tag:theconversation.com,2011:/uk/topics/government-borrowing-7073/articlesGovernment borrowing – The Conversation2023-06-22T16:04:33Ztag:theconversation.com,2011:article/2082152023-06-22T16:04:33Z2023-06-22T16:04:33ZWhy the Bank of England’s interest rate hikes aren’t slowing inflation enough and what that means for mortgages<p>Consumer price inflation <a href="https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/d7g7/mm23">stuck at 8.7%</a> in May, defying expectations of a slowdown and making a further rise in UK interest rates inevitable. </p>
<p>The May figures came out the day before the Bank of England’s Monetary Policy Committee (MPC) was due to meet to discuss changing the UK base rate. This sets the interest rates for borrowing by the government, businesses and banks – who then feed any increases through to borrowers such as people with mortgages.</p>
<p>A 13th consecutive rise in June had been expected for some time, because <a href="https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/may2023">the headline rate of inflation</a> has been well above its medium-term 2% target since mid-2021. At the risk of being accused of derailing the UK’s post-COVID economic recovery, MPC members’ main decision at the most recent meeting was not whether or not to hike rates, but by how much. </p>
<p>The latest <a href="https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/june-2023">0.5% increase (to 5%)</a> represents a jump from previous 0.25% increments, showing their concern that inflation is becoming embedded in the economy.</p>
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Read more:
<a href="https://theconversation.com/inflation-why-prices-look-likely-to-stay-high-in-the-uk-and-ireland-and-what-that-means-for-mortgages-207625">Inflation: why prices look likely to stay high in the UK and Ireland, and what that means for mortgages</a>
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<p>By increasing rates, the central bank is engaging in “monetary tightening”, which is designed to reduce the level of demand for goods and services in the economy. Households are encouraged to pay down debts and channel more of their incomes into saving. Those who cannot reduce their borrowing must pay more for it, leaving less to spend on other things. </p>
<p>The knock-on effect of rate hikes on people’s mortgage costs could result in a <a href="https://www.theguardian.com/money/2023/jun/21/1-point-4m-uk-households-huge-hit-to-finances-mortgage-timebomb-payments-fifth-disposale-income">20% hit to the disposable incomes</a> of 1.4 million mortgage holders before the next election, according to the Institute of Fiscal Studies. The government also finds its own <a href="https://tradingeconomics.com/united-kingdom/government-bond-yield">debt costs going up</a>, curbing ministerial inclinations to spend more money. </p>
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Read more:
<a href="https://theconversation.com/uk-bonds-are-in-meltdown-again-what-does-that-mean-for-pensions-expert-qanda-206533">UK bonds are in meltdown again – what does that mean for pensions? Expert Q&A</a>
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<p>And so, this policy has obvious social costs. As well as ruling out any government help with this latest cost of living shock, it punishes those who have been <a href="https://www.jrf.org.uk/report/dragged-down-debt-millions-low-income-households-pulled-under-arrears-while-living-costs-rise">forced to borrow due to poverty</a>, as well as the better-off who chose to borrow to accumulate more assets. It also has longer-term economic costs, <a href="https://www.bankofengland.co.uk/quarterly-bulletin/2021/2021-q2/influences-on-investment-by-uk-businesses-evidence-from-the-decision-maker-panel">deterring firms from borrowing for investment</a>. </p>
<p>But the MPC believes it has no alternative. Although volatile items, especially food, can be blamed for some of the current overshoot, core inflation (which removes these fluctuating items) has risen to a <a href="https://tradingeconomics.com/united-kingdom/core-inflation-rate">31-year high of 7.1%</a>. </p>
<p>For monetary policymakers, the fear is that, if they don’t act decisively now, inflation will become built into firms’ expectations when setting prices, as well as those of employees bargaining over wages. Such self-fulfilling expectations are blamed by many for a “<a href="https://ukandeu.ac.uk/stagflation-the-return-of-an-unwelcome-monster/">wage-price spiral</a>” that created a decade-long period of inflation and stagnation in the UK following the <a href="https://obr.uk/box/the-changing-impact-of-fossil-fuel-shocks-on-the-uk-economy/">oil price shocks of 1973</a>. </p>
<p>The number of rate increases since 2021 reflects an unexpected slowness for these hikes to take effect on inflation. Although a painfully blunt instrument in this respect, interest rates are the only one the MPC has. </p>
<h2>A convenient scapegoat</h2>
<p>The government has <a href="https://news.sky.com/story/cost-of-living-on-me-personally-if-inflation-isnt-halved-says-rishi-sunak-12898285">pledged to halve inflation</a> by year-end and is now in danger of breaking this promise. It’s convenient, then, to allow the <a href="https://www.telegraph.co.uk/business/2023/06/21/recession-inevitable-bank-of-england-lost-control-inflation/">blame for overshooting inflation</a> to be placed on the independent central bank. </p>
<p>With hindsight, the Bank of England’s <a href="https://www.bankofengland.co.uk/explainers/what-are-interest-rates#:%7E:text=That%20includes%20the%20lending%20and,Bank%20Rate%20is%20currently%204.5%25.">policy since the 2008 global financial crisis</a> is easy to criticise. It kept interest rates close to zero from February 2009 to March 2020, reducing them further during the COVID pandemic, then lifting them rapidly since December 2021. </p>
<p><strong>Base rate changes: 2006-2023</strong></p>
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<a href="https://images.theconversation.com/files/533230/original/file-20230621-27-naqm9v.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="Line chart showing the base rate at nearly 6% in 2008 before dropping below 1% until 2021 when it started rising again to reach 4.5% in May 2023." src="https://images.theconversation.com/files/533230/original/file-20230621-27-naqm9v.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/533230/original/file-20230621-27-naqm9v.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=345&fit=crop&dpr=1 600w, https://images.theconversation.com/files/533230/original/file-20230621-27-naqm9v.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=345&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/533230/original/file-20230621-27-naqm9v.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=345&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/533230/original/file-20230621-27-naqm9v.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=433&fit=crop&dpr=1 754w, https://images.theconversation.com/files/533230/original/file-20230621-27-naqm9v.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=433&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/533230/original/file-20230621-27-naqm9v.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=433&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="caption">The Bank of England base rate, 2006-2023.</span>
<span class="attribution"><a class="source" href="https://www.bankofengland.co.uk/explainers/what-are-interest-rates#:~:text=That%20includes%20the%20lending%20and,Bank%20Rate%20is%20currently%204.5%25.">Bank of England</a></span>
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<p>The long phase of ultra-low interest rates deterred households and firms from paying down the debts that underlay the 2008 crisis. So the unprecedented jump in interest rates since 2021 has caused a sudden shock to corporate and household cashflows. Even now, many mortgage borrowers are <a href="https://www.mirror.co.uk/money/martin-lewis-says-mortgage-timebomb-30282073">still waiting to feel the full force</a>. </p>
<p>When this does happen, the rise in borrowing costs – on top of the surge in other living costs – could tip an already slow-growing economy back into full-blown recession. That would be compounded if, as in the <a href="https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1995/the-housing-market-and-the-economy.pdf">early 1990s</a>, falling house prices knock a further hole in the finances of UK homeowners. </p>
<p>But it could also be argued that the post-2008 decade of low interest rates was unavoidable. Governments and business needed to borrow at low cost to haul the economy out of the deep 2009-2010 recession. During this time, inflation was close to zero and any lasting fall in consumer prices could have created a further slump. </p>
<p>The sharp interest-rate rise since 2021 has been equally unavoidable. As well as restraining inflation, it is needed to attract foreign investment to finance the UK’s <a href="https://www.ons.gov.uk/economy/nationalaccounts/balanceofpayments/bulletins/balanceofpayments/octobertodecember2022">persistent current-account deficits</a>. </p>
<p>These used to be comfortably financed by foreign direct investment (FDI), which offset the UK’s excess of imports over exports. But FDI has <a href="https://commonslibrary.parliament.uk/research-briefings/cbp-8534/">tailed downwards</a> since the 2016 Brexit vote. </p>
<p>So external financing now relies more heavily on foreign financial investors, who are looking for a higher return – as is evident from the rising yield the government must pay on its <a href="https://www.ft.com/content/04b15997-c4a3-4ad1-9244-db0fbb68b537">own borrowing</a>. </p>
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<img alt="A long exposure capturing the traffic trails at a busy junction at night." src="https://images.theconversation.com/files/533245/original/file-20230621-3894-nhy5sj.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/533245/original/file-20230621-3894-nhy5sj.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=338&fit=crop&dpr=1 600w, https://images.theconversation.com/files/533245/original/file-20230621-3894-nhy5sj.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=338&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/533245/original/file-20230621-3894-nhy5sj.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=338&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/533245/original/file-20230621-3894-nhy5sj.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=424&fit=crop&dpr=1 754w, https://images.theconversation.com/files/533245/original/file-20230621-3894-nhy5sj.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=424&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/533245/original/file-20230621-3894-nhy5sj.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=424&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">The Bank of England building (left) in the City of London.</span>
<span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/long-exposure-capturing-traffic-trails-busy-2186057577">Jason Wells/Shutterstock</a></span>
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<h2>Treatment-resistant inflation</h2>
<p>Although inevitable, the recent succession of interest rate rises has done little to tame the inflation we’re all experiencing at the moment. </p>
<p>Since early 2022, most prices have been pushed up by rising costs, which is known as <a href="https://www.investopedia.com/terms/c/costpushinflation.asp">cost-push inflation</a>. Raw material costs have been fuelled by the global rise in food and energy prices, and last autumn’s steep <a href="https://www.goldmansachs.com/intelligence/pages/why-the-british-pound-fell-to-a-record-low-against-the-us-dollar.html">depreciation of the pound against the US dollar</a>. Rising wage costs are an inevitable result of widespread labour shortages, exacerbated in the UK by a <a href="https://obr.uk/box/the-impact-of-the-pandemic-on-labour-market-participation/">post-COVID fall in workforce numbers</a> and the <a href="https://www.ecb.europa.eu/pub/economic-bulletin/articles/2023/html/ecb.ebart202303_01%7E3af23c5f5a.en.html">loss of EU workers</a> since Brexit.</p>
<p>With the government’s own borrowing costs climbing back towards the level that triggered fiscal meltdown after <a href="https://www.niesr.ac.uk/wp-content/uploads/2022/12/NIESR-Term-Premia-Tracker-Dec-2022.pdf">last September’s Truss budget</a>, it now risks a further <a href="https://www.santander.com/en/stories/what-is-stagflation#:%7E:text=%E2%80%9CStagflation%E2%80%9D%20is%20a%20combination%20of,less%20bang%20for%20your%20buck.">stagflationary spiral</a> – a combination of high inflation and an economy in recession. Rising interest rates are likely to divert more budget spending from growth-promoting projects into servicing public debt.</p>
<p>But if mortgage borrowers get any short-term relief from rising rates, it will only be in the <a href="https://www.reuters.com/world/uk/uks-hunt-says-mortgage-holders-should-not-expect-financial-help-2023-06-20/">unlikely event</a> that the shock from the <a href="https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/june-2023">latest rate rise</a> to 5% prompts emergency action to avert a pre-election recession.</p><img src="https://counter.theconversation.com/content/208215/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Alan Shipman does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Interest rate hikes are the Bank of England’s main monetary policy weapon against inflation, but they aren’t working.Alan Shipman, Senior Lecturer in Economics, The Open UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1915502022-09-29T14:19:27Z2022-09-29T14:19:27ZHow bonds work and why everyone is talking about them right now: a finance expert explains<p><em>The Bank of England is <a href="https://www.theguardian.com/business/live/2022/sep/28/sterling-slumps-imf-urges-uk-reconsider-tax-cuts-stinging-attack-business-live">buying bonds again</a>. Just as it was about to start selling the debt it had accumulated as part of its last effort to support the economy during the COVID-19 pandemic, the central bank has been forced to announce a new scheme to shore up investor confidence.</em></p>
<p><em>The bank’s <a href="https://www.bankofengland.co.uk/news/2022/september/bank-of-england-announces-gilt-market-operation">£65 billion short-term spree</a> aims to <a href="https://www.bbc.co.uk/news/business-63070445">address the slump</a> in bond prices caused by investors rushing to sell after the government’s recent <a href="https://www.bbc.co.uk/news/live/business-63069137">mini-budget</a>. This led to a surge in bond yields that hiked borrowing costs for the government and spread to pensions, housing and the general economy. So far, it has had a <a href="https://www.theguardian.com/business/live/2022/sep/29/pound-slides-former-boe-chief-carney-accuses-government-undercutting-bank-business-live">limited initial impact</a> on the markets.</em></p>
