Public spending rises and “cuts”

This week’s public spending and borrowing figures do not make happy reading in the UK. In August 2010, four months after the arrival of a Coalition government which made “immediate cuts”, public spending in the month was 11% higher than a year earlier. It just goes to show how much dynamic growth the last government had injected into UK public sector spending.

The figures for those who believe all the stories of cuts are on the Treasury website, and show current public spending at £49.8 billion for August 2010, compared to £44.9 billion for 2009, an increase of almost £5 billion. £1.7 billion was a general increase in spending, £0.8 billion went on extra benefit payments, and £2.5 billion on additonal debt interest. The high rate of inflation does not help, as some of the debt is inflation linked. The increase in public spending was more than three times the government’s published rate of inflation.

Ministers are, as reported, locked in discussions about how to reduce inherited budgets and programmes. The worry is that debt interest will absorb too much of the £90 billion of spending increases allowed for in the five year budget announced this summer. The more of the increase debt interest takes up, the less of the spending increase is available for departments and worthwhile programmes.

Central to making a success of the spending round is to curb inflation. If the government and Bank get inflation down and keep it down, there is no need to offer inflationary wage awards to employees, or to uprate benefits so much to keep up with the inflation. Removing inflationary pressure would leave much more of the £90 billion increase for improving public services. It would also relieve some of the pressure on the debt interest programme by cutting the amount the government has to pay holders of inflation linked bonds.

Meanwhile The Bank is making more noises about printing money to boost the economy. This in the short term helps as it lowers the interest rate the government has to pay for its borrowings. It is, however, vitally important to the success of the public spending strategy that the Bank takes it inflation duties seriously and gets inflation down to low levels. That is the best way to manage public spending well, avoiding cuts in services that matter within the £90 billion increase allowed.

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22 Comments

  1. ferdinand
    Posted September 23, 2010 at 9:05 am | Permalink

    Of course inflation is important but you can't print money and prevent inflation unless you can slow circulation or reduce the amount of business being done.

  2. Ray Veysey
    Posted September 23, 2010 at 10:28 am | Permalink

    John, a question more than a comment, do we need changes at the B of E ?
    the present chairman has come under some flak for his performance with the recent unrepentant labour government, and I was somewhat disturbed by his tone a the Trades Union congress. Do we need a change to go forward ?

  3. StrongholdBarricades
    Posted September 23, 2010 at 11:41 am | Permalink

    Surely the arguement politically is:

    The debt interest from Labour's mismanagement is £x

    Imagine what we could have spent that money on if we didn't have to pay for the overspending

  4. sinosimon
    Posted September 23, 2010 at 11:47 am | Permalink

    Mr Redwood, as I understand it the only direct tool the bank has , if it wishes to 'takes its inflation duties seriously' is the interest rate(assuming that the bank is not going to reverse QE and destroy all the money created over the last two years). Mortgage levels are already crippled, and many hundreds of thousands are clinging on to their homes after reduced hours have slashed their incomes….so even a small hike in rates would probably produce a wave of reposessions. Under these circumstances, say the bank raises rates to 2.5-3 % over the medium term, are you really saying this will help?

    • Sally C.
      Posted September 23, 2010 at 1:15 pm | Permalink

      Good point – this is the awful dilemma going forward. If the B of E carries on its current path of keeping interest rates at historically low levels, printing money via more QE and actively encouraging Sterling to devalue, more inflation is a certainty. The only question is how high will inflation go? However, this strategy will keep government funding costs contained, as the B of E acts as buyer of first resort for UK Gilts. This strategy also allows stressed homeowners to hang on to their overvalued houses.
      Unfortunately, the huge mortgage, personal and business debt, on which our economy is based, remains in tact and the B of E's actions are designed to encourage businesses andindividuals to take on more debt. In fact, their actions are completely immoral.
      The unacceptable truth is that we need much higher interest rates in order to burst the debt bubble, encourage savings and contain inflation. No-one in business believes that interest rates will remain at these historically low levels forever and businesses are to some extent paralysed by this uncertainty. Why would you expand your business here in the UK if you think that interest rates might rise next year, and if not next year, the year after? The longer the Bank of England delays raising interest rates, the longer they are delaying the increase in investment and economic activity that they are desperately trying to promote. Discuss.

      • waramess
        Posted September 23, 2010 at 4:01 pm | Permalink

        Spot on, and whilst spenders desist from borrowing because of the risk of interest rates rising and possible job losses, savers will not spend because they risk eating away their capital. Nevertheless the Bank of England wish to increase the money supply through QE in order to encourage consumption self promoting madness by people who profess to know better.

