are much more experienced in handling a modern medical infrastructure than we backward Brits.

  4. You raise very good questions!

    Forgive my ignorance, if the government are currently engaged in covert "quantitative easing" how will this manifest itself in months/years to come? (apart from a surprising ability to raise required funds). In the official inflation figures? In hidden inflation, not officially reported?

  5. Large numbers being hard to comprehend, I'm grateful to the Daily Mash for explaining matters in terms I can more easily grasp:

  6. Very interesting article AND comments. I will just address B33ENN.
    Yes, savers money are used as a reserves - so what? Banks still need that money to create reserves - to create the "new money" for lending. So the basic idea was right...?

  7. so, i deposit 10k in the bank and 10% is held as " leagal reserve " (£1000)and the other 9k is use to fund other depositors loans. And his/her`s monthly deposits of that loan are also used to build up a loan to another body who filed for a loan (-10%).

    And theres me thinking pyramid schemes were highly illeagal in this country.


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