<p><em>We asked an expert in finance to explain what’s going on in bond markets.</em></p>
<h2>What is a bond and what is the difference between bond prices and yields?</h2>
<p>A bond is essentially a tradeable IOU. It’s a loan that investors make to issuers such as companies or governments (UK government bonds are often called gilts). A bond has a price at which it can be sold and a yield, which is an annual amount the investor receives for holding the bond, a bit like interest on a savings account, and is expressed as a percentage of the current price. </p>
<p>When the price of a bond falls, it signals less demand for the bond because fewer investors want to own it. At the same time, the yield rises, which represents a higher cost of borrowing for companies or governments that issued the bond because this is what they have to pay to investors. </p>
<p>In the days since the government’s mini-budget, yields on 10-year Treasury bonds – which are issued by the UK government – increased from approximately 3.5% to 4.52% – the highest since the 2007-2008 global financial crisis. The expectation of continued increases prompted the recent intervention by the Bank of England.</p>
<p><strong>UK government 10-year bond yields</strong></p>
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<a href="https://images.theconversation.com/files/487275/original/file-20220929-23-3sn1q3.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="Line chart showing UK 10-year bond or gilt yields, August - September 2022" src="https://images.theconversation.com/files/487275/original/file-20220929-23-3sn1q3.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/487275/original/file-20220929-23-3sn1q3.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=553&fit=crop&dpr=1 600w, https://images.theconversation.com/files/487275/original/file-20220929-23-3sn1q3.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=553&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/487275/original/file-20220929-23-3sn1q3.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=553&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/487275/original/file-20220929-23-3sn1q3.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=696&fit=crop&dpr=1 754w, https://images.theconversation.com/files/487275/original/file-20220929-23-3sn1q3.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=696&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/487275/original/file-20220929-23-3sn1q3.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=696&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="caption">United Kingdom 10-year bond yield.</span>
<span class="attribution"><a class="source" href="https://uk.investing.com/rates-bonds/uk-10-year-bond-yield">Investing.com / Tradingview</a></span>
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<h2>What causes bond yields to move?</h2>
<p>To understand this, it is important to bear in mind that, while people often talk about the interest rate, there are actually a number of rates. This includes the rate at which the central bank lends to commercial banks (the base rate), the rate that banks lend to each other (the interbank rate), the rate that the government borrows at (Treasury yields) and the rate at which households and firms borrow (commercial loans and mortgages).</p>
<p>When the Bank of England changes the base rate, this cascades through all these rates. As such, the Bank of England carefully considers the state of the economy – that is, growth and inflation – when deciding on the base rate.</p>
<p>When an economy is growing, interest rates and bond yields tend to rise. This occurs for several reasons. Investors sell bonds to buy riskier assets with better returns. Firms and households also look to borrow more money in a growing economy, for example, to invest in new machinery or to move home. More demand for borrowing means lenders can charge higher interest on their loans.</p>
<p>Higher inflation often accompanies economic growth because of the increase in demand for goods and services. This tightens supply and causes prices to rise (including wages for labour). The Bank of England, which is mandated by the government to try to keep inflation as close to 2% as possible, will respond to higher inflation by raising base rates, which, as noted, feeds through to the different rates. </p>
<p>Investors will often anticipate the increase in base rates and look to act before it goes up by selling Treasury bonds and buying alternative, higher-return assets. This causes bond yields to rise further. As a result, the Treasury bond yield is often seen as a predictor of future Bank of England base rate changes.</p>
<h2>So, if yields are rising, does this mean that investors are expecting future economic growth in the UK?</h2>
<p>No, not at the moment. When the government raises money by issuing bonds, it does so over a range of time periods (called maturities), from one day to 30 years. When an economy is expected to grow, the yield on longer-term bonds will be higher than the yield on shorter-term bonds. </p>
<p>This relationship between yields across different maturities is referred to as the term structure or yield curve. An upward-sloping yield curve implies a growing economy. At the moment, the UK yield curve is flat, or even downward-sloping across some maturities. <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3474420">My research</a> shows that a falling yield curve is a good predictor of <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3343617">a coming recession</a>. </p>
<p><strong>Yield curve for UK government bonds</strong></p>
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<a href="https://images.theconversation.com/files/487281/original/file-20220929-12-uql6xo.gif?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="Line graph showing downward-sloping yield curve for UK gilts" src="https://images.theconversation.com/files/487281/original/file-20220929-12-uql6xo.gif?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/487281/original/file-20220929-12-uql6xo.gif?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=430&fit=crop&dpr=1 600w, https://images.theconversation.com/files/487281/original/file-20220929-12-uql6xo.gif?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=430&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/487281/original/file-20220929-12-uql6xo.gif?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=430&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/487281/original/file-20220929-12-uql6xo.gif?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=540&fit=crop&dpr=1 754w, https://images.theconversation.com/files/487281/original/file-20220929-12-uql6xo.gif?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=540&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/487281/original/file-20220929-12-uql6xo.gif?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=540&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="caption">UK gilts 40-year yield curve. *The curve on the day of the previous MPC meeting is provided as a reference point.</span>
<span class="attribution"><a class="source" href="https://www.bankofengland.co.uk/statistics/yield-curves">Bloomberg Finance L.P., Tradeweb and Bank of England calculations</a></span>
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<p>It’s important to remember that these different yields act as a benchmark for commercial lending rates of equivalent lengths. The approximate jump to 4.5% in 2-year and 5-year yields has been reflected in mortgage rates, which is why some lenders have <a href="https://uk.finance.yahoo.com/news/uk-record-number-mortgage-deals-pulled-from-market-154650902.html">pulled available mortgage deals</a> recently while they reassess the lending rates charged to households. </p>
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Read more:
<a href="https://theconversation.com/is-the-uk-in-a-recession-how-central-banks-decide-and-why-its-so-hard-to-call-it-191237">Is the UK in a recession? How central banks decide and why it's so hard to call it</a>
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<h2>But if the UK economy is not expected to perform well, why have bond yields been rising after the chancellor’s mini-budget announcement?</h2>
<p>The rising bond yields we are seeing relate to an additional factor: the amount of government debt. The mini-budget introduced tax cuts and increased spending and investors know the government will need to increase borrowing to meet these commitments. Some estimates put potential government borrowing at <a href="https://ifs.org.uk/articles/mini-budget-response#:%7E:text=to%20climb%20to-,%C2%A3190%20billion,-.%20At%207.5%25%20of">£190 billion</a> due to this plan. </p>
<p>An increase in the amount a homeowner borrows versus the value of their home (called the loan-to-value) causes the mortgage rate charged to the borrower to rise. Similarly, an increase in the number of bonds that the government will be looking to sell (the amount it wants to borrow) will push down the price of existing bonds, increasing yields. More importantly, more debt without growth raises the risk level of the UK economy. </p>
<p>Anticipating this, investors triggered a large-scale bond sell-off after the government’s mini-budget announcement. This contributed to the fall in the value of the pound as investors selling UK Treasury bonds bought US bonds instead, essentially swapping pounds for dollars. </p>
<h2>So will the Bank of England’s plan work?</h2>
<p>The intervention will have a short-term positive impact, which started as soon as <a href="https://www.bloomberg.com/news/articles/2022-09-28/uk-bonds-surge-as-boe-says-it-will-purchase-gilts-delay-sales">it was announced</a>. But the bank is really only buying time. Any ultimate success depends on the government restoring investor confidence in its economic plans. </p>
<p>Unfortunately, rising yields and borrowing costs for the UK economy is the price we are now paying for the government’s recent fiscal announcement.</p><img src="https://counter.theconversation.com/content/191550/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>David McMillan does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Investor confidence in the UK is at a low, and the bond market has reacted dramatically.David McMillan, Professor in Finance, University of StirlingLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1811392022-04-18T12:28:58Z2022-04-18T12:28:58ZRussia faces first foreign default since 1918 – here’s how it could complicate Putin’s ability to wage war in Ukraine<figure><img src="https://images.theconversation.com/files/458329/original/file-20220415-16-jlry37.jpg?ixlib=rb-1.1.0&rect=143%2C0%2C5847%2C3664&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Replacing ships like the Moskva will be pricey. The flagship of Russia’s Black Sea Fleet recently sank after suffering damage.</span> <span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/RussiaUkraine/96ef4c8b56c24796a61a124270f573b9/photo?Query=moskva&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=643&currentItemNo=1">Russian Defense Ministry Press Service via AP</a></span></figcaption></figure><p><em>Russia may be on the cusp of <a href="https://www.npr.org/2022/04/12/1092077016/russia-historic-debt-default-sanctions-invasion-ukraine">its first default on its foreign debt</a> since the Bolsheviks ousted Czar Nicholas II a century ago.</em></p>
<p><em>On April 14, 2022, Moody’s Investors Service warned the country’s decision to make payments on dollar-issued debt in rubles <a href="https://www.nytimes.com/2022/04/14/business/russia-default-moodys.html">would constitute a default</a> because it violates the terms of the contract. A 30-day grace period allows Russia until May 4 to convert the payments to dollars to avoid default.</em></p>
<p><em>A default is one of the clearest signals that the sanctions imposed by the U.S. and other countries are having their intended effect on the Russian economy. But will it have any impact on Russia’s ability to wage war in Ukraine?</em> </p>
<p><em>We asked <a href="https://scholar.google.com/citations?user=bSApaj4AAAAJ&hl=en&oi=ao">Michael Allen</a> and <a href="https://scholar.google.com/citations?user=uLty40oAAAAJ&hl=en&oi=ao">Matthew DiGiuseppe</a>, both experts on political economy and conflict, to explain the consequences of default and what it would mean for Russian President Vladimir Putin’s war.</em></p>
<h2>Why did Russia default on its debt?</h2>
<p>The Russian government has a total of <a href="https://www.nytimes.com/2022/03/15/business/russia-debt-bonds-default.html">US$40 billion worth of debt</a> in dollars and euros, half of which is owned by foreign investors. Russia had an <a href="https://www.npr.org/2022/04/12/1092077016/russia-historic-debt-default-sanctions-invasion-ukraine">April 4 deadline to pay</a> about $650 million in interest and principle to the holders of two bonds issued in dollars.</p>
<p>Russia has plenty of cash – <a href="https://asia.nikkei.com/Politics/Ukraine-war/G-7-resists-going-after-1bn-a-day-Russian-energy-revenue">it collects the equivalent of over $1 billion a day</a> from its oil and gas deliveries alone – but has limited access to dollars because of sanctions imposed by the U.S. The Biden administration had been allowing Russia to use some of the foreign reserves <a href="https://www.nytimes.com/2022/02/28/us/politics/us-sanctions-russia-central-bank.html">it had previously frozen</a> to make debt payments. The U.S. changed course on April 5, when <a href="https://www.reuters.com/business/us-cracks-down-russian-debt-payments-latest-sovereign-payments-halted-2022-04-05/">it blocked Russia from using dollar reserves</a> held at American banks to make the debt payments. </p>
<p>That gave Russia little choice but to try to make the payments in rubles, whose value <a href="https://www.xe.com/currencycharts/?from=USD&to=RUB">has been very volatile</a> since the invasion. If Russia doesn’t switch the payments to dollars by May 4, the government will be in default on its foreign obligations for the <a href="https://doi.org/10.1111/j.1540-6563.1986.tb02008.x">first time since 1918</a>, when the Bolshevik revolutionaries took over Russia and refused to pay the country’s international creditors. Russia also defaulted in 1998 but only on its domestic debt. </p>
<figure class="align-center ">
