Free money?

“There's No Such Thing as a Free Lunch.” Milton Friedman

My last post, ‘Too good to be true’, looked at Jeremy Corbyn’s most contentious economic proposal, People’s QE. I highlighted two issues: the threat to the BoE’s independence and the belief that the debt can be cancelled and then proceeded to discuss the first. In this post, I deal with the second.

Recapping from last week: 

"So what is People’s QE? Well, it begins the same as QE, with the BoE creating money. But this money is then only allowed to be used “under government direction and subject to government guarantees” to buy bonds of a new institution set up to promote investment and innovation the UK, called the National Investment Bank (NIB). Moreover, it is believed that the debt created by the NIB can be subsequently cancelled on a technical detail."

Earlier this year, Richard Murphy put forward his proposal for Green QE (the policy idea that spawned People’s QE). In his post, he writes that Government debt bought by the BoE as part of a QE programme is cancellable. This in and of itself, he argues, is no different to conventional QE:

"The government no longer pays interest on this £375 billion of its borrowing, because to do so would mean that it would simply be paying interest to itself since the government gilts now belong to the Bank of England, which is in turn owned by the Government. That’s one clear indication that the debt no longer existed, because if it did the interest would have been due. And that is quite obviously true: whilst one part of government can obviously owe money to another part, if no one outside government is due money as a result there can be no government debt owing, and that has been the consequence of QE."

He explains again, in another post:

"If the government buys its own debt then it cancels it. This, as  a matter of fact, is true. It is, of course, technically legally possible to argue that the debt still exists, but if I create a loan to myself, even if it is legally recorded, it has no economic consequence:  my repayments of my loan from me to me means that no money actually in net terms leaves my own pocket and that is exactly what  happens when, as a consequence of any form of quantitative easing, the government owns its own debt.   So, quantitative easing actually cancels government debt and does not increase it."

Now, this might not sound like a big deal but it has enormous ramifications for economic policy. First, it means that the motivation for embarking on a QE programme could have nothing to do with monetary policy, but rather fiscal issues (which bring us down the route of questioning central bank independence). Second, it means that the government could essentially be getting free money. 

So, it makes sense to figure out what is actually happening. In the rest of this post, I’ll explain why I think government debt bought in a QE programme CANNOT be cancelled under the current framework.

The evidence

A look at the correspondence between the BoE and the Treasury gives us a fair idea of the financial agreements in place between them. The first thing to remember though, is that the Government is indemnified to the Bank of England (BoE) and its subsidiaries, i.e. the Government covers losses as well as receives profits arising from the BoE’s activities. 

In the Monetary Policy Committee (MPC) meeting of 7-8 November 2012, committee members were briefed on (and subsequently agreed to) the Government’s request to receive excess cash, on a quarterly basis, from the entity set up to carry the QE transactions (the Asset Purchase Facility - APF). This excess cash was defined as the interest paid by the Government on the bonds the APF held as part of their QE programme, minus operating and other costs. 

When the APF was initially set up, it was agreed that the total profit/loss for the APF would be settled with the Government when QE was finished and the APF was closed. During that time, the Government would borrow money to finance the interest payments on the bonds that the APF owned (just as if the bonds were owned by private investors). 

George Osborne, in his letter correspondence with Sir Mervyn King (former Governor of the BoE), argued that with the UK recovery sluggish, it was apparent that the APF would be around for a while longer. This then meant that the APF’s cash balances from received interest payments (a sizeable £35 billion at the time) would continue to grow. Osborne (correctly) argued that the Government was borrowing too much to fund these payments, and the set-up was economically inefficient. Therefore, he said, it made sense to transfer the cash back on a quarterly basis.

Essentially, the Treasury believed that as the APF was just another governmental department, it made little sense for one part of the government borrowing to fund another, and so the interest payments were economically moot. So far, so good for Murphy and his theory.

The letters though, made clear that these payment will likely be reversed in the future (due to the Government’s indemnity to the BoE) as the APF incurs losses on its bond positions when the MPC decides to sell their bond holdings and increase the Bank rate in response to a strengthening economy.

What does this mean?

The OBR noted in its press notice that the fiscal effect of this transfer would be two fold. In the short term, Government net borrowing would be lower than it would have been - so QE provides a helping hand to the government finances. In the longer term, the OBR said, it is likely to be higher than it would have been as the Government has to borrow to fund any losses the APF incurs, just as the letters noted. It's critical to realise that these losses could amount to MORE than what the Treasury saved from the APF’s quarterly transfers to it (depending on how violently the UK bond market reacts to the MPC deciding to raise the Bank rate). In this case, QE doesn’t cancel any debt, but in fact raises it. This is where Murphy's theory breaks down.  

What’s more, Mervyn King was sure to spell out that principal (cash) received from the maturing bonds would not be transferred to the Treasury, and would  be used at the discretion of the MPC. In an example: if the APF bought £100 billion of government debt as part of QE at an interest rate of 3%, though government would get a £3 billion windfall from this transfer set up, it would still have to pay £100 billion back to the APF (and hence the BoE) once the bonds mature. 

Also bear in mind that once the MPC normalises monetary policy by selling its government bond holdings back to the market and raising the Bank rate, the APF will no longer be the owner of Government bonds - private investors will. The Government will then have no choice but to resume making interest payments and the interest costs become, in some sense, ‘live’ again. 

So, government debt cannot be cancelled; only interest payments can be cancelled (and that, only for a short period of time). But as I explained above, if the APF incurs substantial losses as part of the MPC raising rates, this doesn’t mean that QE will necessarily reduce government borrowing.

The bottom line

For People’s QE to be fiscally neutral (i.e. have no effect on government debt), the debt must be cancellable. This is, in my view, impossible under the current set up of QE. One way it could be done, is if the MPC is instructed to buy and hold government debt until maturity, and then create more money to finance any losses it might incur. The outcome? The loss of central bank independence.

In my first ever economics lesson, we were taught that economics is the theory of allocating finite resources to satisfy infinite wants. Richard Murphy seems to have forgotten the fundamental principle of economics; and in doing so has forgotten that there’s no such thing as a free lunch.