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Do rising interest rates in the future create a problem for the UK government?

Dr Dirk Ehnts discusses rising interest rates and their effect on the UK economy.

The Office for Budget Responsibility (OBR) issued stern warnings at the end of November stating that fiscal adjustment would very likely be required to arrest the continued rise in public debt. This led British finance minister Rishi Sunak to make the claim that public finances are on "unsustainable" path. According to the BBC reports, Sunak stated that "there are record peacetime highs in borrowing and debt, and the forecasts that were set out yesterday show us on a path where that continues to be at a very elevated level, so that’s not a sustainable position". The elephant in the room is this: How is a sustainable position in public debt defined?

Some, like the OBR, apparently seem to think that the public debt needs to be "stabilised’. What that exactly means is not made explicit. The OBR warned:

The increase in borrowing does, however, render the public finances more vulnerable to changes in financing conditions and other future shocks. This heightened vulnerability is compounded by the shortening of the effective maturity of that debt as a result of both a greater focus on short-term debt issuance by the Treasury and further Bank of England purchases of longer-dated gilts financed through the creation of floating rate reserves. Taken together, these leave debt interest spending twice as sensitive to changes in short-term interest rates than prior to the pandemic. Arresting the continued rise in public debt is likely to require some fiscal adjustment once the virus has run its course. Only in our upside scenario, in which the pandemic is swiftly ended and there is little lasting damage to activity, does borrowing fall below the level required to stabilise the debt-to-GDP ratio by the forecast horizon. In our central forecast and downside scenario, tax rises or spending cuts of between £21 billion and £46 billion (between 0.8 and 1.8 per cent of GDP) would be required merely to stop debt rising relative to GDP.

Monopoly money

Dr Phil Armstrong has written an article on fiscal policy for The Gower Institute of Modern Money Studies that is worth reading in relation to this. In it he mentions the "government budget constraint" which conceptualises government as a currency user – that is that the government would have to have income before spending. This is upside down because the government is the monopoly issuer of the currency, not a user. The Bank of England is today wholly-owned by the UK government, and no other body is allowed to create UK pounds. It can create digital pounds in the payments system that it runs, thus marking up and down the accounts of banks, the government and other public institutions. It also acts as the bank of the government, facilitating its payments. The Bank of England also determines the bank rate, which is the interest rate it pays to commercial banks that hold money (reserves) at the Bank of England.

The interest rate that the government pays on its government bonds (gilts) follows that bank rate closely. Looking at the figure below, it is clear that the interest rate on gilts with a 10year maturity is mostly determined by the bank rate. The reason is that there is an arbitrage relationship. Banks can choose to hold their money in the form of reserves (deposits at the Bank of England) or they can purchase gilts with these reserves. When reserves pay a lower rate of interest than gilts, banks have an incentive to adjust their asset portfolio. Swapping reserves for gilts delivers more profit for commercial banks.

Gilts and bonds

The interest rate that the UK government pays is a policy variable determined by the Bank of England. Furthermore, it is not the Bank of England's remit to bankrupt the government that owns it. The institutional setup ensures that the Bank of England supports the liquidity and solvency of the government to the extent that it becomes an issuer of currency itself. Selling government bonds, it can create whatever amount of pounds it deems necessary to fulfill its functions. Given that the Bank of England stands ready to purchase huge amounts of gilts on the secondary market (for "used" gilts), it is clear to investors that gilts are just as good as reserves. There is no risk of default.

Moreover, consider that the Bank of England can always allow the government to spend using overdrafts of its ways and means facility. This prompted the Financial Times to publish this article: "Bank of England to directly finance UK government’s extra spending". The Bank of England can, in effect, just execute all the payments that the Treasury sends its way. Issuance of gilts is optional. While this might seem strange at first sight, it is only a logical consequence of the fact that the Bank of England is the issuer of currency. Before gilts can be purchased, the government first has to spend some money into the economy. Alternatively, banks can borrow from the Bank of England before they purchase gilts. Issuing gilts provides a risk-free asset with some interest, but it is not need to "finance" the government.

Deficit versus surplus

The figure above shows the UK public debt to GDP ratio and the Bank of England's policy rate through the centuries. Note that UK public debt peaked in 1945 at above 250 per cent of GDP. Unsustainable? Obviously not. In 1951, the interest rate started to increase from 2 per cent to 16 per cent in the mid-1970s. Unsustainable? Obviously not. What the figure shows is that the government of the UK cannot "run out of money". When it spends more into the economy than it collects through taxes, a "public deficit" is produced. This means that the private sector saves a part of its monetary income which it has not spend on paying taxes (yet). When the government spends less than it collects in taxes, a "public surplus" results. This reduces public debt. That public debt to GDP ratio can be heavily influenced by GDP growth, which explains the fall in the public debt to GDP ratio in the second half of the 20th century.

I would like to raise one last issue, even though it should be clear by now that as a currency issuer the government will not run out of money. Lately, the Bank of England has purchased quite a lot of gilts through its Asset Purchase Facility. On September 30, 2020 it held 674.9 billion pounds worth of gilts. At the end of October 2020, the public debt to GDP ratio hit 100%. This was £2,076.8 billion in currency. Roughly one third of outstanding gilts is held by the Asset Purchase Facility. Where does the interest go that the Treasury pays on these gilts and accumulates at the Asset Purchase Facility? The answer is this: "As a result of the Indemnity Agreement, all profits and losses are passed onto HM Treasury." So, HM Treasury pays interest, then gets one third of it back immediately. There is no technical reason why the Asset Purchase Facility could buy up all of the outstanding gilts. Then, all interest payments made by HM Treasury would come back immediately. The banks would have reserves at the Bank of England worth the public debt. These earn interest equal to bank rate. Since this interest rate is set by the Bank of England, it can be set at zero if the Bank believes this makes sense. At positive interest rates, the Bank of England will pay the banks holding reserves by marking up their accounts. They do this with the computer and as the monopoly supplier of currency there is no limit.

So, do rising interest rates in the future create a problem for the UK government? No. The Bank of England is the currency issuer. There is nothing that stops it from paying what HM Treasury instructs it to pay. Gilts can be issued in this process as an option. The government's ability to pay is not put into doubt since the Bank of England acts as a lender of last resort, offering to buy up gilts on the market so that the price of gilts can never crash. Higher interest rates cannot bankrupt the UK government.