Rishi Sunak’s dilemma over how to pay for his coronavirus spending
It’s a while until payday and a big, unexpected bill has arrived. The money will eventually be there but in the meantime, there is a cash flow problem. Most of us have been there – and Rishi Sunak is no different.
The chancellor has a whopping cash flow problem. Locking down the economy in response to the Covid-19 pandemic means that tax revenues have dried up at a time when the state is promising to spend billions more on health, wage subsidies, small business grants and universal credit.
It’s not unusual for the state’s spending to exceed its revenue and when it does the gap is normally covered by borrowing. The government sells bonds – or gilts – to investors and uses the proceeds to plug the hole.
In the current crisis, the government’s need for ready cash is so great it can’t get the gilts out of the door quickly enough. Fortunately, though, Sunak has an understanding bank manager in the form of Andrew Bailey. The governor of the Bank of England, has agreed to solve the Treasury’s cashflow problem by printing as much money as the chancellor needs provided Sunak agrees to pay off his overdraft by the end of the year.
This may sounds a bit technical, but it matters a lot. For the time being the economy is effectively being kept going by the state. Only bits of the private sector are operating as normal and the longer the lockdown the bigger the bill for the Treasury. All of which raises the question of how it is to be paid for. More specifically, does the use of the government’s overdraft facility mean that the UK is heading down a road that ends with the Bank printing money to pay for government spending?
How the government goes about footing the bill for Covid-19 depends on the scale of the economic damage, but it is already clear that early estimates of a short, sharp shock were too optimistic. The current crisis looks likely to prove more costly than the recession of 2008-09, until now the deepest slump of the post-war era.
Sunak has options. The first is to do what George Osborne did in 2010 and impose a period of belt-tightening as soon as the recession ends. This would involve an austerity budget – or more likely a series of austerity budgets – in which taxes would be raised and spending cut in order to reduce the size of the government’s annual budget deficits.
This option is unlikely to prove all that attractive. The lesson of the Osborne experiment is that trying to get the deficit down too fast leads to sluggish growth, which reduces tax revenues and means it takes longer to reduce borrowing. Moreover, the tightest financial settlements on the NHS in its history left the health service poorly prepared to cope with a pandemic. There will be political uproar if Sunak goes to the austerity route.
A second option is to to follow the example of post-war governments and rely on a mixture of growth and inflation to restore the public finances to good health over time. Between 1939 and 1945, the wartime government ran annual budget deficits of 20% of national output or more. National debt – a measure of the budget surpluses and deficits accumulated over centuries – rose to 250% of gross domestic product. Yet over the next half century, the debt to GDP ratio gradually came down to stand at around 30% by the turn of the millennium.
Borrowing is currently dirt cheap for the government, so Sunak could decide to get the economy fully functioning again before worrying too much about the public finances. The lesson from the decades after 1945 is that governments only really have a deficit problem if they have a growth problem.
The third option is monetary finance, under which the Bank of England is instructed to print enough money to cover whatever the government chooses to spend. In the short-term, this is precisely what Bailey is doing with his overdraft facility. There are those who say it should be made permanent in order to help rebuild the economy and prepare it for the challenges of global heating.
The temporary nature of the overdraft means that it is not really monetary finance. Gordon Brown’s government made use of the same arrangement during the financial crisis of 2008-09 but paid its £20bn overdraft off within two months. Sunak has promised to pay off his overdraft by the end of the year, which he could do either by selling more gilts or by raising taxes. Alternatively, he could decide that his overdraft – on which he only has to pay 0.1% interest – is far too useful to dispense with in the current circumstances.
No question, going down the monetary finance route means a line will have been crossed. The Bank of England’s independence would be called into question. Fears that printing money would lead to runaway inflation would be stoked.
But the lines are getting pretty blurred anyway. Back in 2009, the Bank of England launched a money creation programme known as quantitative easing. It involved Threadneedle Street buying gilts and corporate bonds from the private sector in return from cash. It was not strictly monetary financing because the Bank did not buy the gilts directly from the government and it pledged that it would later sell them again. No gilts or other assets have been sold, although the Bank and the Treasury like to maintain the fiction that they will be.
So, yes, Sunak’s overdraft may prove to be temporary. But that was what was said 11 years ago about ultra-low interest rates and QE. In a crisis what was once taboo can quickly become mainstream.