The BBC podcast linked below looks at the use of quantitative easing since 2009 and especially the most recent round since the onset of the pandemic.
Although QE was a major contributor to reducing the depth of the recession in 2009–10, it was barely used from 2013 to 2020 (except for a short period in late 2016/early 2017). The Coalition and Conservative governments were keen to get the deficit down. In justifying pay restraint and curbing government expenditure, Prime Ministers David Cameron and Theresa May both argued that there ‘was no magic money tree’.
But with the severely dampening effect of the lockdown measures from March 2020, the government embarked on a large round of expenditure, including the furlough scheme and support for businesses.
The resulting rise in the budget deficit was accompanied by a new round of QE from the beginning of April. The stock of assets purchased by the Bank of England rose from £445 billion (the approximate level it had been since March 2017) to £740 billion by December 2020 and is planned to reach £895 billion by the end of 2021.
So with the effective funding of the government’s deficits by the creation of new money, does this mean that there is indeed a ‘magic money tree’ or, indeed, a ‘magic money forest’? And if so, is it desirable? Is it simply stoking up problems for the future? Or will, as modern monetary theorists maintain, the extra money, if carefully spent, lead to faster growth and a reducing deficit, with low interest rates making it easy to service the debt?
The podcast explores these issues. There is then a longer list of questions than normal relating to the topics raised in the podcast.
- Which of the following are stocks and which are flows?
(c) The total amount people save each month
(d) The money held in savings accounts
(e) Public-sector net debt
(f) Public-sector net borrowing
(g) National income
(h) Injections into the circular flow of income
(i) Aggregate demand
- How do banks create money?
- What is the role of the Debt Management Office in the sale of gilts?
- Describe the birth of QE.
- Is raising asset prices the best means of stimulating the economy? What are the disadvantages of this form of monetary expansion?
- What are the possible exit routes from QE and what problems could occur from reducing the central bank’s stock of assets?
- Is the use of QE in the current Covid-19 crisis directly related to fiscal policy? Or is this use of monetary policy simply a means of hitting the inflation target?
- What are the disadvantages of having interest rates at ultra-low levels?
- Does it matter if the stock of government debt rises substantially if the gilts are at ultra-low fixed interest rates?
- What are the intergenerational effects of substantial QE? Does it depend on how debt is financed?
- How do the policy recommendations of modern monetary theorists differ from those of more conventional macroeconomists?
- In an era of ultra-low interest rates, does fiscal policy have a greater role to play than monetary policy?
On 25 November, the UK government published its Spending Review 2020. This gives details of estimated government expenditure for the current financial year, 2020/21, and plans for government expenditure and the likely totals for 2021/22.
The focus of the Review is specifically on the effects of and responses to the coronavirus pandemic. It does not consider the effects of Brexit, with or without a trade deal, or plans for taxation. The Review is based on forecasts by the Office for Budget Responsibility (OBR). Because of the high degree of uncertainty over the spread of the disease and the timing and efficacy of vaccines, the OBR gives three forecast values for most variables – pessimistic, central and optimistic.
According to the central forecast, real GDP is set to decline by 11.3% in 2020, the largest one-year fall since the Great Frost of 1709. The economy is then set to ‘bounce back’ (somewhat), with GDP rising by 5.2% in 2021.
Unemployment will rise from 3.9% in 2019 to a peak of 7.5% in mid-2021, after the furlough scheme and other support for employers is withdrawn.
This blog focuses at the impact on government borrowing and debt and the implications for the future – both the funding of the debt and ways of reducing it.
Soaring government deficits and debt
Government expenditure during the pandemic has risen sharply through measures such as the furlough scheme, the Self-Employment Income Support Scheme and various business loans. This, combined with falling tax revenue, as incomes and consumer expenditure have declined, has led to a rise in public-sector net borrowing (PSNB) from 2.5% of GDP in 2019/20 to a central forecast of 19% for 2020/21 – the largest since World War II. By 2025/26 it is still forecast to be 3.9% of GDP. The figure has also been pushed up by a fall in nominal GDP for 2020/21 (the denominator) by nearly 7%. (Click here for a PowerPoint of the above chart.)
