Britannia, beggared

Feathers were thoroughly rustled yesterday. The accounts of Her Majesty’s Treasury were released in all their terrible glory. The fate of Britain’s finances laid bare across 150 pages.

Britannia pawned her trident many years ago. It still stands, proud and gleaming in the pawnbroker’s window, but she cannot possibly afford to buy it back. She lingers by the window, near the “we buy gold for cash” sign that Gordon Brown was so enamoured with, before turning away. Her face is gaunt; sunken, sallow cheeks pulled raggedly across an ageing skull.

In 2010, the Royal Mint hired a guest artist, Suzie Zamit, to design its silver and gold coins. Zamit, a sculptor, was to create a new image of our national heroine and emblem, Britannia.

Although previous coins and all since depict Britannia (and indirectly, our country) as youthful and strong, Zamit lifted the veil. Two years after the financial crisis, Britannia no longer appeared as a noble warrioress, the ruler of the waves. She was weary and worn, looking more like an addict than a deity. But addict is the word when it comes to Britain’s relationship with debt. I almost feel nostalgic for the year broken Britannia was stamped into coins, purely because we hadn’t yet reached the dark shore known as “trillion pound debt levels”.

UK government debt then stood at £960 billion. Seven years on, our net public debt has reached £1.98 trillion – nearly a full trillion more than 2010. Were Zamit to depict Britannia now, I dread to think what she’d look like. The report from the Treasury states that we have a total liability of £3.7 trillion, when including future tasks such as the decommissioning of nukes and future payments like civil service pensions.

This doesn’t look good for either Labour or the Conservatives. Labour wants to increase public spending to mad levels, while nationalising multiple major industries. The Conservatives meanwhile, have tried to distance themselves from “austerity” (where public spending didn’t even go down) and are eyeing the debt trough greedily once more.

Neither of these ambitions bode well for the future. Of our total liabilities, government borrowings are at £1.26 trillion. The value of our government’s borrowings, which are made up of treasury bills and gilts, are subject to the interest rate decisions of the Bank of England (BoE).

Pawnbroking changes Rolex prices?

The cost for commercial banks to borrow on a short-term basis from the BoE is a pathetic 0.25%. This short-term rate is the primary interest rate everybody focuses on when the Monetary Policy Committee meets every month, as it sets the trend for all other rates.

What a 0.25% interest rate means is that the BoE will only charge 0.25% on a “14 day gilt repo”. Do not be confused by the terminology. Gilt repos are just pawnbroking arrangements, except instead of bringing your Rolex to the desk you bring a gilt. Commercial banks own gilts, and will pawn them for money from the BoE. What makes the BoE special is the money it uses to buy the gilts are “central bank reserves” which can be converted into banknotes. These “reserves” are created on the spot by the BoE, and there is no real limit to how much it can create, provided there is enough collateral (like gilts).

The bizarre nature of central banking is revealed when you imagine this situation in real life. You go to the pawnbroker with your Rolex for some fast cash; the pawnbroker prints money on the spot to pay you. And if you want to get your Rolex back, you need to pay them 0.25% interest.

Of course central banks have different ambitions from pawnbrokers. Were a pawnbroker to have the power of the BoE, I’d imagine they’d simply buy everything. Central bankers meanwhile, say they’re not in it to make profit, they’re here to “stabilise the economy” (I’m sure some of them believe that, anyway).

Too many Rolexes

But we’ve gone off the trail a bit here. Commercial banks pay 0.25% interest on the Rolex (gilts) they give to the BoE. Commercial banks work by taking the money they’ve received from the BoE and lending it to customers in the form of longer-term business loans and mortgages, who they charge a higher rate. It is in this way that retail banks make money – on the difference between short and long-term interest rates. