Merlin Weekly Macro: Debt, delinquency and Manchesterism

“There go the people. I must follow them, for I am their leader”. Attributed to 19^th Century French revolutionary Alexandre Auguste Ledru-Rollin, his is a metaphor for 21^st Century British focus-group-led politics. Will Andy Burnham be the one who breaks the mould in Westminster and leads from the front? Absolutely he will, or at least that is his firm intent. He said exactly that in Manchester this week as he pitched his pending-prime-ministerial vision of “Manchesterism”.

Manchesterism is a decisive shift in the powerbase of government from London to “Number Ten North” based on Manchester itself and an accelerated programme of devolved powers to regional mayors. His is the federalisation of England to complement what has already taken place through national devolution in Scotland, Wales and Northern Ireland.

“He’s a very naughty boy!”

“He’s not the Messiah!” quipped a Westminster Tory member at Burnham’s swearing in as Makerfield’s hastily contrived new MP; “A naughty boy!” sniggered Andy as the perfect riposte from Monty Python’s Life of Brian. It got a good laugh. It was a deft touch. As seen later in Manchester, he is a public performer in a way that Keir Starmer could never be.

He is a naughty boy: he has premeditatedly unseated a prime minister. And he is not the Messiah, however much he has accrued a Messianic aura: he is an opportunistic but very mortal politician (at least unlike Starmer, Burnham has politics and politicking coursing through his veins: it is all he has ever done in his entire “working” life). It is just as well he has powerful ideas to back his self-confidence. Having wanted the top job for so long and finally attaining it on the third attempt, he has unveiled his ideological thinking: “Good growth in every postcode and hope in every heart”; a “rewired Britain” with “Number Ten of the North” as the circuit-breaker which disintermediates but reorients the Westminster-based civil service and restores the principle of it working for the elected government rather than its own self-preservation and self-perpetuation. His three strategic priorities are the public ownership of utilities, regeneration and reindustrialisation. Now he urgently needs detailed policies to carry him through what he defines as a 10-year mission of renewal. 

He inherits a poor situation. The 2024 Tory bequest was bad enough, but it has been made considerably worse in the last two years under the Chancellorship of Rachel Reeves for all the reasons we have rehearsed so often in these columns. From an investment standpoint, Burnham’s biggest calls are on the economy and financing. In the national interest (rather than his own and that of the Labour Party) his priorities need to be: a credible defence policy; restoring self-sustaining growth; re-balancing the entire economy and not merely its geography; addressing the UK government’s enduring deficits and reducing its debt; attracting a strong stream of foreign inward investment; restoring productivity; a new energy policy; slashing welfare and getting a million 16-24 year-old NEETs (not in education, employment or training) into productive work in the private sector, explicitly not the public sector, contributing to economic wealth creation. The most important political appointment he will make will be a new Chancellor.

Economically and financially, reports are that he personally is being advised by a triumvirate of heavy-weights: ex-Goldman Sachs chief global economist Jim (Lord) O’Neill advocates a significant increase in government spending on infrastructure funded by borrowings -- highly questionable given the rotten record of successive governments either as efficient allocators of capital or being any good at large-scale project procurement and management; former Bank of England Chief Economist and incumbent President of the British Chambers of Commerce Andy Haldane wants tax simplification and a relaxation of the intervals over which government borrowings are assessed against the fiscal rules; and former Resolution Foundation (left-leaning economic think-tank) member Richard Hughes, forced to resign as chief executive the Office of Budget Responsibility when his department inadvertently leaked Reeves’s March Budget an hour before she was due to present it to Parliament.

Burnham’s own understanding of national economics and government financing had previously appeared sketchy. When pressed, he had been hazy on the meaning of the fiscal rules agreed with the OBR (that operating expenditure will be wholly met from tax receipts by 2029/30 while only capital expenditure requirements will be met through borrowings; and that the Public Sector Net Financial Liabilities must be falling as a percentage of GDP by the fifth year of the programme). In less than six months this year he has flipped 180 degrees from fully supporting smashing the borrowing constraints, to affirming the sanctity of the fiscal rules in his Manchester Speech.