The high levels of PSNB are pushing up public-sector net debt (PSNB). This is forecast to rise from 85.5% of GDP in 2019/20 to 105.2% in 2020/21, peaking at 109.4% in 2023/24.
The exceptionally high deficit and debt levels will mean that the government misses by a very large margin its three borrowing and debt targets set out in the latest (Autumn 2016) ‘Charter for Budget Responsibility‘. These are:
- to reduce cyclically-adjusted public-sector net borrowing to below 2% of GDP by 2020/21;
- for public-sector net debt as a percentage of GDP to be falling in 2020/21;
- for overall borrowing to be zero or in surplus by 2025/26.
But, as the Chancellor said in presenting the Review:
Our health emergency is not yet over. And our economic emergency has only just begun. So our immediate priority is to protect people’s lives and livelihoods.
Putting the public finances on a sustainable footing
Running a large budget deficit in an emergency is an essential policy for dealing with the massive decline in aggregate demand and for supporting those who have, or otherwise would have, lost their jobs. But what of the longer-term implications? What are the options for dealing with the high levels of debt?
1. Raising taxes. This tends to be the preferred approach of those on the left, who want to protect or improve public services. For them, the use of higher progressive taxes, such as income tax, or corporation tax or capital gains tax, are a means of funding such services and of providing support for those on lower incomes. There has been much discussion of the possibility of finding a way of taxing large tech companies, which are able to avoid taxes by declaring very low profits by diverting them to tax havens.
2. Cutting government expenditure. This is the traditional preference of those on the right, who prefer to cut the overall size of the state and thus allow for lower taxes. However, this is difficult to do without cutting vital services. Indeed, there is pressure to have higher government expenditure over the longer term to finance infrastructure investment – something supported by the Conservative government.
A downside of either of the above is that they squeeze aggregate demand and hence may slow the recovery. There was much discussion after the financial crisis over whether ‘austerity policies’ hindered the recovery and whether they created negative supply-side effects by dampening investment.
3. Accepting higher levels of debt into the longer term. This is a possible response as long as interest rates remain at record low levels. With depressed demand, loose monetary policy may be sustainable over a number of years. Quantitative easing depresses bond yields and makes it cheaper for governments to finance borrowing. Servicing high levels of debt may be quite affordable.
The problem is if inflation begins to rise. Even with lower aggregate demand, if aggregate supply has fallen faster because of bankruptcies and lack of investment, there may be upward pressure on prices. The Bank of England may have to raise interest rates, making it more expensive for the government to service its debts.
Another problem with not reducing the debt is that if another emergency occurs in the future, there will be less scope for further borrowing to support the economy.
4. Higher growth ‘deals’ with the deficit and reduces debt. In this scenario, austerity would be unnecessary. This is the ‘golden’ scenario – for the country to grow its way out of the problem. Higher output and incomes leads to higher tax revenues, and lower unemployment leads to lower expenditure on unemployment benefits. The crucial question is the relationship between aggregate demand and supply. For growth to be sustainable and shrink the debt/GDP ratio, aggregate demand must expand steadily in line with the growth in aggregate supply. The faster aggregate supply can grow, the faster can aggregate demand. In other words, the faster the growth in potential GDP, the faster can be the sustainable rate of growth of actual GDP and the faster can the debt/GDP ratio shrink.
One of the key issues is the degree of economic ‘scarring’ from the pandemic and the associated restrictions on economic activity. The bigger the decline in potential output from the closure of firms and the greater the deskilling of workers who have been laid off, the harder it will be for the economy to recover and the longer high deficits are likely to persist.
Another issue is the lack of labour productivity growth in the UK in recent years. If labour productivity does not increase, this will severely restrict the growth in potential output. Focusing on training and examining incentives, work practices and pay structures are necessary if productivity is to rise significantly. So too is finding ways to encourage firms to increase investment in new technologies.
