How do you assess the UK government’s economic approach to the coronavirus?
The government has done a good job, and a very quick one at that. The success of the Treasury and the Bank of England’s reaction contrasts strongly with the government’s cack-handed handling of the medical situation.
Despite some questions around the furlough scheme and business loans, we have seen top-notch performance from the government in terms of the speed, scope and amount of cash being deployed.
Negative talk of the government issuing too much debt in response to the crisis usually comes from those who understand very little about the way sovereign debt works compared with corporate or personal debt.
We are seeing the UK DMO set record breaking targets for debt issuance to combat the coronavirus. Is this putting the UK at risk of another wave of austerity?
The UK entering another period of austerity is unlikely — and, in fact, pretty crazy. Some market watchers have become unnecessarily uptight about the debt and I do not think it is justified.
The UK has never been in a position where it has defaulted on its sovereign debt or had its finances out of control to the point of not functioning properly. Looking at this country’s history of debt should serve as a comfort to some of those market watchers. The government’s debt as a share of GDP jumped to more than 250% as a result of World War Two, but economic growth, aided by a bit of inflation and cautious fiscal policy enabled us to bring it down to below 30%.
The idea that the current government may reach a debt to GDP ratio of 100%-120% is frankly not that impressive or surprising, relative to other periods of national crisis. For most of the past 200 years, the government has spent more time with a debt-to-GDP ratio above 100% than it has with a debt ratio lower than 100%.
Similarly, appetite for UK government debt will not dry up. There is huge uncertainty in the private sector, which is subject to significant risk. The notion that UK Gilts will not be sold because of a lack of appetite is bonkers. One only needs to look at Japan to see how much appetite there is for government debt at negative rates.
Additionally, it will be very prudent to have the Bank of England play a larger role in absorbing some of this debt. The BoE pays interest on commercial bank deposits at a rate of 0.1%, so if it buys a bond yielding 0.5%, it is essentially sending 0.4% back into the Treasury, meaning the total cost of borrowing is 0.1%.
I think the DMO’s expected debt raising plans and the Bank of England’s quantitative easing programme will both likely expand. The issue for the DMO isn’t the size of issuance, but the economic conditions in which debt raising is taking place.
With that being said, we are looking at a notable increase in the UK’s debt-to-GDP ratio in the post-Covid-19 period. While austerity measures may not be introduced, what will the government do to minimise the risk of an economic slump?
The appropriate way for the government to respond to this high debt ratio once the pandemic is over is initially to do nothing.
The government should instead allow the ratio to be brought down gradually and naturally by economic growth, as was the case in the 19th century and in the post-World War Two period.
We are lucky to be in a regime of low interest rates, and that will allow the government to avoid being burdened by a high cost of financing, while it is able to get the bulk of the borrowing taken up by the Bank of England.
This does not mean that the government has a completely free hand to spend money. The goal should still be to keep the budget deficit low, at about 2%.
At the same time, the government must do what it can to avoid raising taxes and avoid killing the golden goose. In the post-Brexit world, the UK must do everything possible to remain competitive relative to other European economies, and raising taxes to stabilise the debt-to-GDP ratio is not worth it.
Instead, the government should pull back on some of its spending plans to avoid raising taxes and therefore to stabilise the debt ratio. Plans like the HS2 rail project will have to be reconsidered. Essentially, the government’s spending rate should be below the GDP growth rate, which will help to bring the deficit down and ensure that the debt ratio stabilises and then falls.
Could we see inflation balloon in the post-Covid-19 period, once the government has achieved or exceeded its already large debt-raising package?
Many people are concerned about inflation; some even think it is inevitable. But I do not believe that. The government, via the Bank of England, is creating masses of central bank money, which is potentially inflationary. But it is manageable at this rate.
Some people think high inflation is a convenient and costless way of getting out of the situation by allowing government debt to fall in significance. But it is not costless. If the government allows inflation to rise, the costs of getting it down again will be substantial, involving high levels of unemployment, stagnant economic growth and the government will spend decades trying to squeeze it out. It is something to be avoided at all costs. The government has the tools to avoid it, by moderately stimulating the economy post-Covid-19.
The government has expanded its role in supporting the corporate sector since the pandemic began, though some industries have struggled to get the government’s backing. In times of crisis such as these, should corporates rely on governments or the private sector and markets for support?
In all honesty, the answer is somewhere in between. If banks refuse to fund and support every struggling corporate that approaches them, then they will bring about the very result they are afraid of — total economic collapse.
What is in the interest of the public — and also the interest of banks and companies — is for these companies in trouble to receive financial support. That favours a strong role for the public sector and also for strong-arming the banks. There should be increased pressure and persuasion from the government on banks to lend.
However, the government cannot be expected to provide support in every case. That sort of burden cannot be placed on the taxpayer. The whole point of capital markets is for these investors and banks to make their own assessments on the appropriate allocation of capital. The government can obviously step in when it needs to, but it can be a difficult balance to strike.
In the case of airlines, for example, the future of the industry is very unclear. In a post-coronavirus world, the airline industry may be dramatically shrunk. People will fly less and we will see some of the world’s largest aviation companies teeter on collapse. What sense is there for the government to now provide blanket support for an industry that will shrink as a direct result of this pandemic?
The natural selection logic may also apply to property companies, travel companies and the hospitality sector too.
There is a strong case for public intervention, but there must be limits and room for the private sector to shoulder some of the burden.
What effect will the financial impact of the coronavirus on the UK’s finances have on the Brexit process? Could we see the UK asking for another extension?
The UK leaving the EU at the end of the transition period in December with no deal is not the worst outcome. A period of high debt raising does not make the UK more vulnerable. After the virus, it is more important than ever for the UK to get out of the EU on time.
What lessons can the government and financial markets take from this crisis?
The best lessons can be learnt by looking backwards through history. Banks should reconsider the hordes of statisticians and financial modellers they have in their offices, and look at hiring more historians.
Identifying, understanding and targeting risk cannot be done simply through mathematical equations, but by having a comprehensive knowledge of history. How did governments and markets react to the Great Plague? Or to World War Two? The problems facing governments now are no worse than what they have faced in the past.