Tuesday, 17 February 2015

Why the Bank of England should 'write off' government debt to counteract the influx of foreign savings into the UK.

Current Account Deficits

The U.S. and the UK both have a problem with current account deficits. As Michael Pettis, with wonderful simplicity, shows, this has less to do with the popular narrative of credit hungry consumers desperate for the newest gadgets, and more to do with the fact that these currencies are both considered reserve currencies and that both have liberal, open markets. What ValĂ©ry Giscard d'Estaing called the United States' 'exorbitant privilege' can also be seen as a curse.

From now on, for simplicity, I will talk about my home country, the UK, but the same will apply for both countries.

Many nations currently follow policies, for example an artificially low exchange rate or suppression of workers wages, which reduce household share of GDP, produce excess savings and thus lead to very large current account surpluses. Notable for their size are China and Germany.  For many low income countries this is a very sensible strategy to safeguard against future crises. However, in the low demand world that we are currently living in, these excess savings suck demand out of the deficit countries. In a time of low demand, a beggar thy neighbour approach leads to a race to the bottom. Other countries follow suit in attempting to reduce their own exchange rates, eg Japan and, until recently, Switzerland. The logical conclusion of this is that everyone reduces internal demand in an attempt to improve competitiveness and overall world demand is pushed ever lower. This is a recipe for world economic stagnation.

The excess savings created by these policies must be exported to another country, and reserve currencies are seen as the safest. If countries are running trade surpluses they must buy US dollars and often will also choose to diversify into Pound Sterling (GBP).

By definiton, the net buying of UK assets by foreigners leads to a UK current account deficit. The simple mathematics here is that if the UK is to run a deficit then the UK public must be net sellers of GBP to purchase the currencies needed for the goods to import. It requires foreign buyers to want to buy and hold GBP to match the amount of UK currency sold by the UK public. But as Pettis shows, the converse must also be true. Increased inflows of excess savings from abroad into GBP must, as an accounting identity, increase the current account deficit. The mechanism for this is that the buying of Pound Sterling keeps the exchange rate too high, therefore encouraging the consumption of foreign goods that are artificially cheap. A deficit is effectively forced upon countries with reserve currency status and to avoid this requires strong policy resistance.


No-one forces people to buy stuff or take out credit. People should have self control, etc etc. I have read a lot of this in the comments section of blogs. But the nature of foreign purchases of UK assets is that, if there are not any productive uses of the capital which UK savings can't fund (which is likely), then either credit must go up or demand must come down so much that savings at home can be exported that match the savings from abroad.

As a worked example; imagine an economy that produces £10m in goods and services, exporting half of this. It also consumes £10m in goods and services, importing £5m of this. This is a balanced economy. Now imagine that someone abroad buys £1m of currency for their reserves, thus forcing a current account deficit of £1m. In order to keep the demand for the £10m of goods and services it was originally selling, the county must now consume £11m worth. The remaining £1m must be borrowed; increasing debt in the country by £1m. Alternatively the country could adjust by continuing to buy £10m worth of goods and services but decreasing domestic demand by £1m. The country will now only sell £9m of goods and services. This means that there will be unemployment in the domestic industries that lost business.

The options for a receiver of excess savings, as shown by Pettis, are either a) public/private sector debt or b) unemployment caused by reduced demand. Most countries chose debt (until, of course, they can't any more). Asset price bubbles typically ensue due to too many savings chasing too few returns.

To emphasise, if an increase in unemployment is to be avoided, foreign net purchases of UK assets necessarily leads to an increase in debt in the UK. This is a problem.

The perniciousness of debt for growth should not be underestimated. The current UK government policy of trying to control state spending (albeit not particularly drastically in any area other than benefits spending) but at the same time encourage private debt to stimulate the economy, is just loading up problems for the future. Any solution to our current economic difficulties which involves raising the already high level of private sector debt is going to cause at best stagnation in the future, at worst crisis.

