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Saturday, August 14, 2010

More Detail on the Proposed BOE Act - Part Four

Note: This is the fourth part of a series filling in details of the Proposed Bank of England Act on which I posted seven articles here from July 31st to August 3rd. Bill Totten

Clearing the National Debt


While clearing the national debt is not an integral or essential part of monetary reform, we are of the opinion that it should be done. This debt exists partly because government handed the profits of creating new money over to private companies (the banks), at the cost of over GBP 1.25 trillion in lost revenue between 2000 and 2009 alone.

We currently spend GBP 32 billion per year on interest payments on the national debt (nearly half of the total budget for schools and universities). If national debt rises in line with Alistair Darling's predictions, this interest cost will be around 64 to 70 billion GBP by 2016, whilst at the same time spending on education will stay flat or be cut. Is it right that we should be spending as much on interest payments as we do on education, while banks are still permitted to create around GBP 200 billion of new money each year and lend this into the economy, generating massive interest payments for themselves?

Recommendation for Clearing the National Debt

We have not mentioned paying off the national debt in the legislation itself, as it is entirely up to the elected government of the day how it spends its revenue. However, we would suggest that over the thirty years after implementing the reform, national debt should be reduced to no more than five per cent of GDP. Realistically, it should be possible to completely clear the national debt and for fluctuations in the government's income to be made up from its own savings. However, there may be situations in which the government needs some 'breathing space' so we have avoided setting the target for national debt at zero per cent of GDP.

What Does Government Debt Consist Of?

Government debt consists of government bonds, known in the UK as 'gilts'. A bond is essentially a contract which states something along the lines of:

This bond is worth GBP XXXX. The UK government will pay you an interest rate of X.X% per annum on the principle (non-compounding), and at the end of XX years will repay the principle too.

The bond is a certificate, and whoever holds the bond in their possession is considered to be the owner of it (that is, there is no named owner, unlike a mortgage contract or personal loan). As a result, bonds are easily bought and sold on the 'secondary' market (that is, second-hand).

Why We Need to Pay Off the National Debt Slowly

In order to prevent disruption in the financial markets (which would hurt pensions more than anyone else), we have to pay the national debt off gradually over a period of time. Although it would be tempting to suggest that we should pay off the national debt as quickly as possible, there are a few strong reasons why we shouldn't:

Reason One: Paying it off too quickly could harm pensioners ...

The majority of these bonds are not owned by the banks. Around forty per cent is owned by foreign investors. However, the big concern for us is the forty per cent of gilts (government bonds) that are owned by pension funds and insurance companies.

To see why it is crucial that we do not pay off the debt too quickly, you need to step into the shoes of a pension fund manager.

Pension funds like to buy government bonds because they know these bonds will always be repaid. Bonds are therefore considered as safe as cash, with the added bonus that they pay interest. Consequently, pension funds, especially those with a large number of customers near retirement age, will use bonds to make up a large percentage of their portfolios - after all, bonds are much safer than stocks and the pension fund will not want stock market volatility to wipe out its assets.

The fund manager needs to ensure that the investment portfolio has a range of low-risk, steady return investments, and higher-risk, higher-return investments. The lowest-risk investment that still offers a return is government bonds, so these make up the 'safe' part of the portfolio.

When we "pay off" part of the national debt, we are actually reducing the quantity of government bonds in the market. If we reduce the quantity of bonds in the market too quickly, we force these pension fund managers to shift their investments from bonds to other investments, such as corporate bonds (more risky) and the stock market (much more risky).

The effect of GBP 800 billion shifting from the bond market to the stock market and corporate bond market would be like tipping a bath of water into a small pond - creating huge waves in the market. Firstly, prices of stocks would start to rise, probably creating a bubble in the stock market. However, as people started to fear that the bubble was getting too big, they would start to 'pull out' of the market by selling shares. This may trigger another stock market crash as pension funds rapidly try to move their money into cash. The result would be, once again, a decimation of the value of pensions, which would harm pensioners and those in middle-age.

To avoid this, we need to gradually remove bonds from circulation over a period of time. Fund managers would be well aware that government bonds were being 'phased out', but would have around ten years in which they could gradually shift their investments away from the bond market and into corporate bonds and the stock market. This would avoid causing any bubbles in the market, avoid a flood of 'cheap' money into the corporate bond market (which would most likely lead to some pointless and badly chosen corporate takeovers if done quickly), and safeguard the value of pensions.

Reason Two: The National Debt is 'Cheap' While Personal Debt is 'Expensive'

The overall interest rate on the national debt works out at around 3.5% per annum. It is low because government debt is assumed to be risk free, so pension funds and other buyers of government debt are willing to accept low returns in return for absolutely zero risk of default.