        These Keynesian ideas must be abandoned in order that common sense might shine through. Savers are not dumbcluts who are stopping the economy from growing, savers are the lifeblood of investment and the sooner our Keynesian friends and their recent conservative converts work this out the sooner we get out of this mess.

      • whistle
        Posted September 23, 2010 at 7:52 pm | Permalink

        Those overvalued houses are the result of too many people coming into this Country,chasing too few houses.Building millions of new ones will not help,as when do you stop concreting over farmland? The interest rates will rise soon,as sure as eggs are eggs,it is then that the fun and games start. As families are being evicted, many thousands of them, what do you think they will do,sit and play tiddly-winks while their homes are taken over by asylum seekers? A period of civil disobedience will follow.

        • Simon
          Posted September 24, 2010 at 12:39 pm | Permalink

          Completely agree with you . It won't be the politicians , bankers and greedy who suffer their wrath though .

          The big problem in the UK is not civil disobedience but civil obedience .

          We put up with far too much .

          None of the 3 major parties are there for the benefit of us , they are only their to represent the vested interest groups ; shadow banking and petro-pharma .

  5. Blue Eyes
    Posted September 23, 2010 at 2:29 pm | Permalink

    The point which seems to be missed in the inflation/QE debate is that the money supply is falling. Current inflation is caused by the falling pound which increases the costs of imports. In rebalancing the economy this is a good thing because it encourages import substitution from domestic sources. If we are not careful the inflation rate will collapse and put us into a disinflationary spiral. Inflation is considerably less bad than deflation.

    • APL
      Posted September 24, 2010 at 2:39 pm | Permalink

      Blue eyes: "Inflation is considerably less bad than deflation."

      It is? How come folk like buying that new PC with all the extra processing power that costs less than the old model you paid for two years ago?

      Modest deflation is good too.

      Or the motor car that now comes with a HiFi sterio, air conditioning, sat Nav, Air bags, all for a similar price (inflation adjusted).

      What we don't want is extremes of either, but what the government have given us is excessive inflation for all of the last fourty years. To the extent that once upon a time within the last half century you might have had a good stab at living a week on 10-/- but today … where will 50pence get you?

      • StevenL
        Posted September 24, 2010 at 6:12 pm | Permalink

        He means house price deflation.

        • Blue Eyes
          Posted September 25, 2010 at 6:18 pm | Permalink

          No, I don't. I mean a downward spiral in the general level of prices which discourages investment and spending.

          I would rather not have inflation, but if we have to choose between inflation and deflation I know which is easier to solve.

          • StevenL
            Posted September 26, 2010 at 2:34 am | Permalink

            Solving inflation is easy, I agree, but only the yanks can do it seen as all commodities are priced in USD. They just have to push all the government debt the Fed has accumalated through QE back into the system and drive interest rates up.

            Voters won't thank them for it though.

  6. Ray Veysey
    Posted September 23, 2010 at 2:39 pm | Permalink

    Strongholdbarricades, sorry but your question is about as valid as saying think how much skiing we could do if there was a snowy mountain in Kent. The debt is the debt is the debt. What would it be like in Britain if the Jacobites had not turned back? the debt is the debt is the debt.

  7. Martin
    Posted September 23, 2010 at 2:53 pm | Permalink

    I have to disagree with those who support printing more money. All that printing money does is cause inflation in those parts of the economy that get access to this money. (Banks get to process this money hence we get inflated Bankers bonuses!)

    The inflation target has been missed for too long. Interest rates ought to be at inflation plus say 2%. (The so called wise (wo)men at the Bank of England would be off down the local DWP office claiming JSA if they were so poor at any other job.)

    For too long this recession has been good news to those with large borrowings.

    Those in well paid jobs with mortgages have been subsidised by others for too long in this recession. These lucky people have able to buy lots of imported goods hence the bad trade figures. This pushes down Sterling and causes us more inflation.

  8. P Haynes
    Posted September 23, 2010 at 3:05 pm | Permalink

    The real problem for the government to solve is to get the banks lending to sound small businesses. They are still not doing this despite their claims. Most, even the government owned ones, are are still actively clawing funds back even where they are well secured (and are charging huge fees and margins to renew if they do).

    If they address this issue businesses could get on with making all the investments they have put on hold and start to lift activity and reduce the slack in the economy.

    This will then slowly start to address the Government's huge borrowing problems through reduced welfare payments and higher tax receipts..

