Lloyds Banking Group Centre for Responsible Business, Department of Finance
The limitations on what the UK government can borrow from the Bank of England are determined primarily by inflation rising above tolerable rates and unacceptable depreciation of sterling, according to Modern Monetary Theory.
The depreciation of sterling will be dependent on what is going on in other major economies that are also undertaking fiscal expansions financed by central bank loans and asset purchases of government bonds. There are several factors affecting the exchange rate movements, such as: relative levels of fiscal expansion; monetary accommodation; debt financing; and prior ratios of debt to GDP. Brexit is also a complicating factor for the UK.
The UK’s growth prospects will depend on its expected productivity growth, following the disappointingly very slow growth since the 2007-9 financial crisis. It may be that labour productivity growth improves at the cost of significantly higher unemployment and a fall from the record employment levels pre-crisis.
UK inflation has remained positive and has both undershot and overshot the Bank of England’s inflation target range (around 2%) over the post-financial crisis period. On average, the UK has been closer to the target than other central banks in the Eurozone countries (the ECB) and Japan. Significant rises in inflation – above the broadly conformable central bank targets – are not anticipated in the immediate post-crisis period; but accelerations may emerge in the medium term as a result of the monetary financing of fiscal expenditures.
How politically tolerable the (nominal debt reducing) accelerations in inflation prove to be after such a long period of low inflation is difficult to judge, but some overshooting may be allowed to offset past undershooting. Again, it is relative inflation rates that will matter, especially for exchange rates.
At some point, however, governments will have to consider imposing some degree of ‘austerity’, winding down government expenditure, and increasing taxes to reduce fiscal deficits and start reducing government debt to GDP ratios.
The UK government will have to decide how much austerity should be born by current taxpayers and how much by future taxpayers. This will determine the volume and term to maturity of its bond issuance. Intergenerational issues may need to be considered. Should the ‘Triple Lock’ on state pensions be relaxed (possibly reversing the decline in pensioner poverty), or should the target rather be to reduce the generous exemptions enjoyed by the relatively high earners on pension contributions?
Underlying the current UK state pension scheme is the idea of a Universal Basic Income for pensioners – should this be extended to all citizens, with appropriate (simplifying) modifications to the Universal Benefits Scheme? Note, both the US and Japan have distributed funds to their citizens to help them cope with the COVID-19 crisis.
Expenditure priorities will also need to be considered. As regards the NHS, health and social care, and funding for research into vaccines that may or may not be required in future, the relentless pursuit of efficiency must give way to a regime that builds in sufficient excess capacity and thus resilience, to cope with crises and peaks in demand.
There is a political judgment to be made here because of the ‘Dutch Dyke Problem’ that, as with flood defenses, it is extremely costly to completely eliminate the chance of a flood, and so investment should be made to reduce the probability of floods to an acceptable level, whilst also investing sufficiently in other public goods.