If the government simply cancelled the £300 bn+ of QE gilts held by the BoE, who would be unhappy?

The UK sits unhappily at the very boundary of what debt burden is acceptable for a AAA rated economy.  If growth continues to disappoint, or if more austerity becomes socially impossible, the UK will be downgraded – and neither of these possibilities look very remote.

At the moment the UK public sector net debt to GDP ratio is about 63%, equivalent to about £1 trillion (these numbers exclude the debt of the part nationalised banks).  Debt servicing costs are over £50 billion per year  – a large chunk of our annual deficit.  Additionally our debt position is likely to deteriorate before it improves.

But do we really need to be paying interest to the Bank of England on the £300 billion+ of gilts that it holds as part of the Quantitative Easing programme?  In fact the Bank holds these gilts on behalf of the Treasury anyway, so the Treasury is effectively paying interest to itself on assets that it bought with “free” printed money.  Could we decide that this is a waste of time, that we are unlikely to sell these gilts back to the market in any case, and that we may as well just cancel the gilts we bought for the nation?  Gold bugs and inflationists will at this point be spluttering into cups of tea – what about all of the printed fivers that have been set free into the economy like in a modern day Weimar Republic?  Well, how about this for a potential statement from the authorities on gilt cancellation announcement day:

“Today the Treasury announces the cancellation of £350 billion of gilt-edged stock held by the authorities.  These gilts were bought as part of the Quantitative Easing programme started in the aftermath of the financial crisis.  The purpose of Quantitative Easing was to boost nominal growth after what we thought was a temporary fall in UK output.  Several years later it appears that this fall in output was permanent – the fall in UK GDP remains more severe than that experienced during the Great Depression.  We will therefore make this liquidity injection permanent in order to boost UK growth and reduce unemployment.  The Bank of England of course remains fully committed to its inflation target of 2% – a cornerstone of UK economic policy. Should inflation rise, or be forecast to rise above the target range, the Bank may raise interest rates, or sell Treasury Bills to the market in order to drain excess liquidity from the system and return inflation to its target.  Today’s action also reduces the UK’s debt to GDP ratio from 63% to 41%, and slashes our interest bill from £50 billion £32 billion per year.  This prudent action safeguards the UK’s AAA credit ratings and leaves holders of gilt-edged securities in a stronger position than before.

Note from the Debt Management Office: the gilt cancellation will take place using the same process and precedent set with the cancellation of £9 billion of UK gilt-edged securities acquired from the Post Office pension scheme in April 2012.”

So who would be unhappy with this?  No default has taken place (no CDS trigger, no D from the ratings agencies who are only interested in failure to pay private investors), the UK’s public finances become sustainable, the economy gets a boost from the knowledge that the QE cash injected will stay there for the foreseeable future, and a mechanism exists to remove cash from the economy should inflation return.  Apart from the fact it all feels a bit banana republicy everybody’s a winner.  In fact the genius of this idea is that it doesn’t need to be done at all – if the Bank of England were to start paying gilt coupons and maturing gilt proceeds over to the Treasury automatically you would have an equivalent economic impact, without any of the awkward Zimbabwe comparisons.

26 thoughts on “If the government simply cancelled the £300 bn+ of QE gilts held by the BoE, who would be unhappy?

  1. The separation of government treasury and central bank is one factor that gives confidence to holders of sterling, both domestic and foreign, that the U.K. could not become another Zimbabwe.
    Should the Bank of England follow the Fed’s example of paying interest earned from its assets (less what is paid commercial bank deposits with the central bank) each year to the Treasury, allowing a significant reduction in the debt interest bill?  Perhaps. One assumes the Bank is keeping the gilt coupons received on an account to cover potential losses when it comes to sell all those long-dated bonds that it now owns.

  2. Great article, made my head spin though and just when i thought i had the concept of QE nailed down… Even if they wanted to, could the UK’s central bank actually do that legally?

