Here’s an interesting one: what is a government’s most valuable asset?
Parliamentary democracy? In many respects, and in light of Sir Kier Starmer’s failure to get his and his Chancellor’s welfare reform through the House of Commons, it is as much a liability as an asset.
Its property portfolio? That doesn’t belong to the government, it belongs to the Crown. It’s tax raising powers? Very much a two-edged sword to which Ms Reeves, that famous ex-Bank of England economist, nine months after her confident budget speech of October 2024 can surely attest. No, a government’s most valuable asset is its inflation option.
As government debt has in the past couple of decades risen and risen, there has of course been much written about how the government can inflate itself out of debt and I can assure you that I have written as much or more than most on that subject. But that is not the only place where the inflation option comes into play. It is at its most powerful at the source of all government revenue. The British government expects to receive in fiscal 2025/2026 somewhere in the region of £1.2 trillion in fiscal income of which income tax and VAT will at £329 billion and £214 billion respectively be the largest providers.
Inflation is a funny fish. Although an everyday occurrence, it gets reported monthly on an annualised basis and once a year – post factum – wages and pensions will rise with an eye on the past year’s reported inflation rate. So they only go up after the increase in prices has already occurred and therefore inevitably lag behind last year’s inflation and rarely, if ever, pre-empt the erosion in income which will befall households in the coming twelve months.
Please don’t get me wrong. It’s the most practical way of dealing with inflation unless as occurs in some economies in times of hyperinflation, adjustments are applied monthly or quarterly. But the government does not have to wait. Every time the price of an item on the shelves goes up by a pound, irrespective of the day of the week, the government here is in there for 20p of VAT. With every extra pound invoiced by a business, whether a large corporation or a small business, HRMC is ringing the till and if prices are increased, so is the bill for corporation tax, not to mention the immediate impact on income tax. Every increase in every price, be that for goods or labour, the government’s revenue stream grows in line and immediately. In other words, the government is on the revenue side and in real time 100% inflation proofed.
That cannot be said of investors who by way of the UK gilts, US Treasury, German Bund, French OAT, Italian BTP or any other government and by extension corporate bond market, fund the portion of government expenditure that is not covered by fiscal revenues.
The average annual UK inflation rate over the past 10 years has been 3.54%, so £1 in 2015 money would have to be £1.42 in order to keep up with inflation. Average interest rates for 10 year gilts, however, have over the same ten years not been 3.54% so the interest income has not compensated for the erosion in nominal capital value. And before sniggering, have the prices of your equity investments risen above the cumulative rate of inflation? The key is not the nominal return, but the real or inflation-adjusted return.
During the high inflation period of the 1970s and into the 1980s, governments were making out like bandits as their debt piles – to a large extent residual from both the cost of fighting the Second World War and the huge expense of war damage and reconstruction – were finding themselves being repaid by Mr Inflation.
But what was pennies from heaven for the Treasury was ruinous for investors who saw the real value of their savings being washed away year after year. Up pops Geoffrey Howe, Chancellor of the Exchequer in the Thatcher government in 1981 and announces that henceforth the UK government will begin to issue a portion of its debt in the form of inflation-linked gilts which will not only pay interest linked to the rate of the Retail Price Inflation index but, additionally, the capital invested will accrete at the cumulative rate of RPI and at maturity will be repaid in accordance. The government has done the unthinkable. It has generously and at no notable cost given away its priceless inflation option to investors, to the people.
A little less than half a century on, last Friday in fact, The Times carried an article, “Britain is broke; how inflation-linked debt cost us £60bn”, penned by one Andrew Ellson, who according to his byline is The Times’ consumer affairs correspondent. With no disrespect to Mr Ellson, I somewhat wonder whether he properly understands the private life of gilts in general and of Linkers – that is as what inflation-linked gilts are generally known – in particular. He based his article, so he indicates, on a paper published by the Office for Budget Responsibility, the OBR, and to be frank I doubt even more that the civil servants at the OBR have a deeper understanding of the subject matter than Mr Ellson himself. Those who would, that being amongst other Sir Robert Stheeman who for a quarter of a century and until last year ran the UK Debt Management Office, the agency tasked with borrowing money for the government in the markets and his successor Ms Jessica Pulay are mentioned by name but were as far as I can tell not asked what they might have to say.
And what Sir Robert’s salary, equivalent maybe to the income of a Goldman Sachs graduate trainee and a tenth of that of a partner in a Big Four firm of accountants, has to do with matters escapes me entirely.
That aside, the cost of borrowing for governments is subject to the same strictures as that of households. The more you owe, the more expensive it gets. What for individuals is their credit score is for governments their credit rating and that of the UK has in more recent times gone only one way.
Yes, inflation has gone up and yes, the cost of servicing Linkers has gone up with it but did Mr Ellson ask how brilliantly linkers served us all during the low inflation years between the GFC and the pandemic?
