Britain confounding the macroeconomic textbooks – except one!

Remember back just a few months ago. We are in Britain. All the Remainers are jumping up and down about Brexit. We hardly see anything about it now as the UK moves towards a no deal with the EU. Times have overtaken all that non-event stuff. Now the developments are confounding the mainstream economists – again. There will be all sorts of reinventing history and ad hoc reasoning going on, but the latest data demonstrates quite clearly that what students are taught in mainstream macroeconomics provides no basis for an understanding of how the monetary system operates. All the predictions that a mainstream program would generate about the likely effects of current treasury and central bank behaviour would be wrong. Only MMT provides the body of knowledge that is requisite for understanding these trends.

Imagine we provide an intermediate macroeconomics class at almost any university in the world with the following facts:

1. According to the – IMF Policy Responses to COVID-19 Monitor – the government has just embarked on a massive fiscal expansion worth around 4.5 per cent of GDP.

In the previous year, government debt rose by 2.6 per cent of GDP. In the current year, it will rise by a further 10 per cent of GDP.

The official agency that helps the government on fiscal matters called this “the biggest ‘fiscal loosening’ from almost any government in almost three decades” (OMB)

2. The central bank has increased its “holding of UK government bonds and non-financial corporate bonds by £200 billion”, has “agreed to extend temporarily the use of the government’s overdraft account at the … [central bank] … to provide a short-term source of additional liquidity to the government”, has made direct “loans and guarantees available to businesses” worth 14.9 percent of GDP.

3. This graph shows the central bank’s holdings of government bonds (in millions of currency) and they dominate the total assets of the bank.

In the last three weeks (since April 22, 2020), the central bank has increased its holding of government bonds by 40,497 million.

What would the overwhelming number of students in the class conclude as an application of the theories they have been taught (dominated by New Keynesian thought) as a result of being confronted with these facts?

Well, many mainstream economists will deny this to avoid humiliation but I have done this exercise in the past with classes I have inherited.

The students would predict:

1. That the government bond yields would rise significantly as the auctions ensued after this sort of fiscal shift.

They would write explanations about how there was an increasing risk of inflation (too much money chasing too few goods) and the bond buyers would have to be compensated for that risk.

They would emphasise that this was especially going to be the case for longer-term bonds – beyond say two-years.

They would also introduce the argument that the risk of insolvency (credit risk) had risen and this required higher returns to bond investors to compensate for the elevated levels of risk.

2. The students would also argue that the willingness of bond investors to purchase the primary issues in the auction process (where government bonds are first issued) would diminish because of increasing fear of insolvency.

The better students who might explore the more technical literature about bond auctions would claim that the so-called bid-to-cover ratio would be falling in successive auctions as the fiscal deficit rose as investors got spooked about the situation.

3. All the students would suggest that the rate of inflation would accelerate, not only because of the fiscal deficit pumping cash into the economy but also because the central bank was obviously – in their words – ‘printing money like there was no tomorrow’ (or words to that effect – ‘printing’ would definitely figure strongly in their answers).

Most would conclude this part of their answer with a rather triumphant appeal to ‘don’t you know about Zimbabwe’ – as if that is the end of the story.

4. And, the more complete answers would then attempt to score bonus marks by introducing and applying the ‘loanable funds doctrine’ to argue that it would be obvious that interest rates would be rising and damaging private investment – fancy terms like ‘crowding out’ would dominate this part of the answer.

They would tell us that there is only so much saving (funds) to go around and that banks adjust loan interest rates to ration that finite pool of savings out among the competing demands for loans.

If the competition heats up – because the government is running large deficits and trying to get the cash from the loanable funds market to cover the tax shortfall on their spending – then the banks will push up interest rates and choke of investment in the non-government sector.

Some students, eager to impress that they belong in the community of economists and share the values they perceive to be a requisite part of membership would then extend this analysis of crowding out to introduce morality type stories about how governments waste resources because they are not disciplined by shareholders and by diverting scarce (finite) investment resources to wasteful government projects from ‘robust’ private projects (yes, the language would all be there – I have seen it in my career as a teacher), the overall well-being of the economy suffers.

Some might even go the next step and start talking about the government using up finite savings to build statues for dictators (seen that too!).

Confusion then enters

And then these characters consult the latest data and obviously get confused.

In fact, the problem is they don’t.

In his great 1972 book – Theories of poverty and underemployment, Lexington, Mass: Heath, Lexington Books), David M. Gordon wrote about how the mainstream deal with cognitive dissonance. Think denial.

His context was mainstream human capital theory, which at the time had been exposed as being deeply at odds with the facts about earnings distributions and other crucial labour market characteristics it sought to explain.

David Gordon said that mainstream economists continually responded to empirical anomalies with ad hoc or palliative responses.

So whenever the mainstream paradigm is confronted with empirical evidence that appears to refute its basic predictions it creates an exception by way of response to the anomaly and continues on as if nothing had happened.

Please read my blog – In a few minutes you do not learn much – for more discussion on this point.

That is a hallmark characteristic of a community crippled by Groupthink.

But the facts are so confronting that any one of these mainstream economists just embarrass themselves when they try to relate their theories and predictions drawn from it to the reality.

All the students in the mainstream courses would be given a deep F grade (fail) by yours truly if they presented that sort of answer to me. And I have done it in the past!

Latest data

The graph shown above documents the decisions of the Bank of England’s Monetary Policy Committee to pursue quantitative easing in three different episodes.

The first episode started in November 2009 with the MPC announcing it would purchase £200 billion worth of government bonds.

In late 2011, the second episode began (after the shocking first two Osborne fiscal austerity cuts threatened to push the UK into a triple-dip recession) and the Bank purchased government bonds in the secondary markets to the take its holdings to £375 billion.

