It had to happen sometime. Someone in the magic circle had to ask the obvious question. Why is the government solemnly paying the Bank of England interest on the government debt it has bought up? After all, the government on behalf of taxpayers, owns the Bank of England.
If I owned 100% of a private bank, and that bank bought up my mortgage from a commercial bank, I could ask my private bank to simply cancel the mortgage. I would, of course, have to tell the taxman about it! The government does not even have to do that, when it finds itself in an analogous position. The government also writes the tax law.
When asked to explain it on the BBC, Mr Peston told us that there could be a problem with the Bank’s balance sheet if the Treasury simply cancelled its debt. He said they would have to convert the outstanding gilts to irredeemables, loans with no repayment date, with zero interest. He clearly does not understand accounting or finance. Such loans would have zero value, so they would not solve the balance sheet problem Mr Peston imagines exists. Even if the zero interest bond theoretically would be repaid in many years time it would have a much reduced value from the bonds the Bank currently owns.
The government’s debts are an asset for the Bank, so anything which diminishes its value sounds like bad news.
Fortunately, Mr Peston, the Bank has bought the gilts on the back of a Treasury loan, with an idemnity from the Treasury. The Bank and the Treasury could agree to cancel the gilts (Bank assets) and cancel the Tresury loan (Bank liability), leaving the Bank’s balance sheet unscathed by the activity. The Bank would owe the Treasury the profits on the gilts it has bought, which indemnity could also be cancelled leaving the Bank all square.
And should they? That is altogether a more difficult question. It would be good, at a stroke, to cut the size of the official (gilt edged) debt by almost 40%, and cut the interest burden. It would be bad to let the markets think that the UK now just intended to print as much money as it felt like spending in the public sector over and above tax revenues. That way is the road to Weimar and Zimbabwe type inflation. If they do end up cancelling this debt, they will need to show greater resolve and success in cutting the deficit and controlling future spending, not less. It would have to be a one off, coupled with obvious commitment and achievement in returning to honest spending and honest money. Confidence is a precious flower, easily killed if the authorities look and act irresponsibly.