So, whose debt is it anyway?

But it is widespread ignorance of financial mechanisms which remains troubling. It is easy to sense a tension between Burnham’s and many Labour MPs’ “soft-left” populist stance of wanting to “socialise” our debt, clashing with the realities of international bond markets. He is not alone in apparently not understanding or not wanting to understand how it all works. It is not at all clear how national financing fits with his planned devolution and regional budgets. Let us therefore try and enlighten the ignorant or to disabuse those who simply want to kick the system, including many in Burnham’s own party, and Reform and the Greens.

“Bank’s bond sales to hand UK taxpayers a £36bn loss”. The headline was in the business section in the Daily Telegraph a couple of weeks ago. Framed as an accusation of ripping us all off, the article went on to say, “Proactive approach to government gilts blamed amid political backlash as national debt nears £3 trillion…The Bank of England’s decision to sell off UK debt has cost taxpayers £36bn in just four years, according to new figures”. The statistic was pulled from an analysis produced by Deutsche Bank quantifying the financial cost of quantitative tightening (QT). QT is the flip-side of quantitative easing (QE), the monetary policy mechanism by which a country’s central bank reduces interest rates and injects cash (liquidity) particularly to stabilise the national financial system in times of systemic stress. Lazily and inaccurately, QE is known colloquially as “central bank money printing”.

Government financing and how it is achieved is at the heart of today’s politics; from different perspectives, the role of the Bank of England and its financial relationship with the Treasury is a central plank of both Reform’s and the Green Party’s political and economic management agendas. Through a spokesman, this month Andy Burnham himself accused the Bank of “sabotaging the government’s balance sheet”. Such indignation is as confected as it is misplaced.   

A-B-C of financial structures & mechanisms

For decades, UK inflation was conventionally “managed” (a loose ideal: in the 1970s and 80s inflation was firmly in charge) through control of the money supply measured through bank deposits and the amount of currency in circulation. Both were the preserve of the Bank of England. Interest rates were set by the Treasury.

Two factors eroded trust and efficacy: first, interest rate policy could be cynically manipulated for political purposes (empirical evidence pointed to the frequency with which rates were dropped by a sitting government in the lead-up to a general election to reduce mortgage rates and borrowing costs); second, with an enduring and growing current account deficit (i.e. imports exceeding exports), control of the domestic money supply was a mechanism that struggled to maintain a stable rate of inflation when prices were increasingly susceptible to extra-national factors of which the 1970s oil shock was one notable event; further, with the rapid increase in the availability of consumer credit (e.g. through credit cards, hire purchase etc), and the acceleration in companies raising finance through bond issuance and borrowing, this non-central bank generated form of shadow money supply gradually eroded the Bank’s ability directly and accurately to control overall money supply.

In 1997, the Bank of England was granted independence by new Labour Chancellor Gordon Brown; it was given sole responsibility for monetary policy and a specific mandate to manage the economy to a target inflation rate of 2%; while the Bank would still nominally control the money supply, with its efficacy significantly reduced, in reality it would be interest rate policy which would be the primary tool for inflation management.

Understanding QE and Prudential Responsibility

Fast forward a decade. The Global Financial Crisis found the global financial system peering into the abyss. Heading off incipient melt-down, the key central banks (the US Federal Reserve, the ECB and the Bank of England) coordinated an emergency monetary response: a massive injection of liquidity combined with interest rates being slashed almost to zero (in the case of the UK, from 5.75% in July 2007—only two months before the run on Northern Rock-- to 0.5% in March 2009; the Base Rate was halved again to 0.25% in 2016 immediately in the aftermath of the Brexit Referendum).

