Financial Repression & Deficit Reduction
The Chancellor today has announced that spending cuts will continue after the next election:
We’ve got to make more cuts – £17bn this coming year, £20bn next year, and over £25bn further across the two years after.
I say ‘announced’ but actually there was little here that was new in the totals – they were all available at the Autumn Statement last month. What was newer was the suggestion that much of this could come from the welfare budget (or at least the half or so of the welfare budget which isn’t targeted on pensioners).
As many, including myself, pointed out last month it was always highly unlikely that these cuts could come from public sector spending. Such cuts would take government spending on public services (as a share of the economy) back to 1948 levels.
The suggestion that these cuts can all come from working age social security seems equally implausible. As Andrew Harrop has pointed out today, it would mean severe cuts in support for children and the disabled.
According to the Institute for Fiscal Studies to avoid accelerating the pace of departmental cuts after the next election (i.e. to keep cutting at the current rate) requires either a cut in welfare spending or tax increases equivalent to around £12bn a year.
Taken together these numbers suggest a grim future. Post 2015 we face either cutting spending on public services to the level of six and half decades ago, rolling back huge segments of the social security system or substantial tax rises.
Politically this is exactly the debate the Chancellor wants. As Andrew Sparrow has noted today, George Osborne is seeking to set the ‘base line’ for the fiscal debate in 2015 – he wants 2015 to be about ‘difficult choices’ and ‘finishing the job’ against an atmosphere of austerity and further cuts to come.
But, leaving political considerations to one side, it is worth stepping back and asking two important (and under asked) questions. ‘Where does the £25bn of fiscal tightening figure come from?’ and ‘can it only be achieved by public service cuts, welfare cuts or tax rises?’.
The answer to first question is quite straight forward – it comes from the government’s current fiscal framework. £25bn of fiscal tightening is required if one wants to be running a small surplus by 2018/19.
The need to be running a surplus by then is not set in stone. That is a political choice.
The second question is perhaps more interesting – can budget deficits only be reduced by spending cuts or tax rises? The first and obvious response is ‘no – growth matters just as much’ but that just takes us back into an existing and long running debate. The more interesting response is ‘what about ‘financial repression’?’.
… any of the measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere. Financial repression can be particularly effective at liquidating debt.
Simply put, financial repression is finding a way to get financial institutions to buy government debt at lower interest rates than would otherwise be the case. By, for example, requiring pension funds, insurance companies and banks to purchase a certain level of government debt then one can guarantee a demand for gilts (UK government bonds) that is higher than it otherwise would be and hence lower yields.
Some would argue that we are already experiencing a form of financial repression in the UK through the Bank of England’s quantitative easing programme.
In the post-war period it was through financial repression that advanced economies dealt with the overhang of debt from the Second World War. As Reinhart & Sbrancia have argued:
For the advanced economies in our sample, real interest rates were negative roughly ½ of the time during 1945-1980. For the United States and the United Kingdom our estimates of the annual liquidation of debt via negative real interest rates amounted on average from 3% to 4% of GDP a year. For Australia and Italy, which recorded higher inflation rates, the liquidation effect was larger (around 5% per annum).
Even after one of the most severe multi-year crises on record in the advanced economies, the received wisdom in policy circles clings to the notion that high-income countries are completely different from their emerging market counterparts. The current phase of the official policy approach is predicated on the assumption that debt sustainability can be achieved through a mix of austerity, forbearance and growth. The claim is that advanced countries do not need to resort to the standard toolkit of emerging markets, including debt restructurings and conversions, higher inflation, capital controls and other forms of financial repression. As we document, this claim is at odds with the historical track record of most advanced economies, where debt restructuring or conversions, financial repression, and a tolerance for higher inflation, or a combination of these were an integral part of the resolution of significant past debt overhangs.
The ‘historical track record of most advanced economies’ as Reinhart & Rogoff put it, suggests that whoever is in government after 2015 may realise that the mix of austerity & growth is not enough to deal with the debt problem.
To see the potential impact of financial repression in the UK, one need only take a look at the OBR documents published with the Autumn Statement.
The OBR assume that the market gilt rates will rise from 2.6% in 2013/14 to 4.2% by 2018/19 increasing the cost of servicing existing debt.
They have also helpfully published a ready reckoner showing the impact of lower or higher borrowing costs on the public finances.
(The numbers become larger over time as more debt is refinanced by higher rates.)
These are big numbers.
A 1p rise in the basic rate of income tax would bring in £4.5bn in 2016/17. In other words – 1% lower gilt yields can have as big an impact on the public finances as an income tax rise in 2016/17 and bigger one in 2017/18 (when more debt is refinanced).
If gilt yields were 2.7% in 2018/19 rather than the expected 4.2%, then borrowing costs would be almost £11bn lower (very near the £12bn figure the IFS have noted).
I would be very surprised indeed if officials in the Treasury were not seriously looking at what financial repression could achieve in terms of debt and deficit reduction.