Sunak’s Covid Cash Splurge — who’s paying, and how?

UK Government spending since the coronavirus outbreak, instructed by the Chancellor Rishi Sunak, has been extraordinary.

The Office for Budget Responsibility has estimated the government’s avalanche of measures in response to coronavirus will cost over £100 billion in 2020–21. A leaked Treasury document is estimating the budget deficit (the gap between income and spending) will be £337 billion this year. To put this into context the annual budget for NHS England is £129 billion per year.

The British public, told by the Conservative government over the last decade that Britain must live within its means, can be forgiven for asking — where is the money coming from?

It’s best explained across three broad stages.

Stage one. The Bank of England prints the money.

The scale and speed of the pandemic has taken everyone by surprise.

Sunak has not had time to fund emergency interventions with taxes or other spending cuts. To fund the rapid response, Sunak’s extended the use of the Treasury’s overdraft with the Bank of England (BOE).

The overdraft allows the Treasury to use immediate cash printed by the bank via the Ways and Means facility. The overdraft usually stands at c£400 million, but the BOE has announced it will now print as much cash as the Chancellor needs. The condition is that the Treasury must pay it off by the end of the year.

Stage Two. Government bonds are sold to the market.

Paying the overdraft off, and funding the ongoing budget deficit, requires additional borrowing. Just as King William III funded his war with France in 1694, Sunak has ordered vast government bond sales.

A government bond, or a gilt, is a loan agreement. It’s an electronic ‘I owe you’ which promises to pay investors back their money plus interest at a later date.

The Treasury announced on April 23rd that bond issuance for April would rise from £15 billion to £45 billion, surging to £180 billion across May and July.

Who buys these bonds?

Bonds are auctioned to private investors, including individuals and financial institutions (such as large banks).

However, there hasn’t been enough private investor demand to absorb the government’s increase in bond sales. To prop up demand, the BOE has intervened to buy £200 billion worth from investors in a significant round of Quantitative Easing (QE). QE involves the BOE creating digital money (like the money in a bank account) at the click of a button. It uses the new cash to buy governments bonds off institutions in the secondary market (off institutions already holding bonds).

The value of bond sales inflates the national debt, which the Office of Budget Responsibility predicts will skyrocket from 79% of GDP to 95% by 2024. This means for every £1 our economy is worth, there would be 95p worth of debt. The Treasury will need to pay the debt off, or keep it running by paying the interest rate.

Stage Three. Reduce/service the national debt.

The Chancellor is conservative — he is unlikely to be comfortable with high government spending and debt for long.

He used one of his first speeches as a Member of Parliament to plea:

“Under this government, Britain will live within its means… no more spiralling debt of the taxpayer’s expense, no more passing the debt to the next generation.”

Sunak has reluctantly needed to break these rules because the crisis is unprecedented, but his conservative instincts are unlikely to have changed.

One controversial option to reduce debt is austerity — ramping up taxes and cutting spending. Boris Johnson may resist these measures, having promised before the election a surge in spending and a round of tax cuts. Sunak may now need to persuade Johnson to ditch pre-coronavirus spending and tax promises. It will be politically contentious to cut public sector pay — society now values teachers and nurses more than ever. In a recent development, the Telegraph reports that the Treasury is considering proposals to increase income tax, reduce state pension increases and freeze public sector pay.

Sunak may find answers from looking at recent history. In 1945, World War II left the government with a debt of 250% of GDP. Governments avoided spending cuts and patiently waited for economic growth to increase GDP at a faster rate than the increase in real debt. By 1973, although real debt had risen, it represented a much lower proportion of GDP at 50%.

A positive for the Chancellor is that interest rates are at an historic low of 0.1%. The era of low interest rates has reduced the cost of serving debt, meaning it has never been cheaper for the government to borrow. Some economists argue that these low interest rates mean Sunak should allow debt to climb, with interest being serviced by increased QE.

However, announcing the £200 billion bond-buying programme, BOE Governor Andrew Bailey stressed he did not intend to keep bailing out the government, telling reporters:

“I want to emphasise that we are not abandoning the central bank philosophy in terms of monetary financing because history tells us where that leads.”

Economists fear that inflation increases if money printing is not matched by an equal increase in economic resources. A greater money supply means more money is chasing the same amount of goods. Imagine a restaurant that’s at full capacity. It can’t expand its seating (its resources). The only way to convert higher demand to higher profits is to increase prices.

However, some economists argue that QE doesn’t automatically result in inflation.

When the BOE buys bonds from institutions like banks, cash on the bank’s balance sheets increase. In theory, in a recession, not all of this cash is lent out as firms and individuals are reluctant to borrow. If cash isn’t lent out, some of the increase in the monetary base is saved rather than spent. Inflation might only occur when the economy approaches full capacity — when demand in the economy begins to outstrip the supply of resources.

Economists suggest that given the UK is entering a recession, QE will not be inflationary. If inflation does occur, they say future policies like tax rises can bring prices back down. Like many theories in economics, nobody can be sure.

Now we just have to hope that Sunak makes the right calls in Stage Three. One thing is certain — it’s a tricky time to be the Chancellor.