<img alt="A black and white photo shows groups of men in dark coats carrying caskets on their shoulders in a snowy scene. Someone in distance holds a flag" src="https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=431&fit=crop&dpr=1 600w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=431&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=431&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=542&fit=crop&dpr=1 754w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=542&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/458272/original/file-20220414-20-8atcc4.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=542&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">The last time Russia defaulted on foreign debt was during the Russian Revolution.</span>
<span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/RussiaRevolution/480b20fec8a84465a3b4bb50a3810310/photo?Query=bolsheviks&mediaType=photo&sortBy=arrivaldatetime:asc&dateRange=Anytime&totalCount=747&currentItemNo=1">AP Photo</a></span>
</figcaption>
</figure>
<h2>What are the consequences of default?</h2>
<p>When a country defaults on a foreign loan, international investors typically become unwilling or unable to lend more money to it. Or they demand much higher interest rates. </p>
<p>Whether because of higher interest costs or an inability to borrow, this forces a country to cut spending. Less government spending <a href="https://doi.org/10.1016/j.jimonfin.2020.102257">reduces economic activity</a>, <a href="http://dx.doi.org/10.2139/ssrn.3785746">increases unemployment</a> and <a href="https://www.doi.org/10.1057/imfsp.2009.21">slows growth</a>. While some of these effects, like weaker economic growth, are often short-lived, other consequences can haunt a country for years. Trade with other countries <a href="https://www.doi.org/10.1057/imfsp.2009.21">remains below normal for an average of 15 years</a> after a default, while full exclusion from capital markets typically lasts just over eight years. </p>
<p>For example, when Argentina defaulted in 2001, the <a href="https://www.doi.org/10.1007/s11079-015-9350-3">peso plunged</a>, the <a href="https://www.doi.org/10.1080/13600810600705098">economy shrank and inflation soared</a>. <a href="https://www.nytimes.com/2001/12/20/world/reeling-from-riots-argentina-declares-a-state-of-siege.html">Riots over food broke out</a> all over the country, leading to the <a href="https://www.nytimes.com/2001/12/21/world/argentine-leader-his-nation-frayed-abruptly-resigns.html">president’s resignation</a>. Although Argentina’s <a href="https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=AR">economy had recovered by 2007</a>, the country <a href="https://www.nytimes.com/2016/04/25/business/dealbook/how-argentina-settled-a-billion-dollar-debt-dispute-with-hedge-funds.html">remained unable to borrow</a> from foreign investors, which led to default again in 2014. </p>
<p>What does this mean for Russia? The country was already <a href="https://www.reuters.com/business/russia-debt-investors-limbo-default-risk-increases-2022-04-07/">locked out of international borrowing markets</a> because of sanctions. A government official recently said Russia <a href="https://www.bloomberg.com/news/articles/2022-04-10/russia-to-halt-bond-issuance-for-rest-of-2022-siluanov-says?sref=Hjm5biAW">would also avoid borrowing domestically</a>, because a default would lead to “cosmic” interest rates.</p>
<p>But its <a href="https://www.businessinsider.com/russia-sell-oil-friendly-countries-any-price-range-ukraine-war-2022-4">significant revenue</a> from sometimes-discounted sales of oil and gas may help offset the need for borrowing in the short term, especially if it can continue to find willing buyers like India and China. On April 14, 2022, Putin acknowledged sanctions <a href="https://www.nytimes.com/live/2022/04/14/world/ukraine-russia-war-news#putin-admits-sanctions-have-hurt-russias-oil-and-gas-sector">were disrupting exports</a> and raising costs.</p>
<h2>Does Russia care if it defaults?</h2>
<p>The Russian government has been trying hard to avoid default.</p>
<p>Until April 5, it was using its precious dollars to stay current on its bond payments. And before its invasion it had built up a <a href="https://www.economist.com/graphic-detail/2022/03/02/russias-attempt-to-sanction-proof-its-economy-has-been-in-vain">significant reserve of foreign currency</a>, in large part to allow it to continue to pay back debt borrowed in dollars and euros even amid sanctions. Russia has even threatened to <a href="https://www.ft.com/content/56df1dc0-6cf3-41f8-a644-d44be5085ee8#post-9a4c235d-5382-40f9-8314-e0c19152ac92">take legal action</a> if sanctions force it into default.</p>
<p>As odd as it may sound, Russia is likely worried about its reputation – at least among bond investors.</p>
<p>A default by a sovereign borrower <a href="https://press.princeton.edu/books/paperback/9780691134697/reputation-and-international-cooperation">establishes a bad reputation</a> that can take years to rehabilitate, as Argentina’s experience shows.</p>
<p>And the long-term impact could be worse for Russia. The reason Russia is in this bind is because it chose to invade Ukraine, <a href="https://www.usnews.com/news/world-report/articles/2021-12-07/u-s-threatens-extreme-sanctions-if-russia-invades-ukraine">despite repeated warnings</a> that doing so <a href="https://www.reuters.com/world/europe/us-uk-ready-punish-putin-associates-if-russia-invades-ukraine-2022-01-31/">would result in severe</a> economic and financial sanctions.</p>
<p>So creditors might wonder if Russia will always prioritize its foreign policy interests over the interests of creditors and raise borrowing costs permanently. If so, they may find it difficult to borrow for years to come. </p>
<p>Another risk is that a default may enable creditors to seize Russia’s overseas assets as a form of repayment. International sanctions have already <a href="https://www.cnn.com/interactive/business/russian-oligarchs-yachts-real-estate-seizures/index.html">enabled countries to seize or freeze Russian assets</a>, which could be used to pay off outstanding debts.</p>
<p>One count suggests that <a href="https://voxeu.org/article/how-creditor-lawsuits-are-reshaping-sovereign-debt-markets">50% of creditors in recent sovereign debt cases</a> have attempted to <a href="https://www.reuters.com/business/finance/clock-ticks-down-towards-russian-default-2022-04-08/">seize assets as an alternative to payment</a>. </p>
<h2>What does this mean for Russia’s war in Ukraine?</h2>
<p>As long as there has been debt, governments have waged wars with other people’s money. In fact, debt has become so vital as a source of power that countries rarely fight without it.</p>
<p>Around 88% of wars from 1823 through 2003 have been at least partly financed with <a href="https://www.cornellpress.cornell.edu/book/9781501702495/how-states-pay-for-wars/#bookTabs=1">funds borrowed from banks and other investors</a>. This reality even bleeds into fantasy worlds, like “Game of Thrones,” in which financing from the Iron Bank of Braavos <a href="https://qz.com/1064757/game-of-thrones-season-7-with-the-iron-bank-a-debt-crisis-is-always-looming/">is vital to financing the wars of Westeros</a>. </p>
<p>Our own research has shown that countries that have defaulted on their debts or have poor credit ratings find it <a href="https://www.doi.org/10.1177/0022343315587970">difficult to build military capacity</a> and, consequently, are more reluctant to <a href="https://doi.org/10.1111/fpa.12044">take up arms</a> against other nations. Related work has found that countries with lower borrowing costs <a href="https://doi.org/10.1177/0022002713478567">tend to win wars</a> – though this effect is stronger for democracies. </p>
<p>One reason is that borrowing allows countries to overcome the guns-versus-butter trade-off: More money spent on the military means less for its citizens’ welfare, which can hurt a government’s ability to stay in power. Foreign loans can help overcome this problem, but losing access to credit forces a government to choose. </p>
<p>In the short term, however, a default is not likely to alter the outcome of Russia’s war – or force Putin to make any unpopular trade-offs – especially if <a href="https://www.bbc.com/news/world-europe-60938544">Russia is able to achieve</a> its <a href="https://www.aljazeera.com/news/2022/4/11/russia-repositioning-in-ukraines-eastern-donbas-region-us">new and more limited military objectives</a> in the eastern Donbas region quickly. </p>
<p>This will change the longer the war goes on. The war was expected to last only a few days, but a <a href="https://www.cnbc.com/2022/03/04/russias-invasion-of-ukraine-is-baffling-military-analysts.html">stronger-than-expected Ukrainian defense</a> has pushed the conflict into its eighth week. Early estimates found that a prolonged war <a href="https://www.consultancy.eu/news/7433/research-ukraine-war-costs-russian-military-20-billion-per-day">could end up costing Russia</a> over $20 billion a day, including both direct and indirect expenses, like loss of economic output.</p>
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<p>If Ukraine becomes a <a href="https://www.theatlantic.com/international/archive/2022/03/how-long-will-ukraine-russia-war-last/627036/">lengthy war of attrition</a>, <a href="https://www.politico.com/news/2022/03/20/ukraine-war-of-attrition-00018752">as some analysts expect</a>, then Russia’s inability to borrow money will weaken its ability to sustain, supply and reinforce its position in Ukraine – especially if <a href="https://www.businessinsider.com/russia-sell-oil-friendly-countries-any-price-range-ukraine-war-2022-4">oil prices fall</a> or the <a href="https://www.nytimes.com/live/2022/04/14/world/ukraine-russia-war-news/europe-starts-drafting-a-ban-on-russian-oil-imports">European Union boycotts</a> or reduces its dependence on Russian fuel. </p>
<p><a href="https://doi.org/10.2968/060002010">Roman statesman Cicero wrote</a>: “Nervos belli, infinitam pecuniam,” which loosely translates as “Successful war-waging capacity requires unlimited cash.”</p>
<p>And that means borrowed money. Wars usually end quickly without it.</p><img src="https://counter.theconversation.com/content/181139/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Michael A. Allen has received funding from the Department of Defense's Minerva Initiative, the US Army Research Laboratory, and the US Army Research Office.</span></em></p><p class="fine-print"><em><span>Matthew DiGiuseppe receives funding from the European Research Council. </span></em></p>Russia is on the verge of defaulting on its foreign debt, which not only could have severe economic consequences but could also complicate Putin’s ability to wage a prolonged war in Ukraine.Michael A. Allen, Associate Professor of Political Science, Boise State UniversityMatthew DiGiuseppe, Assistant Professor of International Relations, Leiden UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1722472021-11-22T15:30:06Z2021-11-22T15:30:06ZSouth Africa faces a slowly worsening chronic fiscal crisis<figure><img src="https://images.theconversation.com/files/432811/original/file-20211119-13-1caybnt.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">South Africa President Cyril Ramaphosa: His party's 2022 elective conference and the country's 2024 national elections will define political choices</span> <span class="attribution"><span class="source">Getty Images</span></span></figcaption></figure><p>South Africa’s National Treasury has done an excellent job in the <a href="http://www.treasury.gov.za/documents/mtbps/2021/">2021 medium term budget policy statement</a> of balancing the fiscal and political pressures forced on it by economic stagnation and the incoherence of government policy. <a href="https://www.businesslive.co.za/bd/opinion/2021-11-12-mokgatla-madisha-the-mtbps-delivered-for-the-markets-with-no-surprises/">Capital markets cheered</a> for two reasons. First the revenue numbers were substantially better than those presented in the February 2021 budget. This created potential fiscal space of about R132 billion in the current year, and R64 and R59 billion in the next two years respectively.</p>
<p>Second, Finance Minister Enoch Godongwana resisted political pressure for substantial commitments to permanent increases in spending. About R60 billion (or 1% of GDP) was added to the spending ceiling in 2021 and R30 billion over each of the next two years, less than half the value of the revenue improvement. Treasury also erred on the side of caution in projecting <a href="http://www.treasury.gov.za/documents/mtbps/2021/mtbps/Chapter%202.pdf#page=5">economic growth</a> and <a href="http://www.treasury.gov.za/documents/mtbps/2021/mtbps/Chapter%203.pdf#page=9">tax buoyancy</a>, which leaves substantial room for higher revenue and a lower deficit. <a href="http://www.treasury.gov.za/documents/mtbps/2021/mtbps/Glossary.pdf#page=8">Tax buoyancy</a> is a measure of relationship between total tax revenue collections and economic growth.</p>
<p>The increased spending is dominated by three items: wage increases for public servants, the extension of the social relief of distress grant, and President Cyril Ramaphosa’s <a href="https://www.gov.za/speeches/speaking-notes-minister-nxesi-announcement-phase-two-presidential-employment-stimulus-14">public works programme</a>. While Treasury <a href="http://www.treasury.gov.za/documents/mtbps/2021/mtbps/Chapter%201.pdf#page=7">presented each of these as temporary</a>, in all likelihood they amount to permanent increases in spending. Instead of conceding this reality in advance, the fiscal framework builds in large buffers of unallocated funds. </p>
<p>By holding back part of the spending increase in reserve, Treasury deftly provided space for the political leadership to make choices and confront real trade-offs while simultaneously clarifying Treasury’s own view of the fiscal constraints within which this debate should take place. </p>
<h2>Cabinet caught in the headlights</h2>
<p>An improved fiscal outlook that accommodates spending pressures is encouraging but there are two caveats. First, the chronic position of the country’s public finances continues to worsen. This can be seen in several metrics. Growth remains <a href="http://www.treasury.gov.za/documents/mtbps/2021/mtbps/Annexure%20A.pdf#page=2">far below interest rates</a> and GDP per capita is expected to continue stagnating. <a href="http://www.treasury.gov.za/documents/mtbps/2021/mtbps/Chapter%203.pdf#page=14">Debt service costs</a> are crowding out social spending.</p>