In contrast, the interest rate for household debt ranges between six per cent and above for mortgages, right up to about seventeen per cednt on credit cards and up to about 29% on store cards. Overall, the average interest rate is undoubtedly higher for households than it is for the government.

Let's assume that the interest rate for all household debt averages out at eight per cent per annum. Total household debt is significantly greater than total government debt (GBP 1,464 billion compared to GBP 857 billion as of April 2010).

A basic principle in debt management is to pay off the most expensive debt first. If we acknowledge that national debt is really the debt of the UK's taxpayers (amounting to approximately GBP 19,000 per eligible voter), then the national debt is the cheapest debt and should be paid off later than household debt. For this reason, it is better to divert more money back to the public (via tax cuts, public spending or direct payments to citizens) than to aggressively pay down the national debt. The money directed to the public will then allow them to pay down their more expensive debts.

That doesn't mean we shouldn't make inroads into paying down the national debt. As a general principal, we would recommend that the national debt should be paid down by around GBP 30 billion per annum, using government revenue from taxation and/or the year's newly-created money.

However, using all the newly created money to pay down the national debt as quickly as possible would be like taking more than GBP 800 billion from the public in order to pay off debt at 3.5% interest, when they are still paying an average of eight per cent on their own debts of GBP 1,464 billion.

Why We Can't Just Create New Money to Pay Off the National Debt

Recall that each month the Monetary Policy Committee would make a judgment on how much money the economy needs, and then authorise the Bank of England's Issuing Department to create it. This newly-created money would then be given to the government to supplement revenue raised from taxation. Repayments on the national debt must come out of the government's total revenue, which will be a mix of tax revenue and newly-created money.

Consequently, if the MPC decided in a particular year that no addition to the money supply was needed, then the government would need to repay the national debt from tax revenue.

The question has been asked, why don't we just create money specifically to repay the national debt, or repay all bonds with newly-created money as they mature? There are two reasons why this would be counter-productive.

Firstly, the MPC is making a decision on how much money should be created on the basis of the needs of the economy. We should not create any more additional money than the economy requires in a particular time period. The bonds that make up the national debt mature at different times over the next sixty years. Simply creating the money to pay for these would completely unbalance the decisions made by the MPC. Consequently we need to separate the decision over how much new money is created, and how the national debt is repaid.

The second reason is mostly psychological. Creating money specifically to pay off the national debt - with no consideration of the needs of the economy - sounds a little like the disastrous approaches taken by dictators of certain economies over the last few decades. Such a policy would potentially trigger a flight from Sterling in the currency markets and devalue the bonds in the eyes of the holders of that debt.

To avoid this, the national debt has to be repaid gradually, and repaying the debt has to incur a cost on the public (either via taxation, or via the 'opportunity cost' of what they could have had if the money had not been used to repay the debt).

Why We Can't Just Pay It Off Immediately

It would be tempting to just create the money to pay off the debt in one fell swoop. However, doing so would be a disaster for two reasons:

1. The national debt currently stands at around GBP 857 billion (although it is increasing rapidly). This amounts to around 38% of the total money supply. Increasing the money supply by 38% in one year will create massive inflation, and by definition, devalue the pound and any money that you hold.

2. As outlined above, recalling all government bonds at once would cause a massive flow of investment money into corporate bonds and stock markets, causing massive volatility in these markets and most likely damaging the value of pensions.

One Beneficial Side-Effect of Paying Off the National Debt

Besides saving up to GBP 200 million per day on interest costs (if national debt rises as expected up to 2014), paying off the national debt has other benefits for the economy.

By phasing out government bonds as an investment option, we force pension funds and other investors to look for alternative investment options. The next safest option after government debt is the debt of the 'blue chip', FTSE 100 corporations. By investing in bonds or even new share issues from these companies, these companies should be able to pay off more expensive debt, which in theory should lead to lower costs for customers, or more jobs being created, or more profit being declared and therefore more tax being paid.

At the same time, when large corporations can borrow cheaply from pension funds looking for a safe haven for their money, they will have no need to borrow from banks. Consequently the banks will themselves need to look for other investment opportunities.

The end result of phasing out government bonds is that small and medium businesses will start to find it much easier to get investment and funding from banks, which should be beneficial for the economy. By clearing the national debt, we channel more credit and investment to businesses rather than to government.

http://www.bankofenglandact.co.uk/how-it-works/clearing-the-national-debt/


Bill Totten http://www.ashisuto.co.jp/english/

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