Podcast and videos
- Initial reaction from IFS researchers on Spending Review 2020 and OBR forecasts
IFS Press Release, Paul Johnson, Carl Emmerson, Ben Zaranko, Tom Waters and Isabel Stockton (25/11/200
- Rishi Sunak is likely to increase spending – which means tax rises will follow
IFS, Newspaper Article, Paul Johnson (23/11/20)
- Economic and Fiscal Outlook Executive Summary
- UK’s Sunak says public finances are on ‘unsustainable’ path
Reuters, David Milliken (26/11/20)
- Rishi Sunak warns ‘economic emergency has only just begun’
BBC News, Szu Ping Chan (25/11/20)
- UK will need £27bn of spending cuts or tax rises, watchdog warns
The Guardian, Phillip Inman (25/11/20)
- What is tomorrow’s Spending Review all about?
The Institute of Chartered Accountants in England and Wales (24/11/20)
- Spending Review 2020: the experts react
The Conversation, Drew Woodhouse, Ernestine Gheyoh Ndzi, Jonquil Lowe, Anupam Nanda, Alex de Ruyter and Simon J. Smith (25/11/20)
- What is the significance of the relationship between the rate of economic growth and the rate of interest for financing public-sector debt over the longer term?
- What can the government do to encourage investment in the economy?
- Using OBR data, find out what has happened to the output gap over the past few years and what is forecast to happen to it over the next five years. Explain the significance of the figures.
- Distinguish between demand-side and supply-side policies. How would you characterise the policies to tackle public-sector net debt in terms of this distinction? Do the policies have a mixture of demand- and supply-side effects?
- Choose two other developed countries. Examine how their their public finances have been affected by the coronavirus pandemic and the policies they are adopting to tackle the economic effects of the pandemic.
Back in June, we examined the macroeconomic forecasts of the three agencies, the IMF, the OECD and the European Commission, all of which publish forecasts every six months. The IMF has recently published its latest World Economic Outlook (WEO) and its accompanying database. Unlike the April WEO, which, given the huge uncertainty surrounding the pandemic and its economic effects, only forecast as far as 2021, the latest version forecasts as far ahead as 2025.
In essence the picture is similar to that painted in April. The IMF predicts a large-scale fall in GDP and rise in unemployment, government borrowing and government debt for 2020 (compared with 2019) across virtually all countries.
World real GDP is predicted to fall by 4.4%. For many countries the fall will be much steeper. In the UK, GDP is predicted to fall by 9.8%; in the eurozone, by 8.3%; in India, by 10.3%; in Italy, by 10.8%; in Spain, by 12.8%. There will then be somewhat of a ‘bounce back’ in GDP in 2021, but not to the levels of 2019. World real GDP is predicted to rise by 5.2% in 2021. (Click here for a PowerPoint of the growth chart.)
Unemployment will peak in some countries in 2020 and in others in 2021 depending on the speed of recovery from recession and the mobility of labour. (Click here for a PowerPoint of the unemployment chart.)
Inflation is set to fall from already low levels. Several countries are expected to see falling prices.
Government deficits (negative net lending) will be sharply higher in 2020 as a result of government measures to support workers and firms affected by lockdowns and falling demand. Governments will also receive reduced tax revenues. (Click here for a PowerPoint of the general government net lending chart.)
Government debt will consequently rise more rapidly. Deficits are predicted to fall in 2021 as economies recover and hence the rise in debt will slow down or in some cases, such as Germany, even fall. (Click here for a PowerPoint of the general government gross debt chart.)
After the rebound in 2021, global growth is then expected to slow to around 3.5% by 2025. This compares with an average of 3.8% from 2000 to 2019. Growth of advanced economies is expected to slow to 1.7%. It averaged 1.9% from 2000 to 2019. For emerging market and developing countries it is expected to slow to 4.7% from an average of 5.7% from 2000 to 2019. These figures suggest some longer-term scarring effects from the pandemic.
In the short term, the greatest uncertainty concerns the extent of the second wave, the measures put in place to contain the spread of the virus and the compensation provided by governments to businesses and workers. The WEO report was prepared when the second wave was only just beginning. It could well be that countries will experience a deeper recession in 2000 and into 2021 than predicted by the IMF.
This is recognised in the forecast.
