Monetising the debt – BoE to buy UK Government Bonds

So it has happened: these extraordinary times have caused our Government to look to Zimbabwe for economic policy inspiration and so, as of last week, the Bank of England will begin a £150 billion programme of printing money.

Technically referred to as Quantitative Easing, it’s actually a lot easier than printing money, and more environmentally friendly too: the Bank just types a number into a computer to increase the balance of a customer’s account and, unless the customer wants to actually withdraw the money, no trees will be harmed.

The majority of this money will be used to purchase Government bonds, but some will also be used to buy high quality company bonds. You might think that using Central Bank money to buy government debt is illegal under EU law, but, as long as they go through an intermediary (even if that is a bank like Lloyds or RBS, who they majority own), it’s allowed:

Article 101 of the Treaty establishing the European Community states:

Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

The Government and the Bank of England are side stepping this law by purchasing Gilts (UK Government bonds) from Commercial Banks indirectly in the secondary market. However, in the long run, the effect will be exactly the same: The Central Bank is printing money to lend it to the government.

Lorenzo Bini Smaghi from the European Central Bank highlighted the potential consequences as follows:

Central bank independence: from theory to practice

It is beyond doubt that conducting an independent monetary policy, aimed at the achievement of low and stable inflation, is made significantly more difficult by the existence of large budget deficits. This is true for two related reasons.

First, when deficits and public debt become unsustainable, the incentive for the government to force the central bank to monetise its deficit, thus eliminating public debt via inflation, increases substantially.

Second, the larger the budget deficit and the accumulated debt, the more market participants become aware of the risk of monetisation.

In addition, they may believe that the central bank will be forced to “bail out” the government by assuming its liabilities, even if Article 103 of the Treaty explicitly prohibits this.

This may jeopardise the anchoring of inflation expectations and make the control of inflation more costly. In this case, fiscal policy may become dominant over monetary policy, thus undermining, de facto if not de jure, the functional independence of the central bank.

The government is taking on so much debt, that it will take many generations to repay. It’s therefore looking more likely that at some point it will need to be eroded through a period of high inflation, which is affectively another stealth tax – the inflation tax.

The Bank of England says this Asset Purchase Programme is temporary and they will look to sell any assets purchased under the scheme back to the market when the economy recovers. Let’s hope they resist the temptation to dramatically expand it, and are serious on their commitments to low inflation.