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The British government did not approach insolvency in March 2020

Summary:
Insolvency is a corporate term which refers to a situation where a company is unable to pay contractual liabilities when they become due. From a balance sheet perspective, it means that the assets are valued below the liabilities. The term cannot be applied to a national government that does not issue liabilities in foreign currencies. Such a government can always meet its nominal liabilities irrespective of institutional arrangements it might have put in place to create contingent flows of numbers from one ‘box’ (account) to another ‘box’. Those arrangements do not override the intrinsic capacity of the legislator. So when the British press went crazy the other day reporting comments made by the Bank of England governor that the British government was on the cusp of insolvency, they did

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Insolvency is a corporate term which refers to a situation where a company is unable to pay contractual liabilities when they become due. From a balance sheet perspective, it means that the assets are valued below the liabilities. The term cannot be applied to a national government that does not issue liabilities in foreign currencies. Such a government can always meet its nominal liabilities irrespective of institutional arrangements it might have put in place to create contingent flows of numbers from one ‘box’ (account) to another ‘box’. Those arrangements do not override the intrinsic capacity of the legislator. So when the British press went crazy the other day reporting comments made by the Bank of England governor that the British government was on the cusp of insolvency, they did the British public a disservice. Donald Trump would have been finally justified in accusing the media of pushing out ‘fake’ news.

As background, this blog post is instructive – On voluntary constraints that undermine public purpose (December 25, 2009).

The UK Guardian decided to go the ‘fake’ news path in its article (June 23, 2020) – Britain nearly went bust in March, says Bank of England.

The lurid headline clearly exercised the imagination of some copy editor or whatever they are called but doesn’t help the reader understand the situation that they were reporting at all.

The UK Guardian continued:

Britain came close to effective insolvency at the onset of the coronavirus crisis as financial markets plunged into turmoil

Note the term “effective insolvency” which has no real meaning anyway.

The interview that started all the hooha was aired as a podcast on the Sky News program The World Tomorrow (June 22, 2020).

The segment saw the “Ed Conway and Sajid Javid talk to Andrew Bailey about the Bank of England’s intervention at the start of the pandemic”.

Conway is Sky’s economics head and Javid is the ex-Chancellor.

Some of the early comments from the interviewers were ridiculous – like those relating to the Bank of England “running out of ammunition to fight the pandemic”.

The Bank of England governor appeared first at the 6:22 minutes mark.

The comments that set the media into a lying frenzy begin at 6:46:

You may remember in the first week, we basically had a pretty near meltdown of some of, some of the core financial market When you get to, I got to Wednesday afternoon, and the markets team came down here, and, in the afternoon. And you know it’s not good when they turn up, en masse. And you know it’s not good when they say we’ve got to talk, and it wasn’t good. We were in a state of borderline disorderly, I mean it was disorderly in the sense that when you looked at the volatility in what was core markets, I mean core exchange rates, core government bond markets, we were seeing things that were pretty unprecedented certainly in recent recent times, and we were facing serious disorder.

Of course it was clear why we were facing it in terms of what was going on outside in this unprecedented shut down of the economy, effectively that was going on.

At 8:02, Ed Conway asked “How scary was that? I mean what were the prospects if the bank had not actually stepped in”.

Andrew Bailey replied:

Oh I think the prospects would have been very bad. Oh, and by the way, I should say that the other major central banks were also doing very similar things and we were all closely coordinated. I think it would have been very serious. I think we would have had a situation where in the worst element, the government would have struggled to fund itself in the short run …

Obviously we had, there are things you could do at that point. It is not, it’s not outright failure in that sense We have got backup mechanisms that you can use.

Note – “there are things you could do”!

The UK Guardian article somewhat down the page admitted that “Although the government said the country would still have had options available” it still persisted with the lurid headline.

Conclusion:

1. Britain did not “nearly go bust in March”.

2. Britain as a nation cannot go bust.

3. It is not a corporation.

4. It is not a household.

5. The concept of a corporate balance sheet does not have any application to a currency-issuing government.

So what was this all about?

What the Bank governor was really talking about was the financial market disruption that emerged in the early days of the pandemic. It is clearly the role of the Bank of England to maintain financial stability in British markets.

That was where the uncertainty lay.

We need to understand the different ways in which governments work within the institutional arrangements they put in place around debt and payments.

For Britain, two types of debt are issued via auction:

1. Gilts – are typically liabilities issued by the government which promise to pay a yield (‘coupon rate’) at regular intervals and return the principle at the agreed maturity date (say, 5 years or 10 years).

