NOTTODAY The Bank of England, like most central banks in rich countries, has two main functions: to maintain monetary stability and to ensure the soundness of the financial system. For most of his life, however, he was also responsible for managing public debt. (Fortunately, the original reason for the bank’s creation in 1694, to raise funds to “continue the war against France,” has collapsed.) This function has only been entrusted to the new Bureau de debt management (DMO) in 1997, when the bank gave free rein to its monetary policy. But over the past decade, the bank’s successive rounds of quantitative easing (QE), through which it creates new money to buy bonds, left it with more than a third of the government’s total outstanding debt. This awkwardly brought her back into the realm of public debt management.
Britain recorded a budget deficit of 14.3% of GDP in the last fiscal year, greater than any peace year on record and comparable to the war loans of 1914-18 or 1939-45. The outstanding public debt fell by around 80% GDP before 100% covid-19. The pandemic is the second fiscal shock in just over a decade, following the global financial crisis of 2007-09. As the experience of post-war debt management shows, the divisions between fiscal and monetary policies can often become blurred in times of high public debt and large deficits, and particularly in times of crisis.
Policy choices and mix
the UK government’s debt to GDP over the past century tells a dramatic but familiar story. The huge borrowing from the two world wars is clearly visible, as is the impact of the banking crisis and the pandemic. Examining maintenance costs changes this dramatic narrative. Despite a sharp increase in debt during World War II, the debt service burden on taxpayers has decreased compared to the 1920s. In the last fiscal year, debt reached its highest level since the early 1980s. 60, but the ratio of interest charges to tax revenue fell to new lows (see graph). Understanding the varying relationship between debt levels and interest charges means examining how the functions of fiscal and monetary policy have changed over time.
World War I may have ended in a military victory for Britain, but it was also a fiscal disaster. Interest rates rose, prompting investors to buy gilts. The 1917 War Loan, a government-issued bond, had a yield of 5%, against a pre-war standard of less than 3%. This left a toxic legacy for the 1920s, especially since most borrowing was short-term and left the Treasury exposed to rising interest rates. Monetary policy in this decade was primarily aimed at bringing the pound back to the gold standard. The result was higher interest rates than needed for national purposes, which not only depressed demand and employment, but added to soaring interest costs for the treasury.
The tax crisis of the 1920s and 1930s cast a long shadow, leading things to take a different course during World War II. John Maynard Keynes laid out his plans for a “three percent war”. The “business-as-usual” approach that characterized the first years of the First World War was totally absent from the second. Monetary policy became subordinate to debt management and the aim of the Bank of England became to help finance the war.
Debt management remained at the heart of monetary policy from the 1940s to the mid-1970s. Interest rates were set to support the burden of public debt, and fiscal policy took hold. initiative to try to stabilize the economy. Central banks were, in other words, subject to what economists call “fiscal domination.” Real interest rates were negative for more than half of the 1945-80 period, in part due to high inflation. An article by Carmen Reinhart and Belen Sbrancia from 2011 revealed that this financial crackdown – a combination of negative real rates with capital controls and the use of prudential powers to force domestic investors to hold public debt – was in the making. Most of the reduction in the debt-to-equity ratio after 1945 originated. Similar policies were pursued in America and much of Europe.
It was not until the late 1970s and 1980s, as concerns about inflation intensified, that British monetary policy downplayed the importance of debt management in setting debt levels. interest rate. By the end of the 90s, a new framework was in place. Monetary policy, set by an independent central bank, would target inflation and stabilize the economy. Debt management would be ensured by the DMO. As long as the outstanding debt remained low, this separation seemed to work well.
Those days of low debt now seem to be a distant memory, however. The question of the roles of monetary and fiscal policy therefore arises again. Subordinating monetary policy to fiscal needs can make public debt management much less burdensome. A period of low or even negative real interest rates may well cause fewer political problems than years of tight spending and high taxes. But while austerity isn’t popular, neither was the inflation that accompanied the financial crackdown. Independent central banks stabilized inflation expectations in the 1990s and 2000s. This hard-earned credibility would disappear if investors thought that helping the government meet its bills was the main task of monetary policy.
Worryingly, some investors already seem to believe that the monetary and fiscal separation has broken down in Britain. An investigation of the Financial Time of the top 18 gilter managers in January 2021 found that most believed that the primary goal of QE was to reduce government borrowing costs. Cynics note that monthly asset purchases by the Bank of England between April and December last year were almost exactly tracked DMO issue. Andy Haldane, the outgoing chief economist of the Bank of England, warned in June of the risk of “fiscal domination”. On July 16, a House of Lords committee, chaired by Lord Mervyn King, former Governor of the Bank of England, marked QE “A dangerous addiction”, arguing that the compromises involved were only acceptable as a temporary measure.
The fears are understandable. Subordination of monetary policy to fiscal needs is not inevitable, but history suggests that when debt is high, the temptation will always be strong. The central bank could do more to reassure investors that it is not giving in to political pressure. He could start by stating more openly the rationale for QE, and outlining his plans for a possible exit. ■
This article appeared in the Finance & Economics section of the print edition under the title “War and Peace”