  3. Hi Jim,
    I’m really glad that you, as a professional investment manager, addressed that point because I’ve asked that same question a number times on several forums about a year ago with no response – what if all the gilts bought via QE were simply cancelled – what would be the downside? Your post aptly points out the upsides and the downsides are not obvious.
    It wouldn’t necessarily be any more inflationary than QE has been already – if the government were to adhere to gently reducing the remaining debt through tax receipts without embarking on a huge fiscal splurge, but maybe a gentle easing of fiscal policy – a VAT cut? more tax cuts for the poor? And to corporates to encourage investment or job creation?
    The only downside I could see – and one I think the Bank of England would most vigorously argue – is that it would represent a new form of moral hazard, something governments would resort to when things got tough. They might also say that it would challenge the whole orthodoxy of sound money effectively that money was freely created with no cost to anyone, at least fresh gilts carry coupons that need to be paid by the taxpayer. I suppose the very thought of the possibility of that occurring could unnerve investors – imagine if the idea caught on in the US and Eurozone (where the potential for moral hazard is enormous because the real problem is one of competitiveness not of just bailing out banks and restarting the economy).
    But still it’s not an idea to be dismissed and might be a sensible solution if done within some fiscal and monetary boundaries. After all we’re not living in normal times and even QE was once deeply unorthodox – now it’s orthodoxy.

    • Welcome to modern monetary theory! Shouldn’t you ask yourselves what government debt actually is if one can just cancel it? Cancelling makes the monetization more obvious and further attempts of qe would be impaired. Cb have to pretend they are independent, of course, they are not.

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  5. Thank you, Jim, for an entertaining article; but I don’t think the proposal would work.  Look at it from the perspective of a book-keeper well-versed in the art of double-entry accounting:

    When the Bank of England bought gilts for the QE programme, it paid for them.  Its balance sheet showed it acquired assets (the gilts) and the same value of liabilities (maybe called reserves).  In fact, the Bank’s balance sheet is now much larger – on both sides – than it was before it started QE.
      
    If I understand you correctly, you propose that those assets should be acquired by the Treasury without payment.  That would leave the Bank with huge liabilities and few assets:  the result would be insolvency.  Who would then bail out the Bank?  Its shareholder would - the Treasury.

    Bear in mind that, outside the ivory tower of the City + Canary Wharf, live some 60 million UK citizens and voters who use the Bank’s banknotes daily (or their Scottish or NI equivalent) and they have absolute faith in the Bank’s ‘promise to pay the bearer’.  A bankrupt Bank would not be trusted; and without full trust, it could not create money nor issue banknotes.

    Maybe I misunderstand you, and you propose that the Treasury should pay for the Bank’s QE assets.  But what would be the point?  That wouldn’t reduce the National Debt.

    Take another look at your proposal:  suppose for a moment it did work painlessly.  It would then be a good idea to run it again, and again, until all the National Debt had been eliminated.  Maybe it could continue , and build us a National Savings.  Then money would be growing on trees, pigs would be flying and England’s footballers would be permanent world champions.

    You may well be right that it’d be worth having a conversation about the extent to which the size of the QE programme has compromised the Bank’s independence (the Treasury indemnifies the Bank for its QE purchases).  The current QE process is that the Treasury issues gilts which the Bank then buys with money it creates.  Can this process continue infinitely?  If this process continued beyond the current £350bn, would there be a point at which the Bank’s credibility became stretched?  Could anybody recognise that point before it was passed? 

    If we ever approached the point where the Bank’s ability to create good money was questioned, we might, as you suggest, end up looking to banana republics for lessons in how to manage an economy.
       

  6. Orthodoxy has it that the hazard with an increase in base money is that it would eventually produce an inflationary spurt of similar magnitude.  However, in a deleveraging environment, that isn’t true at all and the new base money gets “mopped up” in the process of reducing the money multiplier (M4/M0 or similar).
    The problem with low bank rates is that not much new base money is being created via interest on reserves, so a new channel is needed (to keep M0 rate of increase roughly in line with desired NGDP, say).  One can argue that that channel should be “no strings attached”, i.e. without the implicit threat of reversal that QE has.

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  8. This would have a significant impact on the credibility of the Sterling.
    This solution would defeat the same reason that it is proposed for (remain classified as AAA).

    Why would someone want to invest in UK in the future? 

