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The UK can borrow cheaply but needs to account for all of the costs

The UK can borrow cheaply but needs to account for all of the costs Mindful Money

One of the features of the credit crunch era has been the rise in price of what are considered to be “safe haven” assets. We have seen this in currency markets for example with the rise of the Swiss Franc and the Japanese Yen which has overrun the efforts of their respective central banks to stop it. More recently we have seen in in the surge in prices in some government bond markets which allow those governments which benefit from this to borrow at what I consider to be extraordinarily low levels.

What are the levels?


If we consider ten-year government bond yields we see that Germany has one of 1.48% this morning and the United States has one of 1.77% whilst the UK can borrow at 1.9%. These are cheap and are close to or at historical lows. Indeed if we combine a currency in demand with a government bond market in demand we see that Switzerland has a ten-year government bond yield of 0.63%.

If we move out to the 30 year maturity we see a similar pattern of extraordinarily low interest-rates. The United States has seen hers fall below 3% and it is now 2.94% and Germany has one of 2.15%. Even the UK has one of 3.2%.

Can we take advantage of this?


Regular readers will be aware of my view which is that the UK should be issuing as many government bonds or Gilts as possible to take advantage of this. In essence we can issue cheaply so let’s do as much of it as we can at these rates.

Other’s have put a different perspective on this and I have been involved in something of a debate with Jonathan Portes of the National Institute for Economic and Social Research on this subject on Twitter. He has made a suggestion as follows.

Jonathan Portes’ Proposal

What does this mean in practice? It means that if the government were, as I suggest, to fund a £30 billion (2% of GDP) investment programme, and fund it by borrowing through issuing long-term index-linked gilts, the cost to taxpayers – the interest on those gilts – would be something like £150 million a year. To put this in perspective, it’s roughly the revenue the OBR estimates will be raised by the “loophole-closing VAT measures” in the last Budget. In other words, we could fund a massive job-creating infrastructure programme with the pasty tax.

Let me start with where we agree


The UK government can borrow cheaply and at quite a few maturities can borrow as cheaply as it has ever been able to.

And where we disagree


Jonathan tells us this.

What does that mean? It means that if the government borrowed £30 billion at 0.5% real, then it would have to pay interest of £150 million per year, uprated for inflation for the term of the debt.

Now in itself I agree with that sentence and by real, he means real interest-rate; but just like JP Morgan’s last week and Lehman Bros. before, Jonathan has used the tactic of moving something off the balance sheet. You see each year index-linked government bonds are uprated for inflation so they have two costs.

The first explicit cost is the £150 million a year uprated for inflation (Retail Price Index)

The second cost is implicit and is the cost of the index-linking and just as important as it is unknown. We do not know what inflation will be over the next thirty years. We can look back at what it was over the last year for example and see that RPI inflation was 3.6%. Were that to continue at the end of year one the implicit cost of the plan would be £1.08 billion and and year two £2.2 billion and so on to a rather large number after 30 years. As you can see any repetition of recent levels of inflation would once the implicit costs are taken into account and put back into the balance sheet actually be more expensive than issuing conventional Gilts. Of course care is needed as we do not know what inflation will be.

How does Jonathan treat this?

What about when the debt comes due? At the end of the term, it would have to repay the £30 billion, uprated for inflation (ie an amount worth £30 billion in today’s prices). But alternatively, and more likely, it could refinance the debt.

I completely agree with sentence one but why is there no estimate of the costs of this and why as I have described above has it been put “off balance sheet”? However I wish to challenge the second sentence.

1. Simply refinancing debt has been the tactic of places like Greece and Portugal- how did that turn out?

So “more likely, it could refinance the debt” is somewhat dubious.

2. Jonathan tells us this

the cost to the government of borrowing money – the real interest rate on gilts – is at historically low levels

but to get his plans to work also tells us this

Assuming real interest rates are the same then as now

So they will stay at historically low levels for 30 years? I think that bit speaks for itself. He does not know that and frankly in current markets they may not stay there for 30 days or 30 hours.

A reason why UK borrowing is so cheap, Quantitative Easing


The Bank of England has purchased some £325 billion of UK Gilts which has raised their price and reduced yields. This is extremely unlikely to carry on for the next thirty years. Whilst it has not bought index-linked Gilts their prices have risen too as nominal yields have changed and thereby moved real yields too.