The persistence of the shock remains uncertain and relates to factors inherently difficult to predict, including the path of the pandemic, the adjustment costs it imposes on the economy, the effectiveness of the economic policy response, and the evolution of financial sentiment.
With some businesses forced to close, others operating at reduced capacity because of social distancing in the workplace and with dampened demand, many countries may find output falling again. The extent will to a large extent depend on the levels of government support.
In the medium term, it is assumed that there will be a vaccine and that economies can begin functioning normally again. However, the report does recognise the long-term scarring effects caused by low levels of investment, deskilling and demotivation of the parts of the workforce, loss of capacity and disruptions to various supply chains.
The deep downturn this year will damage supply potential to varying degrees across economies. The impact will depend on various factors … including the extent of firm closures, exit of discouraged workers from the labour force, and resource mismatches (sectoral, occupational and geographic).
One of the greatest uncertainties in the medium term concerns the stance of fiscal and monetary policies. Will governments continue to run large deficits to support demand or will they attempt to reduce deficits by raising taxes and/or reducing benefits and/or cutting government current or capital expenditure?
Will central banks continue with large-scale quantitative easing and ultra-low or even negative interest rates? Will they use novel forms of monetary policy, such as directly funding government deficits with new money or providing money directly to citizens through a ‘helicopter’ scheme (see the 2016 blog, New UK monetary policy measures – somewhat short of the kitchen sink)?
Forecasting at the current time is fraught with uncertainty. However, reports such as the WEO are useful in identifying the various factors influencing the economy and how seriously they may impact on variables such as growth, unemployment and government deficits.
Report, speeches and data
- World Economic Outlook, October 2020: A Long and Difficult Ascent
IMF, Report (October 2020)
- World Economic Outlook Databases
IMF (October 2020)
- “We Must Take the Right Actions Now!”—Opening Remarks for Annual Meetings Press Conference
IMF, Speech, Kristalina Georgieva, IMF Managing Director (14/10/20)
- Press Briefing: World Economic Outlook
IMF, Gita Gopinath, Chief Economist and Director of the Research Department, IMF; Gian Maria Milesi-Ferretti, Deputy Director, Research Department, IMF; Malhar Shyam Nabar, Division Chief, Research Department, IMF; Moderator: Raphael Anspach, Senior Communications officer, Communications Department, IMF (13/10/20)
- Explain what is meant by ‘scarring effects’. Identify various ways in which the pandemic is likely to affect aggregate supply over the longer term.
- Consider the arguments for and against governments continuing to run large budget deficits over the next few years.
- What are the arguments for and against using ‘helicopter money’ in the current circumstances?
- On purely economic grounds, what are the arguments for imposing much stricter lockdowns when Covid-19 rates are rising rapidly?
- Chose two countries other than the UK, one industrialised and one developing. Consider what policies they are pursuing to achieve an optimal balance between limiting the spread of the virus and protecting the economy.
In March 2020, the UK government introduced a Coronavirus Job Retention Scheme. Businesses that had to close or cut back could put staff on furlough and the scheme would allow employers to claim 80% of workers’ wages up to £2500 per month. This would be passed on to workers.
There was large-scale uptake of the scheme. By the end of August, 9.6 million employees were on furlough (28% of the workforce) from around 1.2 million employers (61% of eligible employers). The scheme significantly stemmed the rise in unemployment. The claimant count rose 121% from March to August from 1.24 million to 2.74 million, far less than it would have done without the furlough scheme.
Since 1 August the level of support has been reduced in stages and is due to end on 31 October. It will then be replaced by a new ‘Job Support Scheme (JSS)‘ running from 1 November 2020 to 30 April 2021. Initially, employees must work at least 33% of their usual hours. For hours not worked, the government and the employer will pay a third each. There would be no pay for the final third. This means that an employee would receive at least 77.7% (33% + (2/3)67%) of their full pay – not far short of the 80% under the furlough scheme.
Effects on unemployment
Will the scheme see a substantial rise in unemployment, or will it be enough to support a gradual recovery in the economy as more businesses are able to reopen or take on more staff?