That financial defibrillation was achieved through QE: rather than the Bank of England literally printing money, which would be inflationary and would most likely devalue the currency adding economic inflation to a financial crisis, the Treasury would auction a calculated value of excess government bonds in the normal way via the Debt Management Office; effectively acting as agents, the big institutions would “bid” for the stock, following seamlessly from which the Bank of England’s hastily formed mechanism, officially called the “Asset Purchase Facility Fund”,  would then buy as many of the excess bonds as were issued (if this seems convoluted, it is for a reason: beyond extending limited very short-term overdrafts which would have been inadequate and the government had no means of repayment, as a means of significant fund-raising and cash flow planning it required cohorts of bonds to be issued with a range of repayment dates; in any case it is illegal for the Bank directly to acquire bonds from the Treasury).

Critically, and frequently ignored or misunderstood and relating specifically to the critique in that recent Telegraph headline, a symmetrical term of business was agreed between the Treasury and the Bank: in the event there were losses incurred on either the interim sale or the ultimate redemption of the bonds held under the APFF scheme, the Treasury would fully indemnify the Bank of England; equally, all surpluses would be rebated to the Treasury in the event of any profits arising. The Bank’s net financial interest is strictly neutral in this arrangement: it neither profits nor suffers capital losses. To add to the reality of this being in effect an interest-free loan facility, on the bonds that it owns, the Bank also fully rebates to the Treasury the coupons (i.e. the interest payments) it has received automatically alongside all other bond holders.

Fundamental neutrality of the Bank

In the UK this principle of central bank financial neutrality is foundational. The Bank of England is colloquially the “lender of last resort”, the government’s financial backstop in the event of emergency. The Bank is a pillar of governance, but it is explicitly not a department of government; the distinction is not merely semantic, it is essential. The Bank’s role is to maintain financial stability and orderly markets, it is not to ease the embarrassment of fiscally incontinent and financially illiterate politicians. And as the regulator responsible for oversight of the banking and insurance system through its Prudential Regulation Authority, by way of setting an example it too has a legal requirement also to manage its own reserves.

Fiat: financial trust not automotive rust

Historically, reserves were dominated and defined by gold; that ended when President Nixon dissolved the international Gold Standard in 1971. Today, while physical gold is still a feature, most of the Bank’s reserves are invisible, intangible but very mobile deposits lodged by the UK’s commercial banks and building societies.

The modern financial system is based on trust; trust underpins the fiat economy. When the system is working smoothly, trust is taken for granted (defined from the bond investor’s perspective as getting their money back in full on the due date and the interim interest payments being made on time).

Periods of great stress can lead to unorthodox remedies as in the case of the GFC financial lifeboat scheme and the central bank directly intervening with its novel, untried system of quantitative easing, a programme that was repeated in size in 2020 during the Covid crisis. Depositors need to be reassured that the system remains innately secure. If the Bank’s position becomes such that, in bailing out the government with emergency loans, the Bank’s own financial security is jeopardised to the extent that depositors try and withdraw all their cash, economic collapse is inevitable. The Bank’s reserves might be largely intangible but they are neither invulnerable nor inexhaustible (as the UK found out in 1976 when the then Labour government had to go cap-in-hand to the International Monetary Fund for financial aid).

The Bank is open to criticism on two fronts. First is technical and the timing of its bond sales: selling fixed coupon bonds to the markets creates a potential over-supply which forces prices down, the corollary of which is that yields rise; this is counterintuitive when the Bank is simultaneously reducing its base interest rate and the two levers of the same policy are pulling in opposite directions. The second is strategic and more pernicious: deploying QE for short-term financial resuscitation was undoubtedly a success; however, leaving ultra-loose monetary policy in place for most of a decade with almost zero nominal interest rates, negative real rates after adjusting for inflation, and easy access to credit for companies which should not have had it, was a mistake; it destroyed Darwinian economics, created and sustained what became known as the “zombie economy” allowing surpluses of underproductive and inefficient capital and labour to build up with their long-term corrosive effects on productivity and real wages. It left a big political as well as economic legacy.

