WIlliam Norton: How a Sinking Fund could stave off a gilts strike

William Norton is a solicitor anc Conservative candidate for Birmingham Perry Barr.  He has been an adviser on tax affairs and legislation to the Conservative frontbench and was a member of the permanent staff of the James Review on Taxpayer Value between 2004 and 2005. William was also the referendum agent for the victorious No campaign in the North East Regional Referendum and is currently a trustee of the Social Affairs Unit and a borough councillor in Worcestershire.

The National Debt, famously, has never been repaid, and no one expects that it ever will be.  Markets have been prepared to lend money to the British Government because it has always been able to service its debt by paying the interest owed and covering the redemption of gilts as they fall due.

All this assumes that the British state is not going to go bankrupt, i.e. that the Treasury is good for the money at whatever inflated rate it has to pay to get itself out of its latest mess.  Gilts have always looked like retaining enough value to make it worth someone’s while to buy them.

But a government can run out of cash without going bankrupt in the formal sense of bailiffs coming round to seize the TV set, the sofa or the keys to the family car.  Its creditworthiness can get so poor that it can no longer cover the interest on new debt, and it could be issuing debt in such quantities that its bonds no longer hold value.  So, the markets stop lending any more money: there is a “gilts strike”.  Before that point is reached, escalating interest costs may mean that a government has insufficient cash to cover its other essential services, such as telling people to eat five pieces of fruit a day.

William Norton is a solicitor anc Conservative candidate for Birmingham Perry Barr.  He has been an adviser on tax affairs and legislation to the Conservative frontbench and was a member of the permanent staff of the James Review on Taxpayer Value between 2004 and 2005. William was also the referendum agent for the victorious No campaign in the North East Regional Referendum and is currently a trustee of the Social Affairs Unit and a borough councillor in Worcestershire.

The National Debt, famously, has never been repaid, and no one expects that it ever will be.  Markets have been prepared to lend money to the British Government because it has always been able to service its debt by paying the interest owed and covering the redemption of gilts as they fall due.

All this assumes that the British state is not going to go bankrupt, i.e. that the Treasury is good for the money at whatever inflated rate it has to pay to get itself out of its latest mess.  Gilts have always looked like retaining enough value to make it worth someone’s while to buy them.

But a government can run out of cash without going bankrupt in the formal sense of bailiffs coming round to seize the TV set, the sofa or the keys to the family car.  Its creditworthiness can get so poor that it can no longer cover the interest on new debt, and it could be issuing debt in such quantities that its bonds no longer hold value.  So, the markets stop lending any more money: there is a “gilts strike”.  Before that point is reached, escalating interest costs may mean that a government has insufficient cash to cover its other essential services, such as telling people to eat five pieces of fruit a day.

Bill Gross of PIMCO, the world’s largest mutual fund, recently suggested that it was time for investors to avoid UK gilts because they were “sitting on a bed of nitroglycerine”.  If the annual deficit cannot be controlled, the Government will have to flood the market with new debt, squeezing the value of existing gilts held by people like Mr Gross.

There is also the question of how the UK exits from quantitative easing.  The Bank of England printed £200 billion to buy up gilts as a way of forcing down interest rates.  That’s about 23% of Public Sector Net Debt, which (if you believe the numbers) is what we call the National Debt these days.  The Bank now has the problem of how to sell off those gilts without causing their value to crash and interest rates to rise.  According to Deputy Governor Charles Bean, “The Bank will seek to sell the assets it owns in an orderly fashion in order not to disrupt the market for government debt” (see the answer to Q11 here).  That’s nice to know, but not terribly informative.

There have been panics about the National Debt before, most notably the 1720s and the 1780s.  The response was to establish a Sinking Fund.  Governments made annual payments to a fund which bought up gilts and this reassured the market that there was real money backing ministerial promises.  Indeed, there still exists a quango from 1786 called the Commissioners for Reducing the National Debt, although in practice it now acts as the Treasury’s in-house fund manager.