On first sight, it might seem that the scheme will give only slightly less job protection than the job furlough scheme with employees receiving only a little less than before. But, unlike the previous scheme, employers will have to pay not only for work done, but also an additional one-third for work not done. This is likely to encourage employers to lay off part of their staff and employ the remainder for more than one-third of their usual hours. Other firms may simply not engage with the scheme.
What is more, the furlough scheme paid wages for those previously employed by firms that were now closed. Under the new scheme, employees of firms that are forced to stay closed, such as many in the entertainments industry, will receive nothing. They will lose their jobs (at least until such firms are able to reopen) and will thus probably have to look for a new job. The scheme does not support them.
The government acknowledges that some people will lose their jobs but argues that it should not support jobs that are no longer viable. The question here is whether some jobs will eventually become viable again when the Covid restrictions are lifted.
With Covid cases on the rise again and more restrictions being imposed, especially at a local level, it seems inevitable that unemployment will continue to rise for some time with the ending of the furlough scheme and as the demand for labour remains subdued. The ending of the new scheme in April could compound the problem. Even when unemployment does begin to fall, it may take many months to return to pre-pandemic levels.
Update: expansion of the scheme
On 9 October, with Covid-19 cases rising rapidly in some parts of the country and tighter restrictions being imposed, the government announced that it was extending the scheme. From 1 November, employees of firms in certain parts of the country that would be required to close by the government, such as bars and restaurants, would be paid two-thirds of their previous wages by the government.
Critics of this extension to the scheme argue many firms will still be forced to shut because of lack of demand, even though they are not legally being required close. Employees of such firms will receive nothing from the scheme and will be forced onto Universal Credit. Also, the scheme will mean that many of the workers who do receive the money from the government will still face considerable hardship. Many will previously have been on minimum wages and thus will struggle to manage on only two-thirds of their previous wages.
- Job Support Scheme: What will I be paid after furlough?
BBC News, Eleanor Lawrie (1/10/20)
- Chancellor unveils new Job Support Scheme and extends self-employed grant
MSE News, Callum Mason (24/9/20)
- Sunak has bought himself time, but his big test will come as crisis eases
IFS Newspaper article, Paul Johnson (28/9/20)
- The businesses that feel left behind by Sunak’s jobs support scheme
Channel 4 News, Paul McNamara (25/9/20
- Covid: Jobs scheme ‘won’t stop major rise in unemployment’
BBC News (25/9/20)
- How the new Job Support Scheme will work
FT Adviser, Richard Churchill (30/9/20)
- Covid scheme: UK government to cover 22% of worker pay for six months
The Guardian, Phillip Inman (24/9/20)
- Hard winter ahead as Sunak tries to stop job losses hitting postwar record
The Guardian, Larry Elliott (24/9/20)
- Job Support Scheme ‘won’t reduce job losses’
Personnel Today, Ashleigh Webber (25/9/20)
- Sunak’s new job support scheme offers warm words but no escape from the coming unemployment chill
The Conversation, David Spencer (24/9/20)
- If people on furlough were counted as unemployed, find out what would have happened to the unemployment rate between March and August 2020.
- If an employer were previously employing two people doing the same type of job and now has enough work for only one person, under the Job Support Scheme would it be in the employers’ financial interest to employ one worker full time and make the other redundant or employ both of the workers half time? Explain your arguments.
- What are the arguments for and against the government supporting jobs for more than a few months?
- What determines the mobility of labour? What policies could the government pursue to increase labour mobility?
- Find out what policies to support employment or wages have been pursued by two other countries since the start of the pandemic. Compare them with the policies of the UK government.
In the current environment of low inflation and rising unemployment, the Federal Reserve Bank, the USA’s central bank, has amended its monetary targets. The new measures were announced by the Fed chair, Jay Powell, in a speech for the annual Jackson Hole central bankers’ symposium (this year conducted online on August 27 and 28). The symposium was an opportunity for central bankers to reflect on their responses to the coronavirus pandemic and to consider what changes might need to be made to their monetary policy targets and instruments.
