Thursday, 3 September 2015

Gilt Issues Considered Harmful

The title of this blog is a riff on the famous 1968 letter to the editor by the late Edsger W. Dijkstra called 'Goto Statements Considered Harmful'. That started the debate within computing to eliminate 'spaghetti code' (funnily enough often written in FORTRAN) and take the long slow road to using advanced 'high level' techniques. It led to the proof that goto statements were never required in programs, and the extensive mathematical work to provide the basis of higher level tools and techniques that I use every day in my work.

The paper contains the following quote:
... our intellectual powers are rather gathered to master static relations and that our powers to visualize processes evolving in time are relatively poorly developed. For that reason we should do (as wise programmers aware of our limitations) our utmost best to shorten the conceptual gap between the static program and the dynamic process, to make the correspondence between the program (spread out in text space) and the process (spread out in time) as trivial as possible
The parallel with economists and the economy should be clear to anyone observing their intellectual approach to the subject.

And secondly the letter sparked a whole series of papers and articles entitled 'X considered harmful' for a whole plethora of X. I am proud to continue the tradition and introduce the seminal work of Dijkstra and his colleagues to a wider audience.

What are Gilts?

Gilts are HM Treasury securities, like the Treasury securities of the USA. They represent liabilities of the National Loan Fund and are issued by the state. 

Functionally they are a form of guaranteed income bond - like the other savings certificates issued by National Savings. In fact in the not too distant past you could purchase Gilts via National Savings as an alternative to the products National Savings issued itself.

But there is one key difference. National Savings Income Bonds can only be bought by individuals, there is a fixed holding limit and they are non-negotiable (i.e. they can't be transferred - only sold back to National Savings or held until maturity), whereas Gilts can be held be any entity national or international, in any quantity and traded in a marketplace.

Once you understand that Gilts, like Savings Bonds, attract regular income and are a government annuity paid by the state to the holder of the Gilt, then you have to start assessing it like any other recipient of a government benefits - tax credits, state pension, disability benefit, housing benefit.

In other words what is the public purpose of providing the Gilt holder with a state income?

Who holds Gilts?

The Debt Management Office, a department of HM Treasury, issues Gilts and the produce a quarterly review of the Gilt Market. The Aug 2015 issue analyses the first quarter, and describes the holding distribution as this:

As you can see from the distribution, and even excluding the nominal holding by the Bank of England, very few Gilts are held directly by Households. The vast majority is held by financial intermediaries and overseas entities.

What is the public purpose of having these middlemen in the process? What is the public purpose of paying a state income to overseas entities? What is the public purpose of the trading market?

Gilts suppress Asset prices

Because Gilts pay an income and are negotiable, they add to the total income available to the private sector, which means - naturally - that the price of other income producing assets is less.

When the Bank of England withdrew Gilts from the market via QE, leaving in place the alternative Bank Reserves, the price of other assets went up.

So because more income is paid on Gilts than on the alternative Bank reserves, the price of private assets is lower than it otherwise would be.

Gilts suppress Spending

Income from Gilts ends up in the hands of a lot of entities that are unlikely to spend it - particularly overseas entities - so there is less demand than there should be given the level of government expenditure.

The actual result is likely to be similar to a tax cut for the wealthy - a greater increase in financial wealth saved by them. 

Gilts are just liabilities of the State.

QE did a swap of Gilts for Bank Reserves, to very little effect in the real economy. As it notes in the Whole of Government Accounts

Consolidating Quantitative Easing does not significantly reduce the overall liabilities of government but it does reduce the number reported as government borrowing. Once intra-government transactions are eliminated, the scheme represents an exchange of gilts (liabilities of the National Loans Fund) for central bank reserves (liabilities of the Bank of England).
Why pay a higher interest rate, or a term premium when you don't need to? 

Gilts back Private Pensions

The main contention made to support Gilts is that they manage the risk profile of private pension firms. And it is true that they do. In fact Indexed-Linked Gilts were introduced in 1981 by the Thatcher government specifically to do just that. The rationale behind them is a triumph of monetarism.

Of course what that tells you straightaway is that the private pension industry is incapable of managing the risk profile of pensions on its own within the private sector. It requires permanent government assistance to do so. The question then is what is the purpose of the private pension industry if it can't deliver the outcome that is required?

A simple pension savings plan at National Savings, along the lines of the Guaranteed Income Bonds and Indexed Linked Savings Certificates, would solve the problem permanently, would be limited to individuals, and would allow them to manage their risk profile as they approach retirement (they would sell out of risky assets and transfer the money to National Savings).

Since it would be only available to individuals and there is no need to pay middlemen, it is clearly far more efficient than the current Gilt issuing system.

Gilt Issues Considered Harmful

I agree with the conclusions reached by Bill Mitchell and Warren Mosler. Read Bill's post on public debt for a more detailed critique.
Most of the arguments made in favour of sustaining public debt issuance can be reduced to special pleading by an industry sector for public assistance in the form of risk-free government bonds for investors as well as opportunities for trading profits, commissions, management fees, and consulting service and research fees. [...] 
The operation of public debt markets absorb a diversity of real resources deployable elsewhere. [...] The opportunity costs in terms of the labour employed directly and indirectly in the public debt ‘industry’ are both real and large.
The ‘cottage industry firms’ that characterise the public debt industry use resources for public debt issuance, trading, financial engineering, sales, management, systems technology, accounting, legal, and other related support functions.
These activities engage some of the brightest graduates from our educational system and the high salaries on offer lure them away from other areas such as scientific and social research, medicine, and engineering. 
On balance, public debt markets appear to serve minor functions at best and the interest rate support can be achieved simply via the central bank maintaining current support rate policy without negative financial consequences. 
The public debt markets add less value to national prosperity than their opportunity costs. A proper cost-benefit analysis would conclude that the market should be terminated.