There are other forms ‘undated gilts’, ‘index-linked gilts’ which have other characteristics but are less significant in the overall picture.

See – About gilts.

2. Treasury Bills – are “zero coupon eligible debt securities” that are typically issued “through regular weekly or ad hoc tenders”. The zero coupon just means that they are issued at a ‘discount’ but redeemed at the ‘par’ value.

For example, say the market yield for short-term debt was 10 per cent. A six-month treasury bill might have a par value of £100 (which is what the holder will receive on redemption).

So the discounted price that the purchaser of the bill at issue would be prepared to pay to the government would be £95.20 (don’t worry about how I calculated that – there is a standard formula and I assumed half-yearly compounding).

Treasury Bill can be issued for just 1 day and up to 364 days but usually they are for 1, 4 and 6 month maturities.

See – About treasury bills.

Treasury Bills are used to match short-run spending needs. The gilts market is less responsive to daily needs – the institutional structure surrounding the auctions, for example, doesn’t lend itself to instant flows of funds.

Under the voluntary institutional arrangements that the government has put in place via legislation and regulation, funds raised from treasury bill tenders are placed in an account from which the Government then draws on when it spends.

If there are contractual or political spending imperatives today, and the treasury bill account cannot cover the funds required then, from an institutional perspective, there is a funding shortfall.

And as Andrew Bailey went on to say – “there are things you could do” – which just refers, in one way, to the fact that the central bank can always fill these gaps for the Treasury department.

One pocket of government can always be replenished by the other pocket any time it chooses, institutional arrangements notwithstanding!

A few months ago there was a bit hooha about the so-called Ways and Means Account held by H.M. Treasury at the Bank of England.

I wrote about this issue in this blog post – Bank of England official blows the cover on mainstream macroeconomics (April 28, 2020).

Effectively, the ‘Ways and Means’ account is an overdraft that the Treasury has with its central bank that allows it to spend freely without satisfying the usual accounting and administrative practices (ex post) relating to treasury bill or gilt issuance.

On April 9, 2020, the British Treasury made this announcement – HM Treasury and Bank of England announce temporary extension of the Ways and Means facility – which told the public that the Bank of England would increase the available funds in that overdraft account if the Treasury needed to spend large sums quickly.

In other words, they can increase fiscal deficits without recourse to the markets ‘matching’ the deficits with debt-issuance any time they like.

We should note, of course, that government spending occurs in the same way, however these administrative, institutional and accounting conventions and practices are exercised.

The Treasury instructs the central bank to credit bank accounts in the non-government sector on its behalf.

Every hour of every day.

That is how spending occurs.

All these other administrative type conventions do not alter that fact.

On April 23, 2020, an ‘external member’ of the Bank of England’s Monetary Policy Committee, gave a speech – Monetary policy and the Bank of England’s balance sheet – where he said that:

1. The Ways and Means account is used to smooth out “government cash flows”.

2. “Such a back-up is rarely needed except in periods of sharp unexpected deviations from the financing plan.”

Or, when there is severe disruption in the short-term money markets due to endemic uncertainty engendered by an event such as the coronavirus pandemic.

The Treasury bills market

The following graph shows the bid-to-cover ratio for the UK Treasury Bills tenders from the beginning of June 2016 to June 19, 2020.

The bid-to-cover ratio is just the the £ volume of the bids received to the total £ volumes desired. So if the government wanted to place £20 million of debt and there were bids of £40 million in the markets then the bid-to-cover ratio would be 2.

The financial media are always predicting the ratios will fall as investors give up on buying government bonds

Over this period, the averages have been:

– 1 month bills = 3.76

– 3 month bills = 3.35

– 6 month bills = 2.95

So mostly, the tenders are strong.

However, occasionally, the demand for the tender can fall well below these average ratios.

So as you can see from the graph, the ratios fell below 1 to 0.87 for 3 month bills on March 20, 2020 but was at 1.56 for 1 month bills on the same day and 1.11 for 6 months bills.

And that ‘weakness’ disappeared by the end of the week, with the ratio of 3.55 in the following week for 3 month bills.

The British government did not approach insolvency in March 2020

The point is that this behaviour reflected general market uncertainty rather than an assessment that the UK government was about to default on its liabilities or some other such sentiment that would stop the private debt markets from buying British government bills.

Later on in the interview, the Bank of England governor sought to clarify what he had said earlier given that clearly in the short-term bills market, except for the blip on March 20, 2020 in the 3 month bills, there was no question the ‘markets’ were willing to purchase British government bills across the maturity range offered (1, 3 and 6 months).