Can we borrow as much as we like then?


Tucked into this analysis is the view that we can borrow as much as we like. As countries like Greece, Ireland, Portugal, Spain and Italy are currently demonstrating there are limits to this. And right now we are borrowing at a fast rate and have a higher national debt than we like to admit. Regular readers will be aware that I include the financial interventions we have made in my figures which gives us a national debt of 141% of Gross Domestic Product and a fiscal deficit for this fiscal year of 6.47% up to and including March. So far we have been able to borrow cheaply in spite of this but I do not believe that this means we can borrow as much as we like. Out there is a “tipping point” which to be fair neither Jonathan nor I know where it is. But we do know one thing once crossed bond yields then shoot up as we have observed most recently in Spain and Italy. We do not have to look to far back in time to see a period when Spain could borrow more cheaply than us.

Infrastructure Projects are not a panacea


Whilst spending money now would employ people such projects are fraught with danger if we consider the long-term benefits/costs and here is an example. I saw an example last night of such a project which took three times as long as expected to build went way over budget and was never fully utilised. Modern day incompetence? Nope it was Thomas Telford building the Caledonian Canal for £905,000 at the beginning of the 19th century rather than the £350,000 predicted. Even worse the delays in building it (19 years rather than 7) meant that when it was finished improvements in the railways and shipping industry left it a white elephant. A great shame for what was an engineering triumph beautifully shown on BBC 4 last night.

If you end up building a white elephant and compare it with a real debt in thirty years time what have you done? Your children and grandchildren who will be paying the taxes then may not thank you for this particular example of kicking a can into the future (and hoping that the future is better).

An alternative for Jonathan Portes


We get told this.

The value of nominal debt is eroded over time by inflation; nominal interest payments compensate for that as well as paying the actual carrying cost of the debt.

And yet we have a ten-year bond yield of 1.9% and a thirty-year one of 3.2% compared to an inflation rate which is over that and indeed has not been at or below even the higher yield for quite some time. Exactly where in such interest-rates do you find “nominal interest payments compensate for that “? Theory does not represent reality right now. In my opinion there is an opportunity here to issue conventional debt as we can issue it cheaply and crucially unlike the example of index-linked debt we benefit from the effects of inflation rather than having to match it. As we have a Bank of England which seems to be targeting inflation above its supposed target we will be borrowing at what look quite likely to be negative real rates of interest should inflation continue on anything like its recent path.

Comment


Some of the differences here are matters of opinion as I doubt that Jonathan and I are likely to agree on the likely path of UK inflation. Please feel free to compare our past records. However the way that the implicit cost of index-linked Gilts is brushed aside weakens his proposal substantially and ironically if you put them back in means that in his view that you can pay for this with the pasty tax misses the fact that it is conventional Gilts which offer the best opportunity right now and not index-linked ones.

Or you can take the view that

the pasty tax revenues go on for ever

And if you project things for ever you can come up with some awe inspiring results can you not? Whereas I wonder what “forever” is and if it even exists in a world where time appears to exist and and for all of us the evidence is that it will be finite. Whilst a famous Manchester City supporter has no doubt had a great few days I am not sure he was right on this point.

You and I are gonna live forever
Gonna live forever
Gonna live forever

Something from yesterday


I pointed out yesterday that markets are very rarely if ever perfect and today I find myself reviewing the UK Gilt market which frankly looks mispriced to me. There I think Jonathan Portes and I do agree and we do agree we should do something about it so in many ways not so far apart.

This article was written by Shaun Richards and originally published on Mindful Money under the title: Jonathan Portes (NIESR) and I agree the UK can borrow cheaply but we need to account for all of the costs

Tags: bond market , bond yields , budget , coalition government , credit crunch , deficit , fiscal deficit , Germany , Gilts , government bonds , index-linked gilts , Jonathan Portes , Loans , maturities , national debt , National Institute for Economic and Social Research , nominal interest payments , quantitative easing , real asset inflation , real debt , real interest rates , Retail Price Index , RPI inflation , safe haven , UK , UK economy , UK Inflation , UK Strategic Investment , USA
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