Mar 13th 2012, 13:41 by Buttonwood
DYLAN Grice of Societe Generale recently highlighted an intriguing quote from Sir Mervyn King, governor of the Bank of England, about the central bank's accumulated pile of gilts. Last month, Sir Mervyn said that
The nature of this cunning plan was not revealed. But there was an intriguing suggestion in yesterday's FT from Jo Owen, a former partner of Accenture. the Bank of England should simply retire (i.e. cancel) the debt. As the author writes
After buying £325 billion of debt from the market, the public sector (the Treasury) is paying interest to itself (the BofE) on debt that it owes to itself. It makes no sense for the public sector to owe itself money.
One can understand the author's reasoning, although wait until he gets started on America's social security trust fund. But what might be the flaws with this plan?
The main obstacle to retiring the debt lies with the markets and the credit rating agencies. They may see this as a slide towards Weimar Republic economics; monetary financing of government debt by printing money.
Indeed they might, for that is what it would be. It would also be an effective default, even if the buyer was conniving in the write-off. Those who were suspicious of QE have feared that this might be the end game all along.
However the author also suggests that the money created to buy the gilts could be "cancelled". I am not sure what this would mean in practice. When the bonds were bought, the money was added to the bank accounts of the sellers; in practice it is an asset of the banks. What would happen if banks suddenly took a £325 billion hit to their assets? One reason central banks went down the QE road was to stabilise the financial system; the overnight reversal of this policy would undo much of the good work.
It seems unlikely that this is really the Bank's plan. Instead, the Bank probably expects to sell the gilts to the commercial banks, which will need to own more government bonds as part of Basle process for beefing up their capital and liquidity ratios. Of course, this is still an oddity, on a par with a government owing money to itself. The government will be standing behind the banks as lender of last resort, and the banks will be standing behind the government as lender of first resort.
Having a captive buyer in the form of the banking sector is a form of financial repression. On that note, Carmen Reinhart has another excellent comment piece on Bloomberg. As she points out
Critical factors explaining the high incidence of negative real interest rates after the crisis are the aggressively expansive stance of monetary policy and heavy central bank intervention in many advanced and emerging economies.
This raises the broad question of whether current interest rates are more likely to reflect market conditions or whether they are determined by the actions of official large players in financial markets. A large role for non-market forces in interest-rate determination is a central feature of financial repression.
Official bodies (including foreign central banks) own around half the Treasury bond market; the share of private sector (and thus profit-maximising) is probably the lowest since the early 1970s. As Ms Reinhart warns
That, too, was a period of rising oil, gold and commodity prices, negative real interest rates, currency turmoil and, eventually, higher inflation.
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As far as the commercial banks/insurance companies etc are concerned, the transaction is over - they've sold their gilts to the BOE and move on (this differs from the LTRO).
So all the BOE is doing now is getting its coupon payments and waiting for the bond to be redeemed. So can't the government when that time comes redeem the bond with one-off interest-free 1,000 year bond?
Hang on. The BoE owns these gilts. You can't go round "cancelling" monies paid by the BoE to insurers and pension funds which sold the gilts to the BoE.
The Bank holds the gilts in a subsidiary. To cancel those gilts would mean writing off the principal. That subsidiary would have to write-off the gilts and potentially require recapitalisation by the Bank. Who would provide that capital to the Bank to downstream? Oh, HMG.
Much more likely to sell the gilts to banks - in UK and elsewhere - which will need these type of assets for their liquid asset buffer.
Jo Owen writes: The BoE will have to retire the debt and at the same time cancel the money it created. This means the money it issued to the commercial banks would not be backed by anything, and that makes purists uncomfortable. But in reality, the money used to buy the gilts in the first place was not backed by anything. Retiring the debt brings what was hidden out into the open.
Buttonwood responds: However the author also suggests that the money created to buy the gilts could be "cancelled". I am not sure what this would mean in practice.
Buttonwood worries Owen is suggesting the BoE void the L325 billion money the commercial banks have on deposit there. Rest easy, Buttonwood. Owen doesn't mean "cancelled" like the dictionary or you or I mean cancelled. He means cancelled as in "not cancelled." Simply retire the govt. bond, with no payout, owned by BoE, and leave it hanging in the wind, owing money to commercial banks for which it has no asset! Only "purists" will be "uncomfortable."
Putting aside dictionary definitions and the moral qualms you seem to have, why not? If it happened as a one-off, at least reasonably transparent process, why wouldn't that give confidence to the markets by removing a major source of worry? If the point is, "But they'll just do it again", I'd think the response would be "Better fiscal health is worth more than fear the line will be crossed again."
I am shocked to hear 'why not?'. The author clearly explains it - monetary supply was increased by 325 B pounds. If it were temporary, it might be ok. If it is permanent, given that the economy did not grow by that same amount, you have an excess of new 325 B for the economy to absorb. So multiply the prices by the ratio of new money supply to the old money supply. Alternatively, look at your bank account and divide it by said ratio. If you don't have anything, you are fine. The rest of us can't feel complacent.
"...eventually, higher inflation..."
Yes, this is the bank plan. To slowly steal the pensions, wages, and life savings of an entire generation of citizens. No wonder our ancestors used gold to protect themselves from bankers.
Bring back the gold standard.
It is pointless waiting for a return to a inter/national gold standard. It will never happen. But you can have your own gold standard by buying it rather than fiat currency. At least until personal ownership of gold is declared illegal.
I suspect this is a way of inflating debt away via financial repression. An interesting BBC article on this is below:
http://www.bbc.co.uk/news/business-17301032
It's not that intriguing a suggestion is it? It's exactly what inflationists expect will happen and have done for years. Also it's not a default - they don't really need to 'cancel' it, they can simply just wait until the gilts are redeemed, then give the money back to the govt.
Clever plan. First step, you shrink the treasury's debts and the BoE's assets by a similar amount. The third step is obviously prosperity.
Maybe it's time to bring back the South Sea Company?
Well,OTC conversion to exchange mechanism would hit heavily on collateral side. That's where this whole thing would end up.
In this blog, our Buttonwood columnist grapples with the ever-changing financial markets and the motley crew who earn their living by attempting to master them. The blog is named after the 1792 agreement that regulated the informal brokerage conducted under a buttonwood tree on Wall Street.
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