Tuesday, June 22, 2010

UK Deficit Spending, QE and Inflation: A Short Analysis

A commentator called “George” on the Cynicus Economicus blog has asked some questions about an earlier post of mine called
“Projections of the UK’s Interest Burden on Gilts as a Percentage of GDP”.

He states:
You merely state a percentage of interest payment against government spending but fail to acknowledge that this becomes unaffordable when lenders demand higher interest rate for the increased risk.
In fact, I have pointed out in the previous post that yields are low now precisely because the government has the tools at its disposal to control yields and hence the cost of its additional borrowing. These tools are open market operations and regulation of the portfolios of banks.

Bill Mitchell of Billyblog has shown how in a fiat currency with a floating exchange rate, the government has the power to control the yield curve:
Bill Mitchell, “Operation Twist – Then and Now,” March 31st, 2010
My views are entirely in line with his. George asks what will happen when lenders want to charge governments higher interest rates. The answer is that governments can decide for themselves what the coupon rate and yield rate will be.
The new Tory-Liberal Democrat government might refuse to use these policy tools, and that would be a foolish mistake on their part, and, if yields surge to a problematic level, then they will be responsible for it. But then again their austerity might reassure the markets – so it is difficult to know what will happen. And only yesterday there are indications that the new government will still use loose monetary policy this year:
Alan Clarke, U.K. economist at BNP Paribas .... tipped the BOE to announce £25 billion of extra bond purchases in August, and a further £25 billion in November.

Natasha Brereton, U.K. budget measures point to loose policy, Wall Street Journal, June 22, 2010
Furthermore, if my plan to nationalize the banks that accepted bailout money were implemented, then they could also purchase the issuance of new government bonds with the excess reserves they have at the Bank of England. This would help to keep yields down. The Bank of Engand’s £200 billion quantitative easing policy ended in February 2010, but there are still a lot of excess reserves in the system. These reserves are sufficient for new loans to be given to creditworthy borrowers as well as additional purchasing of government bonds when the private sector does not take them up.

It should be noted that in May 2010 the total UK public sector net debt was £903 billion, or 62.2% of GDP.

Since the public sector debt is £771 billion or 54% per cent of GDP if we exclude the bailouts and financial interventions, then nationalizing banks will be a good way to bring down the debt as a percentage of GDP in the future.

For the figures on debt, see here:
UK National Debt
The commentator “George” also claims that I
“previously have stated that governments can print without limit.”
But this is entirely false. I have repeatedly stated that there are real limits to money creation and budget deficits.

The level of money creation and stimulus for one country will depend entirely on its particular available resources, capacity utilization, unemployment, credit growth, external balance, and inflation rate.

George then asks what is the limit of UK money printing before inflation kicks in.

Most deficit spending is naturally inflationary, so presumably George means what is the limit of UK money printing before serious and very high inflation kicks in.

In 2009/10 the budget deficit will be about £178 billion or 12.6% of GDP.

My guess is that if the deficit rises to 15% or even 20% of GDP without austerity but with more stimulus, then this would cause serious higher inflation, which might be problematic. In the Weimar Republic, it is estimated that budget deficits were 50% of GDP, and in an economy suffering severe output shocks and crippling reparations.

Yet it is obvious that the UK is nothing like Weimar Germany.

For excellent analysis of Weimar hyperinflation, see here:
The Richebächer Letter, Number 417 June 2009 (p. 3 following).
George refers to the term “money printing.” It should be noted that this could mean (1) more open market operations (or the radical version of this called quantitative easing) or (2) budget deficits indirectly funded through QE and borrowing from private markets.

The fact is that QE is not inherently inflationary since in the present environment most of the new money just goes back to the central bank in the form of excess reserves, as is shown here:
Bill Mitchell, “Building Bank Reserves is not Inflationary, December 14th, 2009
Since credit growth is weak, a highly inflationary injection of money by this route is unlikely.

Direct central bank creation of money used to fund a budget deficit is undoubtedly inflationary. But this is not happening in the UK. At most, you could say that QE allows indirect funding of deficits. But a significant amount of the government borrowing is coming from private markets too, so money is withdrawn to match the money spent in the latter case.

The inflation figures for May 2010 show disinflation in the UK: the inflation rate slowed from 3.7% in April to 3.4% in May.

So clearly deflationary forces are at work, despite the budget deficit.

The projection for 2009/10 is that the government needs to borrow £178 billion or 12.6% of GDP. But austerity will cause deflationary forces.

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