The Fed’s previous targets
Previously, like most other central banks, the Fed had a long-run inflation target of 2%. It did, however, also seek to ‘maximise employment’. In practice, this meant seeking to achieve a ‘normal’ rate of unemployment, which the Fed regards as ranging from 3.5 to 4.7% with a median value of 4.1%. The description of its objectives stated that:
In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.
The new targets
Under the new system, the Fed has softened its inflation target. It will still be 2% over the longer term, but it will be regarded as an average, rather than a firm target. The Fed will be willing to see inflation above 2% for longer than previously before raising interest rates if this is felt necessary for the economy to recover and to achieve its long-run potential economic growth rate. Fed chair, Jay Powell, in a speech on 27 August said:
Following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time.
Additionally, the Fed has increased its emphasis on employment. Instead of focusing on deviations from normal employment, the Fed will now focus on the shortfall of employment from its normal level and not be concerned if employment temporarily exceeds its normal level. As Powell said:
Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals
The Fed will also take account of the distribution of employment and pay more attention to achieving a strong labour market in low-income and disadvantaged communities. However, apart from the benefits to such communities from a generally strong labour market, it is not clear how the Fed could focus on disadvantaged communities through the instruments it has at its disposal – interest rate changes and quantitative easing.
Modern monetary theorists (see blog MMT – a Magic Money Tree or Modern Monetary Theory?) will welcome the changes, arguing that they will allow more aggressive expansion and higher government borrowing at ultra-low interest rates.
The problem for the Fed is that it is attempting to achieve more aggressive goals without having any more than the two monetary instruments it currently has – lowering interest rates and increasing money supply through asset purchases (quantitative easing). Interest rates are already near rock bottom and further quantitative easing may continue to inflate asset prices (such as share and property prices) without sufficiently stimulating aggregate demand. Changing targets without changing the means of achieving them is likely to be unsuccessful.
It remains to be seen whether the Fed will move to funding government borrowing directly, which could allow for a huge stimulus through infrastructure spending, or whether it will merely stick to using asset purchases as a way for introducing new money into the system.
- In landmark shift, Fed rewrites approach to inflation, labor market
Reuters, Jonnelle Marte, Ann Saphir and Howard Schneider (27/8/20)
- 5 Key Takeaways From Powell’s Jackson Hole Fed Speech
Bloomberg, Mohamed A. El-Erian (28/8/20)
- Fed adopts new strategy to allow higher inflation and welcome strong labor markets
Market Watch, Greg Robb (27/8/20)
- Fed to tolerate higher inflation in policy shift
Financial Times, James Politi and Colby Smith (27/8/20)
- Fed inflation shift raises questions about past rate rises
Financial Times, James Politi and Colby Smith (28/8/20)
- Dollar slides as bond market signals rising inflation angst
Financial Times, Adam Samson and Colby Smith (28/8/20)
- Wall Street shares rise after Fed announces soft approach to inflation
The Guardian, Larry Elliott (27/8/20)
- How the Fed Is Bringing an Inflation Debate to a Boil
Bloomberg, Ben Holland, Enda Curran, Vivien Lou Chen and Kyoungwha Kim (27/8/20)
- The live now, pay later economy comes at a heavy cost for us all
The Guardian, Phillip Inman (29/8/20)
- The world’s central banks are starting to experiment. But what comes next?
The Guardian, Adam Tooze (9/9/20)
- Find out how much asset purchases by the Fed, the Bank of England and the ECB have increased in the current rounds of quantitative easing.
- How do asset purchases affect narrow money, broad money and aggregate demand? Is there a fixed money multiplier effect between the narrow money increases and aggregate demand? Explain.
- Why did the dollar exchange rate fall following the announcement of the new measures by Jay Powell?
- The Governor of the Bank of England, Andrew Bailey, also gave a speech at the Jackson Hole symposium. How does the approach to money policy outlined by Bailey differ from that outlined by Jay Powell?
- What practical steps, if any, could a central bank take to improve the relative employment prospects of disadvantaged groups?
- Outline the arguments for and against central banks directly funding government expenditure through money creation.
- What longer-term problems are likely to arise from central banks pursuing ultra-low interest rates for an extended period of time?