Having first put Sir Robert’s and Ms Pulay’s names up in lights, he then decides that they weren’t really to blame as they only execute what their masters at HM Treasury ask them to do. The role of the DMO Is not only to issue debt on behalf of the government but to advise the Treasury on where demand will be, both in terms of whether with a fixed coupon or inflation linked, and what maturities are in demand and will sell at the finest rates to the taxpayer.
The DMO reported that in 2023 it had undertaken the valuable exercise of evaluating how Linkers had from the borrowing side’s perspective performed in comparison to fixed rate gilts, known in the trade as “Conventionals”. They found that, since first issued in 1991, Linkers had saved the country a nominal £76 billion which in 2023 money was worth £158 billion. The Times article then cries that when inflation spiked at 14.2% the cost of Linkers had “ballooned” but by how much the author fails to add. This is, to go back to one of my more recent analogies, like trying to shoot flying pheasants with a rifle.
I personally in the late 1990s had the privilege of being co-opted onto the French Trésor’s team involved in pre-marketing their own inflation-linked government bonds, to be known as an OATi. My main bailiwick was German-speaking Europe with an obvious focus on Germany, the 500 lb gorilla in the European investment market. In Germany at the time, there was behold a prohibition on the issuance of inflation linked bonds. Germany has with good reason lived with congenital fear of inflation and the Bundesbank, then still managing rates in the Deutschmark, had a peerless record of fighting incipit inflation early and hard. Thus it was that the Fed had the reputation of setting the lowest rates it could justify whilst the Buba set the highest. So far, no German has ever been President of the ECB. The passing over of Jens Weidemann, a virtual shoe-in for the presidency, in favour of the French politician Christine Lagarde provided proof positive that German monetary conservatism was not in demand and that for political reasons installing a “Minister for the Single Currency” was what the Brussels Eurocrati really wanted.
Alas, as I did my rounds in Germany and found the regulatory constraints on Linkers, I had explained to me that from the Bundesbank’s point of view issuing and investing in inflation-linked securities was deemed to be tantamount to speculating against the Buba’s strict anti-inflationary monetary policy.
I had many strained conversations with regulators, several of which ended with the phone being put down on me. Eventually, the German government relented, joined the Linker market but in 2023 suspended issuance. It’s ironic that Howe launched the UK Linker market with the argument that their very existence would encourage governments to keep inflation as constrained as they could – this was before the Bank of England had been granted its independence – and yet the Germans saw investing in them as an expression of a lack of faith in central authorities. Now put that in yer pipe and smoke it.
I must confess to having become a little bit rusty on the subject, but I do recall the discussion as to what might happen if the cumulative rate of inflation over the life of the bond were to be negative. Would that mean that the capital repayment could be below the sum initially invested? UK, Canadian and Japanese Linkers don’t guarantee that so that at the end of a prolonged period of deflation the nominal return could be negative even if the real return wasn’t. Meanwhile, my friends at the French Trésor thought of their face value floor as a terrific selling point.
The Times article opens with the following: “Britain is broke. That was the depressing conclusion of the Office for Budget Responsibility’s annual report on the future of the public finances published this week. Of course the fiscal watchdog did not choose those exact words. Instead it used 65,000 other words, but if you were to distil the overall message, it’s hard to come to a different conclusion.”
Really? With a debt/GDP ratio of around 100%, the country is far from broke. Chancellor Reeves’s manifesto promise not to raise taxes on “working people” has become an albatross around her neck. A definition of who is included in that category is still outstanding and on form nobody in government, Starmer and Reeves included, appears to be able to offer one.
But that aside, a penny or two on income tax would quickly solve much of the problem. Compared to countries such as France – which is by the way much deeper in fiscal doodoo than Britain – the UK still enjoys comparatively low personal taxation. I suppose “We’re all in this together” ends on the doorstep of 11, Downing Street, the official residence of the Chancellor.
The article is packed solid with piffle. The staggering increase to the taxpayer of debt service costs has in reality, not mentioned of course, next to nothing to do with the rates of interest on the national debt which remain historically fairly benign and nearly everything to do with the exponentially expanding amount of it.
To be honest, the term “historically” can in markets be hugely misleading as historically is as long as a piece of string. If one goes back far enough, or the opposite if required, one can prove more or less anything. Seriously, I remember a few years ago seeing a piece of research bearing a chart tracking inflation back to biblical times. Last week, I got a note from a reader – unverified by me I hasten to add – that over 25 years gold has outperformed stocks, dividends included. And as John Maynard Keynes himself concluded, in the long run we are all dead.
I used to have a strapline on my Bloomberg screen “Investing is an art, not a science”. I suppose the same to quite some extent applies to government borrowing.