  9. You know the argument, as it’s straightforward and logical:-

    QE isn’t inflationary so long as it is a credibly reversible policy, with the “new money” that was used to fund the BoE’s gilt purchases being siphoned back out of the economy, even if this occurs over the long term. In  the normal course of events, all those gilts currently parked on the BoE’s balance sheet will have to be repaid by the Treasury, using taxes receipts extracted from the economy. That’s the long term mechanism by which QE will be reversed, with the “new money” being cancelled out of existence. ie. no long term inflationary impact, since there is no permanent expansion of the money supply. 

    Your proposal breaks that “promise” and makes the money supply expansion permanent. In simple terms, that’s open monetary financing, and thus a clear sterling devaluation and hence inflationary. Whether it’s Weimar-esque depends on the size of the numbers, but that’s the path you’ve stepped onto as soon as the money printing becomes a non-reversible policy.  and 

    Do I think it’s possible? Most definitely. Politicians and central planners will like the sound of the easy option, and the sound of the consequences being born by others in the future, not on their watch.

    That’s why, despite the immense deflationary pressures that the great deleveraging is bringing to bear I believe the eventual end-game will be significantly inflationary. Thus like Mervyn, I’ve a portfolio carrying a wodge of index-linked stuff, UK and beyond, to ride out the long term dénouement. John Hussman knows the score: 2nd half of this decade = major inflation.

  10. Sterling would be sharply devalued in the foreign exhange markets on announcement as there would surely be an immediate reaction in a mass dumping of sterling. Though one could say that erosion of the currency is an indirect aim of the BofE anyway regardless of the supposed inflation target.
    But after the initial shock (and stabilisation of the currency at some lower price) how do you counter Jim Leaviss’ point that gilt holders are then arguably holding what should be in principle a more secure asset in that the overall debt burden is reduced?  As a premise this would appear indisputable, but…
    … doesn’t it come down to the high probability that cancelling debt will lead to loss of UK’s AAA rating by the rating agencies using whatever reasoning appears expedient, which would itself lead to a sell off of gilts, increased borrowing costs and undo the very point of the initial exercise. I suspect this must be the (unwelcome) answer.
    IMHO, it should be the initial exercise in QE that leads to a loss of credibility and loss of rating. Once the BOE has bought the bonds with funny money, cancelling them would be the natural conclusion to the exercise.
    A lovely question to set economics undergraduates I suspect. Please discuss.