<p>Money owed by provincial governments to suppliers (largely for essential medical goods) is rising at a rapid rate. Most municipalities are in financial distress, with <a href="http://www.treasury.gov.za/documents/mtbps/2021/mtbps/Annexure%20A.pdf#page=4">uncollected revenues</a> reaching R232 billion. The fiscal crisis of local government feeds into the bankruptcy of public utilities, and the latter shows no sign of abating. </p>
<p>As long as Cabinet appears caught in the headlights, unable to offer a programme to overcome the grave operational and financial crises in the provision of municipal services, electricity, water, road construction, and passenger rail, declarations that <a href="https://ewn.co.za/2021/11/11/godongwana-no-more-easy-bailouts-just-tough-love-for-soes">“there will be no bailouts”</a> are posturing. The ongoing destruction of value must be reflected somewhere in the national balance sheet, even if it is not recognised in the budget.</p>
<p>Second, Treasury’s strategy to overcome this chronic fiscal crisis rests on highly uncertain political and economic foundations. The strategy proposed is a deep shock to public expenditure executed over the next two years –- 2022 to 2023. In real terms, core spending is set to contract by 4% each year. This amounts to reduction in real spending per capita of more than 10%.</p>
<p>The 2021 medium term budget policy statement tells us that following this short, sharp, shock to government consumption, the period of fiscal consolidation will be concluded. Having achieved a primary surplus, the national debt will stabilise, and expenditure increases will resume along a prudent path. </p>
<h2>Credibility of the fiscal framework</h2>
<p>This strategy depends on <a href="http://www.treasury.gov.za/documents/mtbps/2021/mtbps/Annexure%20B.pdf">a large reduction in the real incomes</a> of public servants and a fall in public employment. But the plan to hold down pay improvements this year has not worked out. Public servants negotiated an effective increase in average pay of more than 5%. This is in line with inflation. Also, headcount numbers have surged during the COVID-19 crisis, especially in the health sector. </p>
<p><a href="http://www.treasury.gov.za/documents/mtbps/2021/mtbps/Chapter%203.pdf#page=5">The idea</a> that public servants will accept the budgeted wage increases of 1.5% in 2022 and 2023 might be a good negotiating tactic but weakens the credibility of the fiscal framework. </p>
<p>This year South Africa is recovering from the COVID-19 shock and its economy is buoyed by a commodity boom. Public spending has also grown, albeit at a very low rate, providing some support to aggregate demand. Over the next two years, by contrast, Treasury is proposing a large negative fiscal impulse. In their forecast, a recovery in investment and sustained household demand will offset this fiscal contraction, resulting in a expansion in domestic expenditure.</p>
<p>But if these offsetting forces disappoint the proposed fiscal shock may be pro cyclical, slowing growth and raising unemployment. This would be the case if for instance the recovery in capital formation fails or global developments (such as deceleration in China and a tightening of global monetary policy) prove more adverse than currently assumed.</p>
<p>It’s true that a debt crisis and associated high interest rates dampen South African growth and point to the need for fiscal consolidation. But it is also true that a large and sustained consolidation – that is reducing government deficits and debt accumulation – will impede the recovery. </p>
<p>The consolidation as proposed in the medium term budget policy statement will also have problematic consequences for the supply side and long term growth. These depend on effective provision of basic education, criminal justice and healthcare. The deeper and more intense the contraction in spending, the more it will permanently scar these services. Public service reform is sorely needed to improve value for money, and it may well be argued that more spending won’t generate better social outcomes if the public service remains inefficient. But this says nothing about the impact of reduced spending. </p>
<p>The last ten years of <a href="https://www.econ3x3.org/article/part-1-fiscal-dimensions-south-africas-crisis">gnawing expenditure cuts</a> show that those with organised interests in the distribution of rent through the budget – public sector unions, business interests, and the political class – are quite capable of defending their share of the pie and passing the real costs of expenditure constraint on to the voiceless or unorganised. The temptation to engage in false economies, temporary measures, and unsustainable spending reductions will be huge over the next two years. </p>
<p>In theory, we might plan for a consolidation that is “growth friendly” for the economy and which limits the permanent damage of austerity on public services. But neither Treasury nor any other component of government have suggested such a programme. It would probably be prudent therefore to assume that it does not exist. The budget instrument that Treasury wields is blunt, the capacity of public administrators to manage the blow is weaker than ever, and unintended consequences will be widespread and debilitating. </p>
<p>The finance minister is proposing a decisive course correction in the fiscal accounts, followed by a steady path of expenditure prudence. In the context South Africa faces, it makes sense for Treasury to advance this clean and bright solution. It will help to negotiate the difficult choices government faces in the next two years. These choices include matters on which President Ramaphosa continues to hedge his bets for obvious political reasons – the public-sector wage agreement, the permanent extension of basic income support to working-age adults, and the resolution of the operational and financial crisis of public utilities.</p>
<p>The outcome is likely to be somewhere between Treasury’s negotiating position and imperatives that will define political choices. These choices will emerge as various factions jostle for supremacy in the 2022 ANC elective conference and the 2024 general elections. The most likely outlook remains a continuation along the current path of economic stagnation and slow worsening of South Africa’s chronic fiscal crisis.</p>
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A version of this article, <a href="https://www.econ3x3.org/sites/default/files/articles/Sachs%2C%20M_MTBPS_Nov21.pdf">The MTBPS clears some fiscal space but it is still a path through a swamp</a>, was first published by <a href="https://www.econ3x3.org/">Econ3x3</a>.__</p><img src="https://counter.theconversation.com/content/172247/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Michael Sachs does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>National Treasury’s strategy to overcome South Africa’s chronic fiscal crisis rests on highly uncertain political and economic foundations.Michael Sachs, Adjunct Professor, University of the WitwatersrandLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1552962021-02-16T01:38:21Z2021-02-16T01:38:21ZWould ‘COVID loans’ be a more affordable and sustainable way to support national economies?<figure><img src="https://images.theconversation.com/files/384332/original/file-20210215-23-1quv34u.jpg?ixlib=rb-1.1.0&rect=14%2C0%2C4875%2C3262&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">
</span> <span class="attribution"><span class="source">www.shutterstock.com</span></span></figcaption></figure><p>Faced with a COVID-19 pandemic of unknown severity and duration, governments around the world are looking for effective and sustainable ways to maintain economic confidence and employment. </p>
<p>Even New Zealand, where lockdowns have been few and short-lived, is confronting the reality of repeated lockdowns, especially since the United Kingdom variant has <a href="https://www.theguardian.com/world/2021/feb/15/new-zealands-auckland-covid-outbreak-is-uk-variant-says-ardern">now been detected</a> in community cases.</p>
<p>With vaccines likely to require all of 2021 to be <a href="https://www.health.govt.nz/our-work/diseases-and-conditions/covid-19-novel-coronavirus/covid-19-vaccines/covid-19-our-vaccine-roll-out-plan">rolled out in significant numbers</a>, more economic disruption has to be expected this year, with each successive shock further testing economic resilience.</p>
<p>For many countries, <a href="https://www.beehive.govt.nz/sites/default/files/2020-03/Wage%20subsidy%20scheme%20factsheet.pdf">targeted wage subsidies</a> of some form have been the principal tool for maintaining employment and economic confidence, often complemented by small business loans. While these have clearly been useful, they also have clear limitations — not least their cost. </p>
<p>This raises questions about the ongoing viability of wage subsidies and small business loans as the economic response measures of choice.</p>
<p>My recently published <a href="https://doi.org/10.1080/00779954.2021.1877185">policy paper</a> proposes an alternative approach, modelled on student loans schemes such as those operating in New Zealand, Australia and the UK. </p>
<p>Rather than attempting to support firms and households to pay wages, rents and other expenses, this alternative enables firms and households whose incomes have fallen due to the pandemic to take out government-supported “COVID loans” to restore their pre-pandemic income levels — a form of “revenue insurance”.</p>
<p>I argue this alternative approach will be not just more affordable and sustainable, but will also be more effective and more equitable.</p>
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<h2>Lowering the burden on future taxpayers</h2>
<p>Insuring small business and household revenues means they should be able to meet all their outgoings, not just wages and rents which are subject to selective support measures under the current approach. </p>
<p>Borrowers can simply determine which outgoings they need to prioritise, and access the resources they need to meet those costs.</p>
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Read more:
<a href="https://theconversation.com/close-contact-test-results-will-be-crucial-to-whether-aucklands-level-3-lockdown-is-extended-beyond-three-days-155289">Close contact test results will be crucial to whether Auckland’s level 3 lockdown is extended beyond three days</a>
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<p>This also simplifies administration, since only one support scheme is required, rather than multiple schemes. With <a href="https://www.parliament.nz/en/pb/research-papers/document/00PLLawrp13011/student-loan-scheme">student loan schemes</a> already in place in many countries, experience and infrastructure are available to support the rollout of the proposed loans.</p>
<p>Just as importantly, firms and households that take out COVID loans would effectively be borrowing against their own future incomes. This places less of a burden on future taxpayers than wage subsidies financed through extra government debt. </p>
<p>In turn this makes the approach more equitable than debt-financed wage subsidies, since that extra government debt is a charge against future generations.</p>
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<h2>More affordable for governments</h2>
<p>In terms of affordability, loans to make up drops in income would be repaid via tax surcharges on those taking out loans, as and when their future incomes allow. This means would-be borrowers need not be deterred by fixed repayment deadlines in times of ongoing economic uncertainty. </p>
<p>Furthermore, since any firms and households borrowing against their own future incomes will ultimately be repaying their debt, COVID loans represent an asset on government balance sheets. </p>
<p>This offsets the extra liabilities governments take on by borrowing to finance these loans — something wage subsidies do not do. This increases the affordability of a loans-based approach from a government perspective (even allowing for defaults and subsidies implicit in student loan schemes).</p>
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Read more:
<a href="https://theconversation.com/its-still-too-soon-for-nz-to-relax-covid-19-border-restrictions-for-travellers-from-low-risk-countries-154643">It's still too soon for NZ to relax COVID-19 border restrictions for travellers from low-risk countries</a>
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<p>Using illustrative data for New Zealand, my paper shows COVID loans are 14% cheaper than wage subsidies (and small business loans) in terms of their impact on net government debt. </p>
<p>More importantly, they are almost 2.5 times as effective in terms of the level of support they offer. And since 67% of the cost of COVID loans ultimately falls to those who make use of them (allowing for defaults and implicit subsidies), they place less of a burden on future taxpayers than deficit-funded wage subsidies.</p>
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<h2>Maintaining economic confidence</h2>
<p>Affordability is also enhanced by a subtle feature of the proposed scheme. By making COVID loans generally available to all firms and households, the scheme sustains economic confidence. </p>
<p>Firms and households are assured the other firms and households they rely on for their own economic prospects have access to the same effective financial lifeline throughout the pandemic.</p>
<p>Households can therefore keep spending confidently, and employers can confidently keep employing. This means the loans might actually not need to be used to any great extent. Their strength lies in preventing economic decline — much like a vaccine’s strength lies in preventing disease.</p>
<p>Finally, COVID loans are not just a sustainable policy tool for minimising the economic harm of COVID-19. They also provide a benchmark for assessing how cost-effective other support measures such as wage subsidies have been, and a possible solution for future pandemics.</p><img src="https://counter.theconversation.com/content/155296/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Richard Meade does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Instead of wage subsidy and business loan schemes, allowing households, workers and employers to borrow against future income could be more efficient and equitable in the long run.Richard Meade, Research Fellow in Economics, and in Social Sciences & Public Policy, Auckland University of TechnologyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1378622020-05-06T19:16:07Z2020-05-06T19:16:07ZPaying for the pandemic: Why the government’s massive coronavirus spending may not lead to higher taxes<figure><img src="https://images.theconversation.com/files/332908/original/file-20200505-83725-mllp4x.jpg?ixlib=rb-1.1.0&rect=0%2C13%2C2997%2C1983&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Canada's federal deficit has skyrocketed since the beginning of the coronavirus pandemic. How will Ottawa pay back the money its borrowed?</span> <span class="attribution"><span class="source">THE CANADIAN PRESS/Sean Kilpatrick</span></span></figcaption></figure><p>The Parliamentary Budget Officer recently released an <a href="https://www.pbo-dpb.gc.ca/en/blog/news/RP-2021-005-S--scenario-analysis-update-covid-19-pandemic-oil-price-shocks--mise-jour-analyse-scenario-chocs-dus-pandemie-covid-19-chute-prix-petrole">updated analysis of the coronavirus pandemic’s impact on the Canadian economy</a> that forecasts the federal budget deficit will be $252 billion in 2020-21, compared to $25 billion in 2019‑20.</p>
