The UK government is spending an enormous amount on COVID-19 \u2013 supporting the health service, helping to relieve the suffering of those who have lost their incomes, and helping businesses keep afloat.<\/p>\n\n\n\n
This spending policy has now been endorsed by the International Monetary Fund. Governments of advanced economies should spend more, says the IMF, not just to keep their economies in good shape until the pandemic passes, but also to invest in preparation for a post-COVID recovery.<\/p>\n\n\n\n
And we should not worry that all this extra spending is causing a big rise in government debt. Although the UK debt\/GDP ratio has already risen above 100%, the government should spend even more. This will stimulate GDP growth and thus stabilise debt\/GDP.<\/p>\n\n\n\n
The way to cope with high government debts, the IMF says, is no longer austerity \u2013 higher tax and lower spending \u2013 but rather the opposite, at least while the pandemic is with us.<\/p>\n\n\n\n
A vital ingredient for the success of this high-spend policy is low interest rates. The UK government\u2019s cost of new borrowing for 10 years is currently 0.3%; it has never been so cheap. The Bank of England is playing an important part in keeping it that way.<\/p>\n\n\n\n
How are we paying for it?<\/strong><\/p>\n\n\n\n To pay for all the extra spending, the government is borrowing in the usual way from the private sector \u2013 from pension funds and insurance companies, for instance. It does this by selling bonds, which are promises to pay back with interest. In the period April 2020 to June 2020 it borrowed an extra \u00a3150bn. Yet, as fast as the government is selling bonds, the Bank of England is buying them from their private sector holders \u2013 paying with newly created money. Technically, this money is \u201creserve\u201d deposits, which are claims against the Bank of England itself.<\/p>\n\n\n\n Indirectly the Bank of England is therefore financing much of the government\u2019s new spending. And, crucially, its continuing demand for government debt is holding down the interest rate that the government has to pay to borrow.<\/p>\n\n\n\n The Bank of England insists that this massive quantitative easing (QE) programme of bond-buying is not driven by a need to support government finances. Rather, the motive is to fulfil its mandate to control inflation, which has been falling increasingly below the 2% target for over a year. The government\u2019s need for finance and the Bank of England\u2019s bond purchases are both consequences of the recessionary conditions, and it is a coincidence that its purchases of bonds and the government\u2019s sales have been at similar rates.<\/p>\n\n\n\n To find out more about how we can assist you with your Second Charge Mortgage please click here<\/a><\/em><\/p>\n\n\n\n You might think that this is splitting hairs, but it matters. If the government can rely on the Bank of England to buy its bonds as necessary to prevent interest rates from rising, then it is hard to be confident that the bank will raise rates enough when needed to stop inflation rising.<\/p>\n\n\n\n And the current low-inflation environment may be short lived.<\/p>\n\n\n\n Inflation may rise<\/strong><\/p>\n\n\n\n Consumer spending has fallen markedly during 2020. Among the causes, restrictions on several sectors of the economy, notably tourism and leisure, have forced people to save rather than spend. When the restrictions are relaxed, pent-up demand may lead to rising prices, especially if the supply of goods and services is reduced because some businesses have not survived.<\/p>\n\n\n\n On the other hand, some argue that rising unemployment will hold down wages and hence prices, and others expect the recovery to be gradual, giving time for supply to adjust. Moreover, with consumption patterns changing, price changes will vary across sectors, leading to doubt about the overall effect on inflation.<\/p>\n\n\n\n A deeper reason to expect inflation has been proposed in a new book by economists Charles Goodhart and Manoj Pradhan. They argue that the current low-interest rate, low-inflation conditions are associated with a favourable dependency ratio. This measures the numbers of young and old people (0 to 14 and over 65 years of age) relative to those in between who are presumed to be the working population. For the last three decades we have been in a \u201csweet spot\u201d, they say, with plenty of workers globally to support the non-workers. This has held down wages and led to high saving which, in turn, has contributed to the long-term decline in interest rates.<\/p>\n\n\n\n But the age composition of populations is changing. With people living longer and birth rates declining, the dependency ratio is rising. There are fewer workers and more people who depend on their output; moreover, the old are requiring increasing care. To balance supply and demand, wages and prices must rise.<\/p>\n\n\n\n If inflation starts rising, the Bank of England\u2019s response should be to choke off demand by raising interest rates. However, this will dampen economic growth, which may still be fragile. It will depress the price of assets, including property, and it will make debts more expensive to service, including public and private sector debts, both of which have been elevated by the pandemic. Under the IMF\u2019s projected increase in government debt to 117% of GDP, even a small increase in rates would make this debt significantly harder to sustain.<\/p>\n\n\n\n While the Bank of England is adamant that it will not divert its attention from the 2% inflation target, other central banks are more equivocal. In the United States for example, Jay Powell, the chairman of the Federal Reserve Board, which sets monetary policy, has recently announced that future US inflation will be allowed to exceed its target for a period of time before monetary policy is tightened.<\/p>\n\n\n\n Despite the Bank of England\u2019s insistence, its accommodating behaviour during the Covid crisis suggests that it, too, may take a more flexible attitude towards future inflation.<\/p>\n\n\n\n BY JOHN WHITTAKER<\/em><\/p>\n\n\n\n Source: Reaction<\/a><\/p>\n\n\n\n