One major reason for this is that the dynamics of debt are such that the poor/middle class, either through private debt repayment or taxes, tend to have to pay interest and principal to the rich or foreigners. The poor/middle class tend to spend a higher proportion of their income on consumption than the receivers of the interest payments. Therefore the repayment of debt means a reduction in demand in the economy. This must either lead to unemployment or the taking out of more debt. Once again this is quite simple mathematics.

So, if we are to avoid recession, the buying of UK assets from abroad must be funded by credit expansion in the UK and increased public/private sector debts to abroad. And the build up of credit is leading the UK on the road to another stagnation/crisis. What to do?

Conventional Responses

Keep interest rates low? This encourages more private borrowing, which at this stage in the UK is, in my opinion, a very bad idea. Further Quantitative Easing? This tends to give money to those with assets, who are less likely to spend. Also, in theory this will be taken back in the future, still leaving an ever larger debt pile.

Both of these blunt monetary policies do have a desired impact of weakening the currency, therefore reducing the deficit. However there are costs to both, in terms of increased borrowing and rising inequality, both storing up problems for the future. Also, both lead to an increase in house and other asset prices, which is increasing inter-generational inequality.

What about increased government borrowing? This would stimulate the economy and may be beneficial in the long term, but the already high levels of debt are an impediment to this. UK investment spending has plummeted under this government thanks to the attempt to reduce the deficit. One has to think that some of the spending cancelled would have positive net present value with current zero real interest rates.

None of these solutions, unless the government debt purchased using QE is to be written off, solve the problem of increased debt every year caused by foreign purchase of UK assets.

Quantitative Easing and writing off government debt equal to the current account deficit.

I would suggest that the sensible option would be to pledge to buy government bonds each year in an amount equal to the current account deficit, and then write them off. Although this is not allowed in name, by pledging to roll the position indefinitely and pay the interest back to the government it would effectively be a write off. The effect of this would be that, even though the current account deficit was still large, the UK would no longer be increasing net debt. It neutralises the foreign purchases of UK assets.

The adverse effects of the savings inflows are countered in two ways. 1) The required increase in debt that is described above is nullified. Net there is now no increase in debt, although potentially there is an increase in debt to foreign creditors and a corresponding reduction in internal debt. 2) The artificial impact on the currency is cancelled out by an increase in the domestic holdings of GBP which exactly matches the amount of GBP taken out of the country.

The leeway that the debt reduction affords would allow the government to invest more money into productive projects which, with the reduction of government debt levels, can now be judged more on merit. Interest rates are low enough that the bar does not need to be that high. This would increase the future growth potential of the economy as well as stimulating much needed demand now.

In fact, I would agree completely with Lord Adair Turner's suggestion to both increase interest rates and monetarise debt. This would work to reduce private debt but at the same time put money into the economy in a more productive place than housing. The reduction in private sector debt caused by higher rates could be counteracted by the increased government spending. But net debt would go down as private sector debt goes down and government debt does not go up.

And if the UK current account goes into surplus? Then the Bank of England can do the opposite and put back into the market some of the bonds it has taken off. In fact this could be a stated exit strategy for the current QE. This strengthens the Pound when it is too weak and keeps net debt levels the same.

So who loses? The Pound should go lower, reducing the buying power of UK citizens, however it is currently too high as evidenced by the trade deficit. It is, in effect, a tax on holders of cash, but only offsetting the subsidy given by the net purchasers of UK assets from abroad; the tax and subsidy in fact exactly cancel. The foreign purchasers of UK assets would be worse off, but if that discourages the purchase of UK assets, so much the better. In the current deflationary environment, any increase in inflation would be welcomed and come from increased demand, not just the weakening exchange rate. The stimulus made possible by this would allow interest rates to be higher to counteract any future inflationary pressures and give more room to cut in a future crisis.