Sinking Funds went out of fashion because, due to various wars, Governments could never maintain the budget surpluses required to keep up the contributions and it was too easy for ministers to raid the Fund for other purposes.  Economic growth in the nineteenth century persuaded markets that the National Debt was manageable, restoring confidence and removing the need for a Fund, and David Ricardo demonstrated that, economically, there was no difference between maintaining a Sinking Fund and raising taxes for a one-off debt repayment, which demolished the intellectual case.  But perhaps the time has come to resurrect the idea and solve two problems at once.

Suppose the £200 billion gilts acquired by the Bank of England under quantitative easing were formally redesignated by legislation as a new Sinking Fund.  The Fund would be prohibited from selling the gilts and would hold them to maturity.  Any interest received would have to be used to acquire further gilts to be held on the same terms.  This could be handled through regular auctions of specified issues of gilt or through occasional market purchases. 

Government could make further contributions to the Fund, perhaps under a statutory obligation.  That would give the deficit reduction plan more credibility than Alistair Darling’s waffly promises, but the main discipline on the Treasury would be the need to pay interest on the accumulating gilts within the Fund.  Pretty soon the Sinking Fund would build up into a significant amount of money.  The terms of the governing law would make the Fund completely un-raidable by ministers.

(Actually, it might be sensible to permit the Fund to sell gilts to pension funds as there might be a market scarcity of paper of given maturity, which the pension funds needed to cover their liabilities, but the cash received by the Sinking Fund would have to be used to buy replacement gilts so the principle would hold firm.)

On the maturity of gilts within the Fund there would be a cancelling out against the original quantitative easing facility.  No cash would have to change hands but part of the National Debt would be eliminated and part of the money printed to finance quantitative easing would have been clawed back.  The Fund will grow to much more than the original £200 billion, so there will be a surplus and thus after the original liability has been exhausted redemption moneys received by the Fund would be used to buy and retire further gilts, thus continuing the accumulation process.  Eventually the National Debt/GDP ratio will fall below a manageable pre-determined level and the Sinking Fund will go into automatic run-off and wind down.

This arrangement has particular attractions in a situation where the annual deficit is out of control and GDP growth is sluggish.

• Bondholders would be able to invest in UK gilts with greater confidence from knowing that the market was not going to be flooded at some uncertain time in the future by the Bank of England.  The £200 billion of gilts acquired under quantitative easing would be locked away forever, not on a bed of nitroglycerine but in a concrete coffin.
• The Sinking Fund would be a buyer of last resort through the auction process, which should enable gilts to hold their value.  To a limited extent, then, the effects of quantitative easing could be achieved without printing any more money, and eventually retiring the money which was printed during 2009.  If, as Andrew Lilico suggests, quantitative easing has to be continued into 2010 – and I hope he is wrong – then the Sinking Fund would be the vehicle for operating it without risking a panic in the bond market.
• The Treasury will have to pay interest on the Bank’s gilts anyway at some point, irrespective of who holds them.  The same cash would still be leaving the Exchequer.  If a compounding proportion of its interest bill goes into a Sinking Fund to retire debt then the Government is in effect paying down part of the National Debt without necessarily having to run a budget surplus.  This would NOT solve the problem of the structural deficit in the UK public finances, but it will make it slightly less painful to pay for it over the medium and longer-term.
• Ricardo is right that there is no point in building up a Sinking Fund from scratch: you might as well put up taxes and run a persistent budget surplus to pay down debt directly.  But here we would not be assembling a fund from scratch to pay off the entire National Debt, we would be making use of a ready-made pot of £200 billion as a guarantee to the markets that the public debt burden will not spiral out of control.
• Creating a £200 billion fund looks like you mean business and intend to deliver more than waffle.  A ring-fenced, transparent fund dedicated to handling the National Debt chimes well with an incoming Iron Chancellor determined to correct past mismanagement of the public finances and keen to restore – and to be seen to restore – fiscal responsibility.

What does anyone else think?