<p>Such a massive deficit would represent 12.7 per cent of Canada’s Gross Domestic Product. In comparison, the deficit for 2019-20 is expected to be be only 1.1 per cent of GDP, according to the PBO’s analysis.</p>
<p>The increase in the deficit is mainly caused by the fall in tax revenues resulting from the lockdown-induced recession and the extraordinary spending measures adopted by the government to support the economy and manage the pandemic. The PBO says these measures totalled $146 billion as of April 24.</p>
<p>So, where is the money for all this extra spending coming from?</p>
<p>With tax revenues down, the only option right now is borrowing. But who can lend the government such large sums? At what cost? And how are Canadians going to pay it all back? Is the federal government going to have to raise taxes and cut regular spending once the COVID-19 crisis is over?</p>
<h2>Cost to taxpayers should be minimal</h2>
<p>The good news is that the cost to Canadian taxpayers and beneficiaries of government services should be minimal. Canadians do not have to fear years of austerity from their federal government once the pandemic has passed.</p>
<p>Domestic and foreign financial institutions (banks, insurance companies, pensions funds and other investment funds) and large corporations are the federal government’s main lenders. They do so by buying bonds (essentially contracts where <a href="https://guides.wsj.com/personal-finance/investing/what-is-a-bond/">the borrower pays lenders or investors a fixed rate of return over a certain period of time</a>) from the federal government.</p>
<p>Demand and supply determine the interest rates the government pays to the investors on these bonds. If there is a lot of demand for the government’s bonds relative to their supply, then interest rates will be low. If demand is low, then interest rates will be high.</p>
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<img alt="" src="https://images.theconversation.com/files/332909/original/file-20200505-83779-u2qgam.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/332909/original/file-20200505-83779-u2qgam.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=404&fit=crop&dpr=1 600w, https://images.theconversation.com/files/332909/original/file-20200505-83779-u2qgam.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=404&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/332909/original/file-20200505-83779-u2qgam.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=404&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/332909/original/file-20200505-83779-u2qgam.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=508&fit=crop&dpr=1 754w, https://images.theconversation.com/files/332909/original/file-20200505-83779-u2qgam.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=508&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/332909/original/file-20200505-83779-u2qgam.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=508&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">Minister of Finance Bill Morneau looks on as Bank of Canada Governor Stephen Poloz responds to a question during a news conference in Ottawa during the coronavirus pandemic.</span>
<span class="attribution"><span class="source">THE CANADIAN PRESS/Adrian Wyld</span></span>
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<p>In the current context, we would expect the demand for Canadian government bonds to be low and their supply to be high. With the economy in recession because of the pandemic, financial institutions and most large companies are struggling. It’s likely they don’t have much spare cash to invest in the vast amounts of bonds offered by the federal government. As a result, the government would be expected to pay high interest rates on its extra COVID-19 borrowing to attract investors.</p>
<h2>Interest rates have dropped</h2>
<p>The reality is, however, the opposite. According to the Bank of Canada, <a href="https://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/">interest rates on government bonds have dropped</a> significantly in the past two months. Canadians can thank the Bank of Canada for this fortunate turn of events. The bank’s unprecedented actions to support the economy and financial markets during the COVID-19 crisis <a href="https://www.bankofcanada.ca/markets/market-operations-liquidity-provision/covid-19-actions-support-economy-financial-system/">have brought down the cost of borrowing</a>.</p>
<p>One such action is the <a href="https://www.bankofcanada.ca/2020/03/operational-details-for-the-secondary-market-purchases-of-government-of-canada-securities/">Government of Canada Bond Purchase Program</a>, whereby the Bank of Canada purchases a minimum of $5 billion worth of federal government bonds per week in the so-called secondary market (from financial institutions and corporations), as opposed to directly from the government itself (the primary market).</p>
<p>In doing so, Canada’s central bank has indirectly pushed up the demand for federal government bonds. In fact, it is as if the Bank of Canada was lending directly to the government at very low interest rates.</p>
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<span class="caption">This graph shows the average yield of three- to five-year Government of Canada Marketable Bonds. Borrowing costs for the federal government have dropped since the start of the coronavirus pandemic.</span>
<span class="attribution"><span class="source">(Bank of Canada)</span></span>
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<p>As a result, the federal government’s cost of borrowing is now lower than it was a couple months ago. For instance, it currently costs the government 0.35 cents for every dollar that it borrows for three to five years. Back in February, it was paying between 1.25 and 1.75 cents per dollar borrowed for the same period of time.</p>
<p>This means the annual cost of borrowing $252 billion for three to five years would be only $882 million, compared to the $3.8 billion it would have cost without the Bank of Canada’s actions. Such a sum would add only 0.04 per cent of GDP to the federal government’s future yearly deficits. It can, therefore, be easily absorbed without raising taxes or cutting regular program spending in the future.</p>
<p>But what about paying back all the extra debt? Won’t that require raising taxes and cutting spending for the foreseeable future? Not necessarily.</p>
<h2>Debt will be rolled over</h2>
<p>Assuming federal government spending and the Canadian economy go back to some kind of normal when the pandemic is over, then the government will simply be able to roll over its debt into the future and, therefore, not have to pay back any of it — possibly forever.</p>
<p>In other words, as long as investors are willing to buy the government’s bonds, then it can issue new bonds to pay back old bonds that are coming due. And if the economy grows faster than the deficit, then the debt-to-GDP ratio decreases, as it has in the last decade.</p>
<p>So Canadians will not have to suffer twice for the coronavirus pandemic: first by being locked down and then by paying higher taxes and/or experiencing cuts to regular federal government programs.</p>
<p>Instead, they should thank the government for doing the right thing by reducing the economic and social harm caused by the pandemic lockdown at little cost to future public finances. They should also thank the Bank of Canada <a href="https://www.ctvnews.ca/business/meet-tiff-macklem-the-new-bank-of-canada-governor-1.4920392">and its outgoing governor, Stephen Poloz</a>, for making it all possible.</p><img src="https://counter.theconversation.com/content/137862/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Patrick Leblond is affiliated with the Centre for International Governance Innovation. </span></em></p>Canada’s federal deficit has ballooned as Ottawa spends billions in response to the coronavirus pandemic. An economist explains why the massive spending will not harm Canadians in the future.Patrick Leblond, CN-Paul M. Tellier Chair in Business and Public Policy, L’Université d’Ottawa/University of OttawaLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/793362018-02-19T00:45:30Z2018-02-19T00:45:30ZExplainer: what are credit ratings and why do they matter?<p>A new report has <a href="http://asic.gov.au/about-asic/media-centre/find-a-media-release/2018-releases/18-042mr-asic-reports-on-credit-rating-agencies/">highlighted</a> room for improvement in Australian credit ratings agencies, including potential conflicts of interest, overseas staff producing credit ratings, and failures to meet compliance standards. </p>
<p>Having effective credit ratings agencies is vital for Australia, as they assess the creditworthiness of governments, corporations, banks and other entities that wish to raise funds by issuing debt.</p>
<p>The agencies’ decisions can have knock-on effects throughout the economy. The ability of governments to borrow money has an impact on investors and companies, and companies pass on the cost of borrowing to their customers. </p>
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<a href="https://theconversation.com/why-we-should-be-wary-of-ratings-agencies-5482">Why we should be wary of ratings agencies</a>
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<p>Ratings agencies are trying to represent not only the ability of borrowers to repay their loans, but also the willingness to repay on time. </p>
<p>Ratings are given as a ranking. AAA is the highest, then AA and A, right through to C and then D (default).</p>
<p>The lower your credit rating the riskier you are deemed to be and the higher the interest rates charged. Some institutional investors (such as pension funds) are not allowed to hold debt with a credit rating of BB or below.</p>
<p>The exact methodology used by the ratings agencies is not publicly released. But ratings are based on a mix of public information and private information provided by the debt issuers.</p>
<p>When it comes to giving the federal government a rating, agencies will use publicly available economic data such as economic growth, income per capita and unemployment and inflation rates. This gives the agency an idea of the current state of the economy, as well as where it might be in the short and long term. </p>
<p>Agencies will also look at the federal government’s budget. They will consider the gap between revenues and expenditures, when the government’s debts are due, and the quality of assets that the government could sell off.</p>
<p>Lastly, the agency will look at the wider economic and political context. This includes the quality of financial regulators and levels of corruption and political stability. It also includes potential internal or external vulnerabilities, such as an economic slowdown in China or the possibility of a trade war. </p>
<p>All of these factors have an impact on the ability and willingness to repay debt, even if they are beyond the government’s control. </p>
<p>Similar considerations are applied to the credit ratings of banks and other large corporations. But the agency would also consider how likely it is that the government would bail out the company in a crisis. There is <a href="http://fsi.gov.au/files/2014/12/FSI_Final_Report_Consolidated20141210.pdf">a perception</a>, for example, that the government would bail out the big four banks.</p>
<h2>The impact of credit ratings</h2>
<p>Last year S&P put Australia on a “<a href="https://www.globalcreditportal.com/ratingsdirect/renderArticle.do?articleId=1882241&SctArtId=431333&from=CM&nsl_code=LIME&sourceObjectId=10163378&sourceRevId=3&fee_ind=N&exp_date=20270713-21:07:43">negative outlook</a>”, meaning the federal government’s AAA credit rating could be downgraded. </p>
<p>The immediate impact of a credit rating downgrade is that the interest rates paid by the federal government will go up. But <a href="http://isiarticles.com/bundles/Article/pre/pdf/23556.pdf">research shows</a> that a federal government ratings downgrade has wide-ranging impacts.</p>
<p>The credit ratings of both banks and many corporations are tied to the federal government’s. This means a federal government downgrade will have impacts on many companies, investors and individual borrowers.</p>
<p>Share markets would be affected, but so would other borrowers, including foreign governments. </p>
<p>Further, the credit assessments of governments and banks are <a href="http://onlinelibrary.wiley.com/doi/10.1111/jofi.12206/abstract">often intertwined</a>, especially in times of financial crises.</p>
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Read more:
<a href="https://theconversation.com/australia-could-be-about-to-lose-its-aaa-rating-and-heres-why-62039">Australia could be about to lose its AAA rating, and here's why</a>
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<p>The link between governments and banks can create a negative feedback loop. A downgrade for either banks or governments increases bank borrowing costs. This makes it more likely banks will need to be bailed out by the government in the near future. This puts more pressure on the government’s finances, which could lead to another government credit rating downgrade. </p>
<p>But a downgrade doesn’t affect only banks. Recent <a href="http://onlinelibrary.wiley.com/doi/10.1111/jofi.12434/full">research</a> shows that when a government’s credit rating is downgraded, companies with similar credit ratings also see a ratings change, even if there is no fundamental change in their own creditworthiness. </p>
<p>Again, there is a negative feedback loop. A government credit rating downgrade leads to downgrades for corporations. The corporations, faced with increased borrowing costs, will respond by cutting back on new investments, which slows down the real economy. The slowdown in the economy will put more pressure on the government’s credit rating.</p>