Then in August 2016, the bank launched a third, smaller quantitative easing program which not only combined gilts but also corporate debt. By the end of that episode, the total public debt holdings had risen to £435 billion.

On March 1, 2020, the Bank’s holdings had fallen slightly to £420.4 billion.

And the latest weekly data shows that on May 13, 2020, the holdings had risen to £529.5 billion, an increase of 25.9 per cent.

When all this ‘comes out in the wash’, the Bank of England, like many central banks now engaging in large-scale government bond purchases in the secondary markets, will have basically bought all the debt issued by the British government in pursuit of its fiscal stimulus.

Right-pocket of government working with the left-pocket. Take your pick which pocket is the bank and which one is the treasury.

It doesn’t really matter does it?

And yields?

The UK Debt Management Office provides detailed data on the – Gilt Market.

The latest data shows that on May 20, 2020, the UK government issued a three-year Gilt (bond, expiring in 2023) worth a total of £3,869 million (quite a tidy sum) at a auction yield of -0.003%.

A week before, they issued £2,250 million worth of 21-year Gilts (maturing in 2041) at a yield of 0.594 per cent.

And on May 6, 2020, they issued a 34-year bond totalling £1,750 million at 0.495 per cent.

Now make sure we know what the latest auction means.

Well we need to tie it together with the latest release from the Office of National Statistics (ONS) – Consumer price inflation, UK: April 2020 (May 20, 2020) – which showed that the annual CPI inflation rate was 0.9 per cent in April 2020, down from the March reading of 1.5 per cent.

For the last two months, the monthly inflation rate for CPI including housing costs (CPIH) has been recorded at zero.

The one month CPI series was zero in March and -0.2 in April.

In other words, generalised price inflation is negative (that means prices fell in April) while the Bank of England was merrily adding £200 billion to bank reserves in exchange for gilts – which means it was effectively covering all the deficit increase.

Who would have thought! Certainly not the students we started this post by interrogating.

Here is the graph provided by ONS (Figure 1) which compares the CPI including with the owner occupiers’ housing costs (CPIH), the CPI itself (CPI) and the owner occupiers’ housing costs (OOH) component (the latter which “accounts for around 16% of the CPIH” and, is therefore, the “main driver for differences between the CPIH and the … CPI inflation rates”).

And the clear signal from the Bank of England is that the bond buying is far from finished.

As the fiscal deficit rises and the government issues matching debt (making sure you understand that there is no necessity for this in relation to the expenditure capacity the government has), the Bank will be out in force buying up all the debt.

Talk about ‘money printing’! The students would be getting feverish.

Pity they don’t understand it is a non event – right and left pockets remember.

It doesn’t do anything to increase the capacity of the government to spend. All it does is offer a portfolio swap for the non-government sector – reserves for bonds.

Now why does that matter for the bond auction?

The negative yield on the latest gilt issue means that the investors are paying a ‘tax’ (sort of) to the government in order to give them transfer bank reserves held by the banks back in return for a nominal public liability.

Effectively, the central bank just shifts numbers from reserve accounts to government debt accounts and a nominal liability on government is incurred.

It has to pay back £3,869 million in 2023. A nominal position.

Whoever holds those gilts to maturity will get back less than they paid (as a result of the negative yield).

What does that signal?

First, in the words of the Financial Times:

The robust demand underscores the appeal of gilts, long considered to be a haven due to the UK’s strong creditworthiness and economy. It also suggests market fears over the large increase in borrowing the UK has undertaken due to the Covid-19 pandemic has not yet weighed on market appetite for the debt.

There is that word – “robust” – again, in a meaningful context this time.

Second, the strong demand for the gilt issue and the negative yields means that the investors do not think that there will be an outbreak of inflation any time soon.

And the fact that 34-year gilts were yielding just 0.495 per cent reinforces that point clearly.

Third, this also means that the bond markets think that the Bank of England will try to push their policy rate down further from its present value of 0.1 per cent.

Further, that means negative!

And so the whole business model of neoliberal investing is being shot to pieces by the reliance on monetary policy ‘to generate inflation’.

We don’t know what the longer term consequences of this weird pandemic are going to be. But you can bet the storyline is going the way the mainstream economists predict.

Bid-to-cover ratios

What about that robust demand for the gilts?

Well, this relates to the concept of bid-to-cover ratios.

I wrote about bid-to-cover ratios in these blog posts (among others):

1. Bid-to-cover ratios and MMT (March 27, 2019).

2. D for debt bomb; D for drivel (July 13, 2009).

Essentially, 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.

It is not even a case of the dead clock being correct twice every 24 hours. These predictions are never correct.

Here is the record of bid-to-cover ratios from January 5, 2016 to the latest gilt auction on May 20, 2020.

That is the ‘robust’ demand the FT was talking about.

The ratio was 2.15 for the negative yield May 20, 2020 auction. That means that the investors actually wanted to buy bonds worth £8.32 billion (that is what they bid for) but the government rationed the corporate welfare out at £3,869.624 million.

And as the pandemic struck and the deficits have risen, the ratio has been rising.

And the average ratio over the period shown has been 2.18 – more than twice the debt wanted than issued.

How does the mainstream explain that in an environment of rapidly rising deficits and huge bond buying from the central bank? They cannot!

Conclusion

So you can see the students haven’t done very well have they?

The reason is that the mainstream macro framework is incapable of explaining anything of importance – I actually haven’t found it useful for unimportant things either.

Only MMT provides the body of knowledge that is requisite for understanding these trends.

And I didn’t get to talk about the massive central bank payments (like up to £57.6 billion) to the large corporations in Britain that have been revealed by the Bank of England under freedom of information requests – see Update to the Covid Corporate Financing Facility (published May 19, 2020).

Where did that money come from? Just kidding.

That is enough for today!

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