Friday 15 November 2013

Magic Money

The magic money tree 

On March 7th 2013 Prime Minister David Cameron made a speech where, in response to calls for more public spending said “It’s as if they think there’s some magic money tree. Well let me tell you a plain truth: there isn’t.” 

Link Here: 

Well as usual the Prime Minister was being economical with the truth and here is why. 
When the coalition government came to power in 2010 Government net debt stood at £828bn (source ONS Q1 2013). As of Q1 2013 (three years later) this stood at £1,182bn (source ONS). So in three years of tough deficit reduction the debt went up by £354bn (at an average of £118bn per year). 

So behind all the “we are dealing with Britain’s debt” rhetoric the truth is we are a still borrowing at an impressive rate. Now the government knew that borrowing was going to rise and that they would have to keep going to the open market to fund this. So it was in the governments’ interest to make sure it could borrow cheaply. So in association with the Bank of England they came up with a wizard wheeze. It was called “Quantitative Easing”, or to put it another way “a magic money tree”. 

Now regular readers will know that commercial banks already have a money tree, because they are allowed to create money to make loans to customers. This process does however have a slight problem in that commercial banks can only create money in relation to funds they hold. This relationship is around 1:10 meaning if they hold £100 they can lend/create £1000. This is a good wheeze but not as good as quantitative easing, because QE is done by what is called the “central bank” and a central bank can create as much money as it likes. We know this because on each bank note is a promise from the central bank to honour payment of that “money”. 

So the Bank of England has created £375bn. Sounds like a money tree to me, but wait there is a twist. The Bank of England is supposed to be responsible for inflation so if it just dumped £375bn of new money into circulation that might just cause inflation so it had to come up with a plan. What it is has done is to create a company to” invest” the new money and over time the plan is that the investments be successful and cover the original money created which will then disappear as easily as it was created – now that is a Magic Money Tree. 

This new company formed to invest the £375bn has an interesting backer. The UK Government has underwritten the business of this company so that if the investments of this company are not successful the taxpayer will bail it out. 

The new company has made only one type of investment, it has bought from UK banks UK Government Bonds. The effect of this is that interest rates on these bonds have been kept artificially low (because of the increased in demand). This has meant the government could continue to finance its debts at low rates of interest. Which helps lower the deficit which is a win for the government? 

But now comes the best part. The government has to pay the holders of its debt interest (and the capital on maturity). So the Chancellor said to the Bank of England – now you hold £375bn of government debt we will have to pay you interest. How about we don’t pay, keep the money and instead use it to further reduce the deficit. 

The Bank of England agreed to do this so now we have a win/win for the Government – low interest rates and a windfall consisting of interest on bonds bought with “magic” money. So far the government has used this magic money tree to pocket £40bn. 

However every silver lining has a cloud and the bank has reminded the Chancellor that over time (and once they stopped buying bonds) interest rates would rise and the value of bonds issued at low rates would fall, this may mean that the value of the investments made by the company set up by the BOE may at some point be less than the original £375bn, in which case the Government would have to find the shortfall. 
But never mind that because probably that time will come after the next election and may well not be this government’s problem. 

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