Banks, borrowing, bonds and Britain’s budget
–Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. Join Reuters for a live discussion with guests as UK Chancellor George Osborne makes an emergency budget statement at 12:30 p.m. British time on Tuesday, June 22, 2010.–
George Osborne must be thankful to Don Fabio and his boys for ensuring that Wednesday’s tabloids will have other things to think about than the Budget, because it is going to be one of the toughest ever.
There is every indication the advance billing is more than just news management. The pain is going to be frontloaded for two reasons.
First, if anyone thought the electoral cycle was dead, the run-up to the last election should have disabused them.
The old wisdom is still valid: get the pain in early, keep the goodies for later, when the next election is in sight. In the present case, it is reinforced by the more Macchiavellian consideration that the more blood is spilt on Tuesday, the less attractive will be the prospect of an early election and hence the stronger the bonds holding the coalition government together.
The more important reason for cutting the deficit drastically at the outset is the message it sends to the markets that we are not going to exploit our position outside the Eurozone to inflate away the debt.
Given our history, it will take more than a single budget, however tough, to convince them – it will certainly take far more than that to convince me! – but Tuesday could be a good start all the same. We will know how well the budget has restored our credit by looking at the impact on sterling and on the money and bond markets.
One of the remarkable features of those markets in the last year or so has been the relationship between long and short rates, the term structure, as economists call it.
At the short end, the government and the banks can borrow at a rate of 0.5 percent or less – higher than in the U.S. or Japan, where rates are near zero, but nonetheless some of the lowest rates ever seen in Britain – whereas for long term loans (20 years+) the cost is 4 percent and more.
The difference between those two numbers, the so-called term spread, is exceptionally large and it reflects a number of factors, of which the most important by far is the expected inflation rate over the next twenty years.
Now there are two aspects of this phenomenon which are largely ignored in media comment.
First, as regards government borrowing, it is often said that the UK has the advantage over other countries with similar debt burdens, because so much of our borrowing is long term, which means that our bonds need refinancing (“rolling over”) at less frequent intervals.
In that respect, the liquidity risk of Britain’s debt is lower than almost any other country’s – but the other side of the coin is that the inflation risk is greater.
We benefit from the longer maturity (or more precisely longer duration) of our national debt, but we pay for the privilege in the form of higher long term rates and a greater current interest burden on our budget.
The second point relates to the banks (yet again!). The basic bread-and-butter business of banking is maturity transformation – which means short-term borrowing (in the form of deposits of one kind or another) and long-term lending (advances, personal loans, mortgages), so as to enable their customers, the nonbank public, to do the opposite.
Bank profits are generated by the gap between these rates, so with short rates at all-time lows, there has never been a better time to be a banker.
They can borrow short term at 0.5 percent – the same rate as the government because in effect they are the government (which owns some of them and underwrites the rest) – and lend at………….20 percent on credit card borrowing, 8 percent on a personal loan, even on mortgages they can charge 4 percent or 5 percent.
Margins like these are unprecedented.
The irony is that, after inflicting economic damage on the country on a scale second only to Germany’s former Nazi dictator Adolf Hitler, Britain’s banks now find themselves in charge of a money machine.
The faster the authorities print money – quantitative easing, as it is now called, currency debasement as it used to be known – the lower it drives short rates and the higher it pushes long rates, thereby widening the margin between borrowing and lending rates.
The relevance of the budget in this regard is that the more the government has to rely on the bond markets, the higher it drives long rates, which also serves to widen the margin (the term spread) generating bank profits.
In fact, it is no exaggeration to say that the government (via the Bank of England) prints money, lends it at near-zero rate to the banks, who often prefer to lend it back to the government at 4 percent rather than to the cash-strapped small businesses that ought to be the backbone of the economy.
Why is this merry-go-round tolerated?
Essentially, because it is the only way to pump the money into banks required to rebuild their depleted reserves and in addition, it is hoped, to provide sufficient funds for them to restart lending to the corporate sector.
As far as the taxpayer-owned banks are concerned, we ought in theory to be rewarded for our largesse when they are reprivatised at some future date. For the remainder, we are simply providing a gift to shareholders, who, without the government bailout, would have been wiped out altogether in 2008.
(In both cases, the calculation has to be adjusted to allow for a few billion to be creamed off in pay and bonuses for top management, who will shamelessly attribute the turn-around in the fortunes of the banks to their own expertise).
On another banking-related issue, this week’s Economist suggests that the government’s new 0.2 percent levy on the banks may make a small contribution to balancing the budget.
If correct, this is worrying. The whole point of the levy, we have been told, is to provide a fund to cover the cost (or a part of the cost) of a future bailout of the banking system.
If it is ever to be a true insurance scheme, it should be kept out of the budget calculations altogether – otherwise it will from the very outset become just another unfunded, open-ended government commitment.
So what can we expect on Tuesday?
I can add nothing to the media speculation, especially as it has often been guided by advance warnings straight from the horse’s mouth (by the way, whatever happened to budget purdah?), except for one hint: a carbon tax looks politically irresistible.
It would not need to be very heavy, because the Chancellor can surely count on rock-solid support for his cuts from all the soi-disant greens.
After all, they can’t be so concerned about choking our grandchildren with petrol fumes, yet totally unconcerned about choking them with debt, can they?
Picture Credit: Chief Secretary to the Treasury Danny Alexander, Prime Minister David Cameron, Chancellor of the Exchequer George Osborne and Deputy Prime Minister Nick Clegg (L-R) sit during a meeting at number 10 Downing Street in London June 21, 2010. REUTERS/Dominic Lipinski/Pool