<p>And on top of all that, when banks face higher borrowing costs, they either pass this on to households and investors in the form of higher lending rates and/or cut back on their <a href="https://academic.oup.com/rfs/article-abstract/29/7/1709/2607032/Bank-Ratings-and-Lending-Supply-Evidence-from?redirectedFrom=fulltext">lending</a>. </p>
<p>This, of course, also has the effect of slowing down the economy, creating a double whammy.</p>
<p>So you can see that ratings agencies play an important role in the economy. </p>
<p>The Australian Securities and Investment Commission has made a number of <a href="http://asic.gov.au/about-asic/media-centre/find-a-media-release/2018-releases/18-042mr-asic-reports-on-credit-rating-agencies/">recommendations</a> to improve governance within credit ratings agencies, to make them more informative and reliable. Adopting these will go a long way to further restore market confidence in the ratings agencies and improve investor protection.</p><img src="https://counter.theconversation.com/content/79336/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Eliza Wu receives funding from the Australian Research Council. </span></em></p>Robust credit ratings agencies are vital for the Australian economy, as the repercussions of their decisions are felt far and wide.Eliza Wu, Associate Professor in Finance, University of SydneyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/746542017-03-15T15:50:51Z2017-03-15T15:50:51ZWhy higher interest rates should make you happy<p>The <a href="https://www.federalreserve.gov/newsevents/press/monetary/20170315a.htm">Federal Reserve just lifted short-term interest rates</a> a quarter point and signaled that more hikes are to come over the course of the year.</p>
<p>The Federal Open Market Committee raised its benchmark lending rate to a range of 0.75 percent to 1 percent, as expected, and <a href="https://www.bloomberg.com/news/articles/2017-03-15/fed-raises-benchmark-rate-as-inflation-approaches-2-target">projected</a> two more increases would be likely in 2017.</p>
<p>Numerous commentators have focused on <a href="https://www.nytimes.com/2017/03/14/business/economy/consumer-interest-rates-federal-reserve.html?_r=1">who is hurt</a> by rising rates, particularly those with lots of floating rate debt, such as a credit card balance, or anyone in need of a loan. </p>
<p>Not everyone, however, is negatively affected by rising rates.</p>
<p>There are some individuals and businesses cheering the <a href="https://www.federalreserve.gov/">Fed</a> on as it pushes up rates, including savers, people traveling abroad and foreign exporters and businesses with large cash balances.</p>
<p>Let’s look at why each group may be celebrating the Fed’s action with a <a href="https://u.osu.edu/zagorsky.1/2013/12/17/what-size-champagne-should-we-buy-for-holidays/">champagne toast</a>.</p>
<h2>Savers are happy</h2>
<p>Interest is the economic inducement – or bribe – that compensates savers for waiting to spend their money in the future instead of squandering it today. </p>
<p>For <a href="https://fred.stlouisfed.org/series/FEDFUNDS">eight years</a>, the Fed has been giving us virtually no inducement to save because its target interest rate has hovered around zero ever since the 2008 financial crisis. People have been essentially punished for saving money because inflation meant at times you’d be better off stuffing cash in your mattress than in a savings account. </p>
<p>Rising rates means people who save money in certificates of deposits, money market funds and bank accounts will see higher returns. Many elderly people and retirees <a href="http://www.mitpressjournals.org/doi/abs/10.1162/REST_a_00140">live off</a> their Social Security checks <a href="http://www.aarp.org/content/dam/aarp/research/public_policy_institute/econ_sec/2013/sources-of-income-for-older-americans-2012-fs-AARP-ppi-econ-sec.pdf">plus interest and dividends from their savings</a>. Retirees and people with large amounts of cash savings will now earn more money, which enables them to spend more and makes them big fans of the Fed’s current policy.</p>
<p>Even if you don’t have a single penny in savings but live or work in an area with a large number of retirees like southern Florida, Arizona or parts of California, the higher rates should translate into <a href="http://onlinelibrary.wiley.com/doi/10.1111/j.1468-2257.1992.tb00572.x/full">more economic activity and thus more jobs</a>.</p>
<h2>Travelers and importers are happy</h2>
<p>Another group that should experience an immediate benefit includes importers and people traveling abroad because interest rate changes usually affect a <a href="http://www.jstor.org/stable/1831272">country’s foreign exchange rate</a>. </p>
<p>When rates rise in the U.S., the dollar tends to go up in value, which means it can buy more foreign currency. This makes traveling to other parts of the world cheaper. </p>
<p>In a nutshell, higher rates mean higher yields on U.S. bonds, mutual funds and certificates of deposit, making them more <a href="http://www.jstor.org/stable/1816176">attractive to foreign investors</a>. These investors need dollars to buy U.S. investments and are willing to give up their euros, yen, Swiss francs and other currencies to get ahold of them. By boosting the demand for dollars, the greenback appreciates, and suddenly that trip to Majorca is <a href="http://www.post-gazette.com/business/money/2016/12/13/Strong-dollar-gives-U-S-travelers-more-bang-for-their-buck/stories/201612090064">looking more affordable</a> as fancy Spanish restaurants, flamenco shows, hotels and taxi rides become cheaper, in dollar terms. </p>
<p>This also makes people who <a href="http://businessmacroeconomics.com/">export</a> goods to the U.S. – essentially foreign companies – much happier as well at the expense of U.S. companies. Swiss chocolates, Korean phones, Chinese textiles, German beer and many other items will become cheaper for people in the U.S., meaning it should make Americans who prefer these items to their domestic counterparts happy too. </p>
<p>And since a boost in exports supports economic activity in countries selling these items, many foreign governments are also big fans of the Fed’s current policy.</p>
<h2>Companies with cash are happy too</h2>
<p>A third group that benefits are businesses with <a href="https://www.ft.com/content/368ef430-1e24-11e6-a7bc-ee846770ec15">large cash reserves</a>. </p>
<p>Nonfinancial companies in the Standard & Poor’s 500 index <a href="https://insight.factset.com/hubfs/Cash%20and%20Investment%20Quarterly/Cash%20and%20Investment%20Quarterly%20Q3%202016_12.21.16_v2.pdf">had about US$1.54 trillion in cash and cash equivalents</a> as of Sept. 30 of last year. </p>
<p>Companies with large cash reserves do not let their money sit in a vault gathering dust. Instead, the money is often put into short-term investments that earn interest. When interest rates go up, they make extra earnings on their cash balances. This increase in profits, without a company doing any extra work, makes some CEOs fans of the Fed’s current policy.</p>
<p>In addition, there are a <a href="http://www.npr.org/sections/money/2010/03/warren_buffett_explains_the_ge.html">number of companies that bill</a> customers up front and then make payments much later. Insurance companies are one example. People pay for their insurance policies first and then, if disaster strikes in the future, the insurance company pays out a claim. This means <a href="https://www.chicagofed.org/publications/chicago-fed-letter/2013/april-309">insurance companies hold large amounts of money</a> for long periods of time that they’re hoping earns a good return.</p>
<p>So when rates rise, insurance companies become more profitable as they earn more money on every dollar of cash they have to set aside to cover an eventual claim. As a result, insurers like it when the Fed wants to tighten monetary policy and lift rates. </p>
<h2>It takes two</h2>
<p>Many people’s first reaction when hearing that interest rates are <a href="http://www.seattletimes.com/business/real-estate/panicking-seattle-home-buyers-spooked-by-rising-interest-rates-rush-to-buy/">rising is one of panic</a> and dread.</p>
<p>The result is less cash sloshing around in the system, which makes mortgages, car loans and credit lines all more expensive. In other words, borrowers take it in the teeth.</p>
<p>However, like most things in life, there are two sides to every story. For every individual, business and government that is borrowing money, however, someone else is lending it. Another name for lenders is savers who want to invest the money they’re setting aside for future use and make a little (or big) return in the meantime. </p>
<p>Savers and many other groups are cheering the rise in rates, which helps move the U.S. back to a more <a href="https://www.chicagofed.org/publications/speeches/2016/08-31-are-low-monetary-policy-rates-the-new-normal-beijing">“normal” interest rate policy</a> – the recent period of near-zero rates has been unprecedented – and also signals the economy is on a surer footing. That should make all of us, even borrowers, a bit happier.</p><img src="https://counter.theconversation.com/content/74654/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Jay L. Zagorsky does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>While borrowers may not be thrilled by the Federal Reserve’s decision to raise rates, many of us have plenty of reason to celebrate.Jay L. Zagorsky, Economist and Research Scientist, The Ohio State UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/475442015-09-17T04:04:26Z2015-09-17T04:04:26ZWhy the Fed is no longer center of the financial universe<p>Markets have been <a href="http://www.nytimes.com/2015/07/30/business/economy/federal-reserve-meeting-interest-rates.html?_r=3">speculating</a> for months about whether the US Federal Reserve would raise interest rates in September. The day has finally arrived, and interestingly, there’s much less certainty now about which way it will go than there was just a few weeks earlier.</p>
<p>In August, more than three-quarters of economists <a href="http://www.bloomberg.com/news/articles/2015-08-13/september-fed-rate-rise-still-seen-as-economists-shrug-off-yuan">surveyed</a> by Bloomberg expected a rate hike this month. Now, <a href="http://www.bloomberg.com/news/articles/2015-09-15/u-s-index-futures-fall-as-investors-await-data-fed-decision">only about half</a> do. Traders were also <a href="http://www.cmegroup.com/trading/interest-rates/fed-funds.html">more certain</a> back then, putting the odds at about 50-50. Now the likelihood of a rate hike based on Fed Funds Futures is about one in four. </p>
<p>The Federal Reserve may be on the verge of lifting rates for the first time in more than nine years because <a href="http://www.tradingeconomics.com/united-states/unemployment-rate">unemployment</a> has dropped to pre-crisis levels, the housing market is the healthiest it’s been in <a href="http://www.rhodesvannote.com/buying-a-home/housing-market-is-healthiest-in-years/">15 years</a> and the economic recovery, while tepid, has continued.</p>
<p>Investors’ and economists’ uncertainty, meanwhile, has been fueled by <a href="http://www.washingtonpost.com/business/economy/why-the-feds-easy-money-era-may-continue/2015/08/25/411dc17c-4b5e-11e5-84df-923b3ef1a64b_story.html">weak growth</a> in China, Europe and Latin America, giving the Fed pause about whether now’s the right time to start the return to normal. </p>
<p>There is growing alarm that a rate hike will make things even worse for the rest of the world. The Fed risks <a href="http://www.latimes.com/business/la-fi-federal-reserve-world-bank-interest-rate-20150909-story.html">creating</a> “panic and turmoil” across <a href="https://theconversation.com/does-the-global-stock-market-sell-off-signal-the-bric-age-is-already-over-46550">emerging markets</a> such as China and India and <a href="http://www.telegraph.co.uk/finance/economics/11858952/BIS-fears-emerging-market-maelstrom-as-Fed-tightens.html">triggering</a> a “global debt crisis.” </p>
<p>The reality, however, will likely be very different. For one, the Fed lacks the power it once did, meaning the actual impact of a rate hike will be more muted than people think. Second, the effect of uncertainty and speculation may be far <a href="https://theconversation.com/explainer-why-stocks-fall-when-the-fed-considers-raising-interest-rates-47457">worse</a> than an actual change in rates, which is why central bankers in emerging markets <a href="http://www.ft.com/intl/cms/s/0/e88abe7a-56e3-11e5-9846-de406ccb37f2.html#axzz3lv7aPefN">are pushing</a> their American counterparts to hurry up and raise them already. </p>
<h2>The Fed’s waning influence</h2>
<p>The Fed, and more accurately the rate-setting Federal Open Market Committee (FOMC), is simply no longer the center of the universe it once was, because the central banks of China, India and the <a href="http://ec.europa.eu/economy_finance/euro/emu/how/index_en.htm">eurozone</a> have all become monetary policy hubs in their own right. </p>
<p>The US central bank may still be preeminent, but the People’s Bank of China, the Reserve Bank of India, and the European Central Bank are all growing more influential all the time. That’s <a href="http://www.eastasiaforum.org/2013/11/22/why-the-peoples-bank-of-china-is-stronger-than-you-think/">particularly true</a> of China’s central bank, which boasts the world’s largest stash of foreign currency reserves (about <a href="http://qz.com/492940/what-if-the-fed-cant-raise-interest-rates/">US$3.8 trillion</a>) and increasingly hopes to make its influence felt beyond its borders.</p>
<p><a href="http://www.spiegel.de/international/business/central-banks-ability-to-influence-markets-waning-a-964757.html">Some argue</a> that central banks in general, not just the Fed, are losing their ability to affect financial markets as they intend, especially since the financial crisis depleted their arsenal of tools. Those emergency measures resulted in more than a half-decade of near-zero interest rates and a world <a href="https://research.stlouisfed.org/fred2/series/WCURCIR/">awash in US dollars</a>. And that poses another problem. </p>
<h2>Can the Fed even lift rates anymore?</h2>
<p>The old toolkit of market leverage that the Fed used is losing relevance since the FOMC has not raised rates since 2006. And it has rather frantically been trying to <a href="http://dailyreckoning.com/the-central-bank-experiment-thats-destroying-the-economy/">experiment</a> with new methods to affect markets.</p>
