Originally posted on Conservative Home on 28th November 2008
Does ‘radical monetary action’ mean more than guaranteeing certain bank loans if the European Commission allows and suggesting the Bank of England cuts interest rates? What will we do to make monetary policy work and the economy recover?
We should start by recognising how the government and its Debt Management Office (DMO) have disabled monetary policy. They are flooding the market with short-dated government debt, doubling the outstanding stock of treasury bills from £16 billion to £32 billion and increasing short-dated gilt issuance from the £25 billion planned to £63 billion. The DMO is even ‘overfunding’, i.e. selling more gilts than needed even to fund Labour’s current borrowing, a policy last used by us to slow the money supply between 1980 and 1985 and one which is utterly perverse in current economic conditions.
Given this flood of gilt-edged debt, risk-averse investors, particularly banks, lend to the government rather than to the private sector. They buy up the surging supply of short-dated government debt, instead of holding short-term private debt such as commercial paper or bank certificates of deposit. Surely it would be better to tackle this problem by cutting supply of the former rather than setting up an EU-backed bureaucracy to guarantee favoured categories of the latter?
Investors, including banks, are clearly scared to lend, so whether or not they do so will depend crucially on the riskiness of the alternatives. Historically in the UK there has been very limited supply of the lowest risk assets, i.e. debt that is government guaranteed, liquid and short-term. Banking problems in the past have not been exacerbated by the supply of huge amounts of low risk government paper to serve as an alternative to private lending.
If we want monetary policy to work and the banks to lend to the private sector we should stop flooding them with low risk public sector debt. The government says it is using fiscal policy to support recovery but it is funding its borrowing spree – and ironically its bank bail-outs – by shovelling treasury bills into the banking system in exchange for sucking cash out.
We need to reverse this policy by cancelling treasury bills and returning the cash to the banking system. The government should instead fund its borrowing by issuing debt which is riskier for banks than private sector lending, so that they do the latter rather than buy the former. That means borrowing by issuing long-dated and/or index-linked gilts, the prices of which are fixed in the long-term but volatile in the shorter term, meaning that they tend to underpin insurers and pension funds instead of offering banks an alternative to private lending.
An even more powerful way to get monetary policy working would be to switch some of the current flood of short-dated sterling denominated government debt into foreign currency borrowing. Presumably not understanding the resulting disablement of monetary policy, the government continues to instruct the DMO solely to minimise borrowing costs subject to risk. However, in this instance, saving borrowing costs and supporting monetary policy point in the same direction – to a measure of foreign currency borrowing.
Given that the UK government is borrowing incomparably more than any other major government, it must make sense to tap at least some of the pools of savings in other currencies, particularly given that our government starts from a position of having an already depreciated currency and virtually no foreign currency debt.
The current alternative of borrowing solely in sterling implies two things. Firstly, it means having to devalue sterling to a level from which foreign investors will anticipate a future rise sufficient to compensate them (at our expense) for the risk of holding large amounts of government debt in a currency other than their own. Secondly, it means denuding UK investors, including banks, of the capital which they could otherwise lend to the UK private sector to bring about recovery.
To make monetary policy work to generate recovery, and mitigate the tax bombshell, the government needs to stop borrowing short-term from UK banks in sterling and start borrowing some of what it needs from overseas in foreign currency.