  1. I am not understanding why 1.5% pa coupon on a 10 year 100pound bond bought for 98pounds yielding 1.8% should be bad for uk? First of all this is very cheap money when mortgages are going at 5% and how can the countries ever get their money back? They need to have a CAD to receive the money on capital account, which they plainly wont do or their exports will fall causing unemployment. and even if they convert to uk investments, how bad is that for foreign investment - it shows your country is going well. As far as I can see the 17tr owed by usa will never be repaid and the creditor countries can take comfort in the net export income their countries received for the widgets or ore sold overseas?

    1. It can't go on forever though, and the UK doesn't have the safe haven status of the US. At some point, the debts will get too big and the creditors will want their money back.

      I know that the situation is different for a number of reasons, but Greece had very cheap borrowing and it didn't do them much good.

    2. I see, without safe haven status, creditors may not even want to bring the money back home, but may instead cash it out to invest in another country bonds, like usa for example. This happened to the Greek bonds which went up to 15% to try and hold the money there.

    3. Your idea of pledging to roll indefinitely seems like a good solution to me and I am hopung M Petis will apply his mind to it and give some comment.. Like you say, the external debt would still be gbp45tr, and going up, but the foreign content would come down to 90% then 80% etc. That way the country would not be so at risk.

    4. In the end, the flow of savings from abroad forces debt upon a country.

      Either the government takes this debt, or the private sector is encouraged to do so by low interest rates. I think that this needs to be counteracted as it is clearly unsustainable. As Michael Pettis quotes Herb Stein, “If something cannot go on forever, it will stop.”

      I think that this applies here.

  2. Ari,

    I meet you via your link on your comment on the Ben Bernanke blog on the impact of "over-saving" in China and Germany v "secular stagnation".

    Larry Summers and Ben were not venturing far from the remit of their past office, Chairman of the Fed. They were basically only talking about stimulus via interest rate reduction and other impacts on credit. These are just one component of economic management. There are lots of other components. For example, we have 600,000 LATs in the UK and for every ten workers we have one person on ICB, the Labour pensions raid has taken £150b from middle class pensions and from investment in UK Plc.............

    At one point some eight years ago 80% of US government bonds were owned by foreigners. But terms like "over-saving" and "under-saving" shouldn't be applied. The only term that can be applied to the buyer, seller, saver and investor is "rational". Even when there is an irrational sell-off of equities each and every seller is behaving rationally. What Ben refers to as "over-saving" is just the Far Eastern natural saver choosing US state bonds that were paying 4% rather than choosing zero on deposit in Japan for instance. Much of the money ended up with investment bankers and went back to China as foreign investment and lifted 1b out of poverty and that's not a bad thing.

    The stagnation in the first world economies is due to ageing population and the imbalance of wages (£10 per hour for a UK clothing worker v 50p per long day in China, $36 per hour for a motor worker in the US v £2 per long day in China). Real economics like the law of supply and demand and the relevance of the rational man trump Larry and Ben.

  3. Hi David,

    The natural laws of supply and demand have been distorted in this case by countries pursuing policies which push their trade surplus up. In my opinion you will always find a policy reason for a trade surplus; it is never a case of natural savers.

    In China, the savings rate is kept high by suppressing the household share of GDP. They have done this by 1) keeping the exchange rate too low which is a tax on the household as it makes imports more expensive 2) keeping interest rates to low, which taxes people's savings 3) keeping wages low because of the semi legal status of the workers from the countryside 4) less environmental regulation. All of these policies make China's goods too cheap and discourage imports, thus forcing a trade surplus.

    If it were simply supply and demand, Chinese wages would rise and the surplus would disappear. The Chinese workers would spend more, and world savings would be reduced.
    So these savings are not natural rational pension savings.

    Also a rising share of income going to the rich increases savings as rich people save a larger proportion of their income than poor people.

    Global policies have led to rising savings, and global policies are required to change the balance back.


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