    • simon
      Posted September 24, 2010 at 12:54 pm | Permalink

      My Dad was a bank manager .

      I don't think the banks have lending expertise like this any more .

      They replaced them with sales people whose remuneration was front loaded and had nothing to lose by lending to customers who would not repay .

      Now that we need the lending expertise where is it going to come from ?

      Same can be said of engineering . There is no substitute for apprenticeships , day release to college and 25-40 years experience . These people have no one to pass their considerable expertise onto , when the remainder are gone the expertise will disappear and the country will be poorer for it .

  9. StevenL
    Posted September 23, 2010 at 3:11 pm | Permalink

    Once that BofE have bought all Gordon's debt back through their QE, can't they just demand the banks hold so much cash in their reserve accounts as a monetary policy lever in return for an interest bearing (funny money interest that is) IOU and write off NuLabs debts for us?

    Or is this fanciful thinking?

  10. Dr Bernard Juby
    Posted September 23, 2010 at 3:38 pm | Permalink

    Simply printing money is the way to a banana republic. Inflation/devaluations is the other side of the coin. Soon we shall be like Zimbabwe or the old German Republic where you needed a wheelbarrow to put your worthless money in – and spent it before you reached the end of the streeet because it had devalued in the meantime!

  11. Mark
    Posted September 23, 2010 at 4:37 pm | Permalink

    Checking the DMO data for gilts in issue, I find there is currently a total of £773.2bn of conventional gilts on which the annual interest is fixed at £36.0bn (an average of 4.65%), and a total of £215.8bn of indexed linked gilts valued to include current inflation uplift. The interest payments on the latter I calculate to be about £4bn (average of 1.83%), although the DMO shows a projected interest bill for 2010-11 that totals £43.3bn, up from £30.9bn in 2009-10. The implication is that remaining borrowing for the financial year will add £3.3bn to the interest bill, even though it will only be for under half a year on average. The numbers don't square with the DMO remit forecast of £78.3bn of further new issues over the remainder of the financial year.

    Whatever the underlying reason for the apparent inconsistency in the DMO figures, it should be clear that the main impact on the interest bill is really from the rate at which the debt is expanding, rather than the inflation rate. However, the fact that £200bn of debt has in fact not been sold because of QE is already provoking the inflation we are experiencing. A further QE dose will only serve to fuel the inflation flames, and will require much tougher interest rates to quell than if it does not happen. The real impact of inflation on gilts is to reduce the real burden of repaying conventional gilts, although money illusion makes it seem that the index linkers have become more costly to redeem. Unfortunately there may come a crisis point at which it is no longer possible to maintain a fiction that government can continue to fund future debt if the progress on eliminating the deficit is too slow.

    The BoE is presumably scared witless that banks may not be able to repay their SLS and CGS financing on time, and that extensions to these props will have to come on to the government balance sheet. That is probably the main reason why they are advocating QE. The danger is that we will reach the tipping point that can lead to hyperinflation if we follow that route. Better to face our demons, and get banks to reduce leverage in UK property lending, and government to cut its spending ambitions.

    When we clear out the Augean Stables we create the foundations for re-growth.

    Reply: You need to factor in the requirement to increase the capital to be repaid in line with RPI on index linked gilts, making them dear borrowing for HMG at current RPI rates.

    • Mark
      Posted September 24, 2010 at 10:03 am | Permalink

      But that is not a cash item, nor is it interest income for the holder of the gilt: it is a future liability due on redemption that represents maintaining the value of the liability in real terms. The interest payment on index linked gilts is roughly the original coupon rate indexed for inflation since issue. The nominal amount of index inked gilts in issue is £148.2bn, so inflation linking has given an uplift of 45.6% so far to nominal capital. If there had been no inflation, then the interest bill would be £2.3bn on IL gilts – an average of just 1.58%.

    • Mark
      Posted September 24, 2010 at 1:33 pm | Permalink

      I should perhaps have added that whether it is better to borrow on conventional or IL terms depends on whether the inflation outturn over the life of the gilt exceeds or falls short of the market expectation of inflation at the time the gilt is issued. The IL issues during the Thatcher years have proved to be cheaper borrowing than conventional gilts, because the market was demanding high yields on conventional gilts to cover anticipated high inflation that was successfully squeezed out of the economy. Comparing yields on new issues, it seems that the market is currently pricing in an average of about 3.5% inflation over the next 35 years. That's rather higher than the 2.5% assumption of the market say 5 years ago. Of course, the numbers are currently heavily distorted by the BoE manipulation of interest rates and the yield curve.

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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