Default: when you run out of everyone else’s money

Whether for individuals, companies or the government, the repayment of debt is an obligation; it is not a discretionary option. The intent to honour the contract to repay in full must be there at the outset. This is the strong argument against the increasingly popular “progressive” economic ideology known as Modern Monetary Theory (MMT—also known colloquially by critics as the Magic Money Tree); under MMT and the socialisation of debt, government expenditure on social spending is unconstrained while rising taxes are used to bridge the gap; when MMT collides with the Laffer Curve which says that tax receipts fall away as a rational response to taxpayers suffering a negative net marginal income or seeing their assets eroded or confiscated through wealth taxes, it is an irresponsible government that continues attempting to issue bonds knowing that it cannot guarantee their repayment out of its own means. It is instructive that in the corporate world, the equivalent is knowingly to trade insolvently, which is illegal with significant sanctions for directors.

That obligation includes honouring all terms and conditions including the mutual indemnities discussed above. Were the indemnity to be unilaterally set aside by the Treasury for political or ideological purposes, it would signal that the government is prepared to renege on its responsibilities. Let us not confuse it for what it would be: it would be a form of default. Then it would be one short step towards saying that, as agents of the same state, under pressure from the Treasury and for political expediency the Bank of England should agree simply to write off all the government debt held on the Bank’s balance sheet. Known as “debt forgiveness”, it is an idea widely propagated and actively championed by Zack Polanski, leader of the Greens. It is a superficially seductive argument.

Instructive insolvency

So why is it a problem? Today, bonds amounting to approximately 19% of all outstanding UK government debt are owned by the Bank of England (thanks to a combination of QT—bond sales—and some cohorts being naturally redeemed at full term, down from 32% at its peak in 2022); 39% are owned by UK institutions, principally pension funds and insurance companies; 30% are held overseas either by counterparty governments or institutions; the remaining 10% underpin government-backed savings schemes e.g. National Savings & Investments.

All democratic governments rely on external investors from whom to raise finance; ours is no exception, the more so with our enduring budget deficits and our unbroken quarter-century record of our inability to balance income and expenditure. If the central bank writes off its portion of the debt, it is sending off two very strong signals: 1) that forgiveness equates to a blank cheque to the Treasury, effectively condoning unconstrained spending and borrowing without redress (in which case the fiscal rules are a waste of time); 2) most importantly, that the bonds which make up that written-off debt are essentially worthless, meaning that on today’s figures and the accounting principle of “mark to market” (i.e. applying period-end real-time valuations), the holders of the other 81% of our outstanding debt would also be forced to recognise the value of their UK government bond holdings as zero. That would include around £1.4 trillion (almost half the size of the UK economy) held in UK pension funds.

Nationally at that point we would be insolvent. The Bank of England would have forfeited its authority, and the IMF would be placed in charge. It would be followed by the imposition of fiscal repression which would make George Osborne’s post-2010 Austerity programme seem like a picnic.

The Greeks know how all this played out for them a decade ago. They emerged much the stronger for it, but only after nearly breaking the eurozone’s financial system and compulsorily consuming much fiscal medicine dispensed by the Troika of the European Commission, the European Central Bank and the International Monetary Fund.

Many argue that such a shock is precisely what the UK needs: a complete financial, economic and fiscal re-set. It is a powerful argument. But the UK is not Greece: it is the sixth biggest economy on the planet; sterling is one of the five currencies in the Special Drawing Rights group underpinning the global foreign exchange system; the City of London is one of the world’s biggest centres for raising and trading capital, trading currencies and placing and underwriting insurance. Letting us “go bust” would have not only significant national but profound global financial consequences.

Far more obvious is not to go there in the first place! Constrain expenditure; foment growth with investment and tax incentives; reduce state intervention; reduce regulation; unfetter the private sector and make it more profitable for people to be in work than to be on benefits; champion wealth and wealth creation, don’t despise those who have it or make it. However radical his restructuring of UK government and his ambition for “good growth in every post code”, on the evidence so far, all Burnham’s instincts, and those of his MPs, point in the opposite direction on virtually every count. Perish the thought that the state should work for us rather than the other way around; that remains a pipe dream and not part of Burnham’s plan at all.

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