Andrew Bailey said his concern was really about “market instability” rather than whether the government would be able to ‘fund’ itself.

After discussing how extraordinary nature of the Bank’s response, he went on to say (starting around 18:49):

I was worried. And let me explain that because it is an important point. So I think one way, I think how would this have played out if we hadn’t taken the action that we and other central banks took? I think what you could have easily seen, would have seen actually a, a risk premium enter into interest rates, I think markets would have priced in a risk premium, and it could have been quite substantial given the degree of instability we were seeing. That would have raised the effective borrowing cost throughout the economy. Now, and that would have, in terms, in terms of the Bank of England’s objectives, that would have made it harder for us to achieve our objectives, both in terms of inflation and in terms of economic stability and economic growth that underlies that.

So it is clearly not in our interest to see that happen. Now the fact that the government, at that point in time, the government is the largest borrower – not the only borrower by the way because the corporate sector was borrowing quite heavily, the big corporates were borrowing heavily in anticipation at that point. But the fact that the government is the largest borrower is actually largely irrelevant to that argument about the risk premium and the increase in the effective rate of interest. So I don’t see that as compromising
our independence …

So, in effect the £200 billion intervention (the largest QE and quickest to be introduced in British history) was nothing to do with government funding requirements under the existing institutional structure.

It was about providing liquidity to the non-government sector to ensure interest rates didn’t spike, which the bank considered would make the economic consequences of the pandemic even more dire.

He wanted to stop irrational asset sales by wealth holders driving down prices and pushing up yields across the relevant maturity ranges.

In other words, insolvency fears had nothing to do with the Bank’s actions. It was a standard QE exercise to keep interest rates low and stable.

While we understand that the media is always trying to sensationalise things one should draw the line about fake and lurid beat ups!

The British media – progressive and otherwise should hang their heads in shame.

They missed the whole point of the interview.

Gilts market remains strong

Further, if you look at the gilts market, the demand for longer-term government debt has remained strong throughout.

I wrote about the evolution of that market in this recent blog post – Britain confounding the macroeconomic textbooks – except one! (May 21, 2020).

Not a lot has changed since then in terms of robustness.

The bid-to-cover ratio is just the the £ volume of the bids received to the total £ volumes desired. So if the government wanted to place £20 million of debt and there were bids of £40 million in the markets then the bid-to-cover ratio would be 2.

The financial media are always predicting the ratios will fall as investors give up on buying government bonds.

Here is the record of bid-to-cover ratios in the British gilts market from January 5, 2016 to the latest gilt auction on June 24, 2020.

Even in the early days of the pandemic, the demand for gilts was strong.

The British government did not approach insolvency in March 2020

I still get sent blog links or papers written as sorts of ‘gotcha’ moments – in the ‘ah, I have you now, you stupid MMT cultists’ tradition that has evolved, which tell me that Modern Monetary Theory (MMT) is plain stupid because it is obvious there are financial constraints on governments as evidenced by these institutional arrangements.

Nothing could be further from the truth.

The point is that MMT makes it clear that there is a difference between the intrinsic capacity of a currency-issuing government in a fiat monetary system and the capacities that they render for themselves through their legislative and regulative volition.

Refer back to the blog post from 2009 where I discuss that in detail.

The difference between the intrinsic state and the state on the ground at any point in time reflect ideology and political choice.

And by exposing that difference, MMT brings the public a long way forward in understanding than if they remain in the world of mainstream macroeconomics which alleges the institutional reality is the intrinsic monetary reality.

Thus blurring the ideological element and covering up a whole raft of lying behaviour by governments who do not want to undertake certain policy options.

Conclusion

The important point is that legislation and regulation can be changed by the majority government.

The British government could always change any of the voluntary arrangements it has set in place and, for example, instruct its central bank to ensure any spending demands have financial integrity irrespective of what numbers appear in different accounts (gilts, treasury bills, tax etc)

It is very disturbing that the media misleads people so manifestly.

That is enough for today!

(c) Copyright 2020 William Mitchell. All Rights Reserved.

Bill Mitchell
Bill Mitchell is a Professor in Economics and Director of the Centre of Full Employment and Equity (CofFEE), at the University of Newcastle, NSW, Australia. He is also a professional musician and plays guitar with the Melbourne Reggae-Dub band – Pressure Drop. The band was popular around the live music scene in Melbourne in the late 1970s and early 1980s. The band reformed in late 2010.

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