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  13. Cancel QE Debt, and QE in a deflationary environment
    See also an interview by John Authers of the Financial Times with Jim Leaviss entitled ‘Cancel QE Debt’ and published on 30 May 2012.
    <a href=”http://video.ft.com/v/1662486791001“>Authers Note (FT) – Jim Leaviss and ‘Cancel QE Debt’</a>
    I should start by responding directly to the suggestion as proposed in the Leaviss blog and interview, namely the consequences of a return of gilts from the BoE to the Treasury. My conclusion, and I apologise for its apparently dismissive brevity, is that it doesn’t matter. What really matters is that as a result of the QE operation the UK debt held by creditors external to the UK government has been reduced. To ask which (extended) arm of the government currently holds the repurchased debt is not productive. The danger of upward pressure on bond yields has diminished. Why? Because there are no bond vigilantes within the BoE seeking to exploit a gilt crisis, let alone engineer one. So apart from reducing interest payments from the Treasury to the BoE (which can easily be achieved by other means), there is little to be gained. Indeed, as indicated by Authers’ polite incredulity, the negative reaction by economists worldwide to such an audacious move by the government could in itself precipitate a gilt crisis.
    I would now like to go much further than the QE cancellation suggested above by the conjecture of using quantitative easing to exactly counterbalance an existing deflationary environment such that net inflation is close to zero. One’s immediate reaction to this is that a proximate cancellation is hugely unlikely. If deflation erupts it is likely to be as a consequence of massive shocks and in such a chaotic situation, any planning is at best guesswork. Furthermore, since QE is a relatively new policy instrument, a detailed understanding of its mechanisms is not available. This practical improbability does not prevent us from exploring the ramifications of non-inflationary quantitative easing.
    So we are working on the assumption of an outcome of net zero inflation. Other considerations are that there are no significant changes to taxation, spending or benefits. Base rates might remain unchanged but this could be an opportunity to jettison the idea that QE only begins when low base rates approach zero. It is perfectly possible to balance more ‘normal’ base rates with even higher QE.
    The positives of QE are well rehearsed. Firstly, we note how stubbornly damaging deflation can be. The use of QE as an anti-deflation strategy would be hailed as a great success even if low positive inflation is the net outcome. Secondly, the use of QE as currently practiced, that is new money from a central bank to buy existing government bonds, is effective in protecting against external creditors, as argued above, even if no transfers formally cancel part of the national debt. Thirdly, QE does have the effect of lowering the cost of further government borrowing, should this be required. Fourthly, we might add that variants from conventional QE are possible. For example, the Treasury might offer special low-coupon long-dated gilts to be purchased exclusively by the BoE with new money. This would not affect national debt (in respect of external creditors) but would create funds for discretionary government spending. Many will wince at this, a QE too far, but it is possible.
    So now what might we expect the negatives to be? Firstly we note that the present conjecture is based upon an existing deflationary environment. In the past, this has only happened in association with an economic slump, high unemployment and other  personal tragedies. It is not to be hoped for. But if we found ourselves in such circumstances, what downsides are there to using QE to combat deflation?. To examine this we should stick to the idealised outcome of a net inflation rate of zero. Fast forward a few months and who are the winners and who are the losers? If inflation has indeed been zero then it is difficult to find any group in either camp simply because little has changed. Prices and wages have remained static, the value of savings has been maintained but borrowers have not been disadvantaged. Similarly, it is difficult to identify any institution that is better or worse off. This fits in with the Leaviss remark about nobody getting hurt or being unhappy. I would also make reference to recent low annuity rates being partly blamed on QE programmes. Purely to remove this as a possible negative to the argument, one only has to invent the artifice of 100% cash return of pension investments rather than compulsory purchase of an annuity – not that I am making any such recommendation.
    So just a minute, am I suggesting there are only positives and no-one is disavantaged? Is this a free lunch where nobody has to pay? Yes I am. It is exceptionally easy to prove me wrong. All you have to to is identify a group or institution which will suffer after an extended period under the regime as outlined. If you cannot make such a claim then you have to accept that this is a free lunch.
    So I would summarise my conjecture in a single sentence. Non-inflationary quantitative easing generates real wealth without any user or future user of the currency being disadvantaged.
    Discuss.
    Geoff Sears

  14. Surely, as others have suggested, Sterling would fall through the floor and along with it foreign investment in Gilts or anything else.

    While it might achieve the budgetary objectives outlined, initially, it would force the UK Government to spend only its current revenues as the gilt market would be closed until credibility had been restored – a decade or more.

    So it would achieve very little other than the outcome of the current state of the world economy is likley to dictate – a decade or more of stagnation. But with no access to any liquidity in the interim. And it would be copied by the EZ, which would certainly be the final nail in its coffin.

  15. I think you are exactly right? Fear of inflation is what prevents it. I suspect a little more inflation is actually helpful at the moment.probably slightly easier for the US to do this than it is for the UK. but by all means, do it NOW!

  16. Just thought I’d restate my previous comment, which seems to have been disallowed, as follows.

    The Bank of England is owned by the Treasury Solicitor, an agency of the government and part of the executive. Thus it makes no difference, except cosmetically, whether the coupons on the gilts purchased via QE are paid over to some other Government bank account or retained by the BOE.

    The UK’s printing presses have whirred to the tune of around a third of GDP in the current crisis. We were rather highly geared to begin with, to put it mildly.
    Currently, scapegoating of big business/bankers/the unemployed/etc. is taking hold- the history of great currency debasements is all too relevant.

    On a slightly different tack, the idea that we can crush inflation as easily as we can create it would be news to Mr Volcker for one. When the velocity of money eventually picks up, we’ll see the fruits of QE, which will be rather nasty inflation and possibly worse.

    The eventual cure is likely to be rather more unpleasant than the accounting exercise proposed, which if it happened, might well have no consequences of itself, but only because it matters not which way the stable gate is left after the horse has bolted.

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