<p>The Fed and the market (including companies and customers) are beginning to understand that it’s not a given that the Fed can even <a href="http://qz.com/492940/what-if-the-fed-cant-raise-interest-rates/">practically raise rates</a> any more, at least not without resorting to rarely or never-tried policies. That’s because its primary way to do so, removing dollars from the financial system, has become a lot harder to do.</p>
<p>Normally, one way the Fed affects short-term interest rates is by buying or selling government securities, which decreases or increases the amount of cash in circulation. The more cash in the system, the easier (and cheaper) it becomes to borrow, thus reducing interest rates, and vice versa. </p>
<p>And since the crisis, the Fed has added an enormous quantity of cash into the system to keep rates low. Removing enough of that to discourage lending and drive up rates <a href="http://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.html?_r=0">won’t be easy</a>. To get around that problem, it plans to essentially pay lenders to make loans, but that’s an unconventional approach that may not work and on some level involves adding more cash into the equation. </p>
<h2>Uncertainty and speculation</h2>
<p>In addition, the uncertainty and speculation about when the Fed will finally start the inevitable move toward normalization may be worse than the move itself.</p>
<p>As Mirza Adityaswara, senior deputy governor at Indonesia’s central bank, <a href="http://www.ft.com/intl/cms/s/0/e88abe7a-56e3-11e5-9846-de406ccb37f2.html#axzz3lv7aPefN">put</a> it: </p>
<blockquote>
<p>We think US monetary policymakers have got confused about what to do. The uncertainty has created the turmoil. The situation will recover the sooner the Fed makes a decision and then gives expectation to the market that they [will] increase [rates] one or two times and then stop.</p>
</blockquote>
<p>While the timing of its first hike is important – and the sooner the better – the timing of the second is <a href="http://www.bloomberg.com/news/articles/2015-07-29/september-december-fed-s-not-saying-and-bond-traders-care-less">more so</a>. This will signal the Fed’s path to normalization for the market (that is, the end of an era of ultra-low interest rates).</p>
<p>Right now, US companies appear <a href="http://blogs.barrons.com/incomeinvesting/2015/09/11/companies-rush-to-issue-debt-ahead-of-rate-hike/">ready</a> for a rate hike because the impact on them will be negligible, and some investors <a href="http://www.thefiscaltimes.com/latestnews/2015/09/16/Top-performing-US-large-cap-fund-bets-interest-rate-hike">are also betting</a> on it. </p>
<p>That’s no surprise. Companies have borrowed heavily in recent years, allowing them to lock in record-low rates and causing their balance sheets to bulge. This year, <a href="http://www.wsj.com/articles/u-s-bond-issuance-nears-1-trillion-1408651952">corporate bond sales</a> are on pace to have a third-straight record year, and currently tally about $1 trillion. Most of that’s fixed, so even if rates go up, their borrowing costs won’t change all that much for some time. </p>
<p>At the end of 2014, non-financial companies <a href="https://www.moodys.com/research/Moodys-US-non-financial-corporates-cash-pile-grows-to-173--PR_324721">held</a> a record $1.73 trillion in cash, double the tally a decade ago, according to Moody’s Investors Service. </p>
<p>Beyond the US, there are reports that <a href="http://www.scmp.com/business/markets/article/1857716/us-fed-rate-rise-not-big-blow-chinese-companies">Chinese</a> and <a href="http://www.financialexpress.com/article/markets/indian-markets/fed-rate-hike-impact-only-2-6-pct-large-companies-may-face-liquidity-issue/136953/">Indian</a> companies are ready for a rate hike as well. </p>
<h2>Foregone conclusion</h2>
<p>So for much of the world, a hike in rates is already a foregone conclusion – the risk being only that the <a href="http://money.cnn.com/2015/09/12/investing/federal-reserve-interest-rates-stocks">Fed doesn’t see it</a>. The important question, then, is how quickly, or slowly, should the pace of normalization be. While the Fed may find it difficult to make much of an impact with one move, the pace and totality of the changes in rates will likely make some difference. </p>
<p>But the time to start that process is now. It will <a href="http://www.marketwatch.com/story/heres-why-the-rest-of-the-world-should-welcome-a-fed-rate-increase-2015-09-16">end the uncertainty</a> that has embroiled world markets, strengthen the dollar relative to other currencies, add more flexibility to the Fed’s future policy-making and, importantly, mark a return to normality.</p><img src="https://counter.theconversation.com/content/47544/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Tomas Hult receives funding from U.S. Department of Education, National Science Foundation, and Michigan Economic Development Corporation. He is also Executive Director of the Academy of International Business, President of the Sheth Foundation, and serves on the US District Export Council.</span></em></p>Market speculation on whether the Fed will raise rates is reaching fever pitch, but the central bank no longer has the pull it once did.Tomas Hult, Byington Endowed Chair and Professor of International Business, Michigan State UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/474572015-09-15T04:12:00Z2015-09-15T04:12:00ZExplainer: why stocks fall when the Fed considers raising interest rates<p>A top-level committee of the <a href="http://www.federalreserve.gov/">Federal Reserve</a>, the US’ central bank, is <a href="http://www.federalreserve.gov/aboutthefed/boardmeetings/20150915advexp.htm">meeting this week</a> to discuss when it should begin <a href="https://theconversation.com/should-the-fed-raise-rates-wrong-question-heres-the-right-one-45813">raising interest rates</a>. </p>
<p>Often when a central bank lifts rates, the country’s stock market falls. When the central bank cuts them, share prices go up. Typically this occurs well in advance of the actual change because investors are making bets on what they think will happen. And sometimes this seems counterintuitive, because a central bank usually raises rates when an economy is strengthening and lowers them when it’s weaker. </p>
<p>For example, at the end of July, the Standard & Poor’s 500 <a href="http://www.latimes.com/business/la-fi-us-markets-20140801-story.html">plunged</a> 2% after a report signaling an improving US economy convinced traders the Fed was more likely to raise its target interest rate sooner rather than later. The <a href="http://www.chicagotribune.com/business/yourmoney/ct-marksjarvis-0311-biz-20150310-column.html">same thing</a> has played out <a href="http://money.cnn.com/2015/03/06/investing/stocks-market-jobs-fed-rate-hike/">repeatedly</a> this year – stocks rising on signs the Fed will keep rates at about zero; shares sliding when it appears the central bank will raise them. </p>
<p>Why does the stock market react like this? The answer is because of an idea called “present value.”</p>
<h2>What’s in a share</h2>
<p>The value of a company’s shares is based on its profits, which are the difference between a company’s earnings or revenue and its costs. For example, if the <a href="https://twitter.com/Prof_Jay_Z">Professor JayZ</a> Company is able to sell US$10 million of products and it costs the company $7 million to make and distribute them, then the profits are $3 million.</p>
<p>Let’s start off simply and assume that after earning $3 million, the company distributes all profits to shareholders and then closes down. Let’s also make another simple assumption that there is just one share of stock available. This means whoever owns the single share gets the entire $3 million profit.</p>
<p>If the price for the single share was $1,000, everyone would definitely want to buy the stock because anyone getting the share would earn almost $3 million from the trade. Even at $1 million, we’d all still want to buy the stock because the trade still results in a tidy gain of $2 million. </p>
<p>If there was an efficient stock market with good information available to all traders, the share price would eventually rise toward $3 million. No trader would pay more than $3 million, because above that level, he or she would lose money. In this very simple world, the price of the share of stock is simply the company’s profits.</p>
<p>Now, in real life, few companies exist just for a single year and then close. Instead, the vast majority exist for many years. What happens if the Professor JayZ Company exists for two years and each year earns $3 million in profits? </p>
<p>Clearly people are willing to bid more for the stock now since they will be getting a larger amount of money. However, they will have to wait some time before getting all their money, so they wouldn’t want to pay $6 million. Forcing people to wait has a cost, since traders pay for the stock today and then get the profits or dividends later.</p>
<p>Waiting is a problem because money received in the future is not worth as much as today. The simplest way to see this is to imagine winning a million dollars today. How would your excitement change if you still won that million dollars, but the prize money wouldn’t arrive for 25 years? Most people are much less interested, because a lot can happen in 25 years. Having to wait makes the prize less valuable.</p>
<h2>How present value works</h2>
<p>A math formula called “present value” (a good calculator is <a href="http://www.investopedia.com/calculator/pvcal.aspx">here</a>, web page <a href="http://www.mathsisfun.com/money/net-present-value.html">here</a>, video <a href="https://www.youtube.com/watch?v=7FsGpi_W9XI">here</a>, book <a href="http://businessmacroeconomics.com/">here</a>) shows exactly how much less valuable money received in the future is compared with money received today. </p>
<p>The idea behind the formula is simple: present value is the amount of money someone would accept today instead of getting some larger amount in the future.</p>
<p>For example, if the interest rate is 5% and a person is expecting a $3 million profit from the JayZ Company in one year, then the present value is close to $2.86 million. Why $2.86 million? This is the amount of money that, when put in a bank with 5% interest, grows to $3 million one year from now. </p>
<p>However, if interest rates rise to 10%, the present value is only $2.73 million. A smaller amount needs to be put in a bank because the higher rate produces more interest.</p>
<p>When interest rates rise from 5% to 10%, investors value the profits earned one year from now by the JayZ company much less and are not willing to pay as much for the outstanding share of stock. When interest rates go up, share prices fall because the present value of profits earned in future years is lower. Future profits are lower because investors can put smaller amounts in the bank to earn a targeted amount.</p>
<p>The present value formula provides very precise estimates of what stocks are worth when interest rates are known. However, no one is able to accurately <a href="http://www.wsj.com/articles/wsj-survey-most-economists-predict-fed-will-stay-on-hold-in-september-1441980000">predict future interest rates</a>. This means some traders are using high interest rates to calculate the present value of profits, while others are using low rates. As people change their expectations of future rates, stocks often move wildly.</p>
<h2>Interest rates and profits</h2>
<p>Beyond their importance in calculating present value, interest rates have another important impact on stock prices. Many companies borrow heavily to finance their activities. </p>
<p>Much corporate borrowing is not at fixed interest rates but instead at rates that change based on market conditions (floating rates). If the market interest rate goes up, then these borrowers pay more interest. Increases in interest rates mean costs rise, profits fall and share prices are reduced. Conversely, when interest rates fall, many companies report higher profits without changing any other aspect of their business, boosting their share price.</p>
<p>In general, stock prices are inversely related to interest rates. If everything else stays constant and you believe interest rates will rise, sell stocks now. If you believe interest rates will fall, buy stocks now. </p>
<p>Unfortunately, since it is difficult to accurately forecast future interest rates and all the other factors that are changing simultaneously in financial markets, this algorithm by itself will not make you instantly rich. And this week’s decision by the Fed could go either way because there is broad disagreement about whether the economy is strong enough to handle a rate hike – among many other factors influencing its decision.</p>
<p>Nevertheless, understanding how interest rates or expectations about future interest rates affect the value of stocks is useful because it explains why the stock market changes dramatically when central banks adjust their interest rate policies.</p><img src="https://counter.theconversation.com/content/47457/count.gif" alt="The Conversation" width="1" height="1" />
Whenever speculation grew louder that the Federal Reserve would lift its target interest rate this year, stocks took a dive. Here’s why.Jay L. Zagorsky, Economist and Research Scientist, The Ohio State UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/313242014-09-23T11:28:47Z2014-09-23T11:28:47ZLabour bid to break from the past ignores the fiscal reality<p>Ed Miliband is trying to wrestle back the political initiative in Manchester. The leader of the opposition must avoid becoming <a href="http://www.bbc.co.uk/news/uk-politics-29306231">mired in deeply complex constitutional questions</a> of devolution at his party’s annual conference – and top of the agenda right now seems to be regaining public trust in Labour’s ability to run the economy. </p>
<p><a href="http://uk.reuters.com/article/2014/09/22/uk-britain-politics-labour-balls-idUKKBN0HG0VG20140922">Ed Balls sought to do that</a> with a keynote speech on Monday which borrowed some of its language on cuts from the coalition government, and there has been a conscious effort to distance the current leadership from the so-called “mistakes” of the past. The problem is that the argument doesn’t stand up to scrutiny, however much it might make electoral sense. </p>
<p><a href="http://www.theguardian.com/politics/2014/sep/01/gordon-brown-labour-lost-credibility-economy">According to Chuka Umunna</a>, Labour shadow minister for business, the UK’s 2010 general election was lost because Gordon Brown failed to make the promise of cuts. Umunna reckons Labour is still struggling to shake off Brown’s Labour legacy of being an anti-cuts party. In Umunna’s opinion, Gordon Brown should have said that the election would be “between Labour cuts and Tory cuts”.</p>
<p><a href="http://www.bbc.co.uk/news/uk-politics-29004196">In a recent speech</a> Umunna said:</p>
<blockquote>
<p>Gordon Brown dealt a blow to Labour’s economic credibility by wrongly giving the impression in his final year as prime minister that the party failed to understand the importance of tackling Britain’s unprecedented peacetime budget deficit.</p>
</blockquote>
<h2>Major precedent</h2>
<p>Umuuna’s economic analysis requires some factual clarification. First, the budget deficits during the last two years of the Brown government were not “unprecedented” in peacetime. A quite similar fiscal outcome occurred under the government of John Major in the first half of the 1990s, and highlight how much better Gordon Brown handled the situation.</p>
<p>Let’s take a look at the numbers. Which of these deficit experiences was “worse” – 1992-94 or 2009-11 – depends on how you measure the fiscal balance. The chart below traces the values of two fiscal balance measures, the overall balance and the balance on the current account. The difference between the two is expenditure for public investment. The chart shows that for fiscal year 1992-93 the overall balance reached minus 8.1% of GDP, compared to minus 10.9% in 2009-10.</p>
<p>No one can dispute that -10.9% was a larger deficit in GDP than -8.1%. But during the 1992-93 fiscal year the UK economy grew, at an annual rate of more than 2%. In contrast, during 2009-2010 the UK economy contracted by more than 2%.</p>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/59592/original/g46b2krj-1411137838.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/59592/original/g46b2krj-1411137838.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/59592/original/g46b2krj-1411137838.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=360&fit=crop&dpr=1 600w, https://images.theconversation.com/files/59592/original/g46b2krj-1411137838.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=360&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/59592/original/g46b2krj-1411137838.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=360&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/59592/original/g46b2krj-1411137838.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=452&fit=crop&dpr=1 754w, https://images.theconversation.com/files/59592/original/g46b2krj-1411137838.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=452&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/59592/original/g46b2krj-1411137838.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=452&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption">Overall Fiscal Balance and Balance on Current Expenditure, 1986/87 - 2013/14.</span>
<span class="attribution"><a class="source" href="http://www.ons.gov.uk/ons/rel/psa/public-sector-finances/public-sector-finances---september-2013/stb---september-2013.html">John Weeks | Data: Public Sector Finances, Office of National Statistics</a>, <a class="license" href="http://creativecommons.org/licenses/by-nd/4.0/">CC BY-ND</a></span>
</figcaption>
</figure>
<h2>Relative values</h2>
<p>You do not need deep knowledge of fiscal policy to infer that overseeing a large deficit when the economy expands is a considerably worse record that suffering a similar deficit when the economy contracts. Growth should increase revenue, while contraction reduces it. Viewed in context, the fact that the overall deficit in 2009-2010 was just 2.8% greater seems a better than expected outcome.</p>
<p>As any business person knows, borrowing is the rational way to finance investment. If the investment is profitable, the output it generates covers the servicing of the loan taken to finance it. If it is not profitable, the investment should not be undertaken, however it would be financed.</p>
<p>This guideline should apply to governments as well as the private sector. It should certainly be endorsed by those who think that the public sector should act more according to “business principles”. Brown stated his commitment to the borrow-to-invest principle in his first budget speech of 1997, which became known as his “Golden Rule”. To my knowledge no prominent politician in Britain took Brown to task for applying this rule to his budgets.</p>
<p>As the chart shows, the Conservative government during the ten years 1988-1997 were not trying to keep to Brown’s Golden Rule. During the fiscal year 1993-94 the deficit on the current account (omitting investment) reached more than 9% of GDP, compared to 7.7% in 2009-10. The earlier deficit was associated with the economy growing by more than 3% (during 1993-94), while it contracted during 2009-2010.</p>
<p>Finally, when considering which the two deficit experiences, we can consider the implication of the current account deficit exceeding the overall deficit in the mid-1990s. By definition, this means that public investment under John Major’s government was negative (less than the depreciation of public assets). It was not until about 1998 that public investment turned positive. This performance on public infrastructure may explain why Gordon Brown in 2010 would have posed the dichotomy, Tory cuts versus Labour investment.</p>
<h2>Heading for a fall</h2>
<p>Umunna’s call to “tackle the deficit” by implementing budget cuts implies that if public expenditure falls, the deficit will fall. While this may seem obvious, it is an invalid inference that calls to mind the famous one-liner from <a href="http://www.stevenlewis.info/gs/stuart_chase_bio.htm">US economist Stuart Chase</a>: “Common sense is that which tells us the world is flat.”</p>
<p>The chart below shows that borrowing declined substantially over the seven quarters from Q3 2010 to Q1 2012. Subsequently, as current chancellor George Osborne’s budget cuts have worked through the economy, there has been no sustained reduction of borrowing. </p>
<p>The Office of National Statistics commented on the stagnation of public borrowing in its <a href="http://www.ons.gov.uk/ons/rel/psa/public-sector-finances/march-2014/stb---march-2014.html">March report</a> on public finances:</p>
<blockquote>
<p>For the financial year 2013/14, public sector net borrowing excluding temporary effects of financial interventions … was £95.5 billion. This was £14.8 billion higher than the same period in 2012/13, when it was £80.7 billion.</p>
</blockquote>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/59599/original/56j4zmvt-1411142037.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/59599/original/56j4zmvt-1411142037.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/59599/original/56j4zmvt-1411142037.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=364&fit=crop&dpr=1 600w, https://images.theconversation.com/files/59599/original/56j4zmvt-1411142037.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=364&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/59599/original/56j4zmvt-1411142037.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=364&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/59599/original/56j4zmvt-1411142037.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=458&fit=crop&dpr=1 754w, https://images.theconversation.com/files/59599/original/56j4zmvt-1411142037.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=458&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/59599/original/56j4zmvt-1411142037.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=458&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption">Excludes “temporary effects”; such as Royal Mail pension transfer and Bank of England asset sales.</span>
<span class="attribution"><a class="source" href="http://www.ons.gov.uk/ons/rel/psa/public-sector-finances/december-2013/sty-current-budget.html">John Weeks | Data: Office of National Statistics</a>, <a class="license" href="http://creativecommons.org/licenses/by-nd/4.0/">CC BY-ND</a></span>
</figcaption>
</figure>
<h2>Tax inefficient</h2>
<p>The persistence of public borrowing at about £88-95 billion can be explained with the argument Labour had been using: expenditure cuts achieved an initial reduction in borrowing, which killed a nascent recovery that began in 2009 and as a result, the economy stagnated for three years. It boils down to the idea that reducing public expenditure is an inefficient way of reducing public borrowing, because of its feedback effects on the private economy that reduce incomes and tax revenue.</p>
<p>Many commentators have suggested that Gordon Brown was not effective on the campaign trail, which I tend to agree with. But Brown knew his economics, which is why he has consistently disparaged Tory promises of fiscal cuts. </p>
<p>The coalition government implemented the promised cuts, <a href="https://theconversation.com/debunking-george-osbornes-recovery-in-four-charts-26550">recovery came later than any on record</a> and borrowing flat-lined for two years. However much they want the electorate to trust them with the cash once again, Labour politicians should restrain themselves from contributing to the current chancellor’s PR by suggesting that his cuts will eliminate borrowing. They will not.</p><img src="https://counter.theconversation.com/content/31324/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>John Weeks does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Ed Miliband is trying to wrestle back the political initiative in Manchester. The leader of the opposition must avoid becoming mired in deeply complex constitutional questions of devolution at his party’s…John Weeks, Professor Emeritus, SOAS, University of LondonLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/178922013-09-06T04:45:31Z2013-09-06T04:45:31ZExplainer: the role of budget deficits<figure><img src="https://images.theconversation.com/files/30842/original/kqhws773-1378430344.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Servicing the current level of public gross debt is not a problem for Australia</span> <span class="attribution"><span class="source">Image sourced from www.shutterstock.com</span></span></figcaption></figure><p>There continues to be a great debate around Australia’s fiscal position. Yet, budget deficits are, in fact, a natural outcome of the business cycle. In a <a href="http://www.melbourneinstitute.com/downloads/policy_briefs_series/pb2013n05.pdf">policy brief</a>, co-authored by myself and colleagues Dr Edda Claus, Dr Viet Nguyen and Dr Michael Chua, we argue that deficits are crucial in their function as fiscal stabilisers, and help to counter the negative effects associated with market downturns.</p>
<p>Australia’s public gross debt to GDP ratio of 33% is low compared to other countries. In 2012, the OECD average in 2012 stood at 109% of GDP, and countries with gross debt as a share of GDP in excess of 100% included: </p>
<figure><table><thead><tr><th>Country</th><th>Debt (as a share of GDP)</th></tr></thead><tbody><tr><td>Japan</td><td>219%</td></tr><tr><td>Greece</td><td>166%</td></tr><tr><td>Italy</td><td>140%</td></tr><tr><td>Portugal</td><td>139%</td></tr><tr><td>Ireland</td><td>123%</td></tr><tr><td>United States</td><td>106%</td></tr><tr><td>United Kingdom</td><td>104%</td></tr></tbody></table></figure>
<p>The general reason to be concerned about deficits is that public debt, like all types of borrowings, has to be serviced. Interest is charged on the amount borrowed and interest charges need to be paid to avoid being caught in the trap of borrowing to pay off borrowings. However, servicing the current level of debt is not a problem for Australia, as net government interest payments as a share of GDP has been below 0.5% since 2001.</p>
<p>When considering whether a budget deficit is cause for concern, it is important to remember that budget balances are generally cyclical. Surpluses tend to occur and rise during times of strong GDP growth when receipts are up and government expenditures are down. Deficits, on the other hand, tend to occur and rise during times of economic slowdowns because receipts fall (driven by declines in income tax due to job losses) and expenditures rise (driven by increased unemployment insurance claims, again due to job losses). </p>
<p>Fiscal deficits are thus natural outcomes of business cycles and are important economic mechanisms that help moderate booms and busts. These automatic fiscal stabilisers counter the negative effect of job losses on consumption and mitigate the fall in GDP through increased unemployment and welfare payments.</p>
<p>Another reason to avoid fixation on the size of deficits in an environment of low growth is the potential tension with monetary policy. </p>
<p>In this regard, monitoring the budget deficit is crucial because it is also about monitoring the stance of fiscal policy. Monetary policy in Australia is currently geared towards stimulating the economy. In contrast acting to decrease the deficit in a climate of low growth is equivalent to adopting a tight fiscal policy. </p>
<p>This means that both levers of policy are now working in opposite directions — tight fiscal policy and loose monetary policy. To use the analogy of driving a car – one foot is stepping on the accelerator while the other foot is stepping on the brake! The outcome for the economy, as in a car, is that both actions cancel each other and, just like a car, the longer it is done the greater the likelihood of damage.</p>
<p>Operating a budget deficit is difficult at the best of times, and operating a deficit during an economic slowdown is especially difficult as closer scrutiny is paid to the components of revenues and expenditures. The view presented within our study is one that argues deficits need to be sustainable. </p>
<p>Deficits also reflect fiscal policy surrounding taxes and expenditures and as such should coordinate with monetary policy (not contradict it, as when the stance of fiscal policy is contractionary while the stance of monetary policy is expansionary).</p>
<p>Deficits do not, necessarily, need to be converted to surpluses. Deficits have an important role to play in stabilising the state of the economy by mitigating against unnecessary hardships associated with downturns. Conversely, surpluses are opportunities for safeguarding the economy. </p><img src="https://counter.theconversation.com/content/17892/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Guay Lim does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>There continues to be a great debate around Australia’s fiscal position. Yet, budget deficits are, in fact, a natural outcome of the business cycle. In a policy brief, co-authored by myself and colleagues…Guay Lim, Professorial Fellow, Deputy Director, Melbourne Institute of Applied Economic and Social Research , The University of MelbourneLicensed as Creative Commons – attribution, no derivatives.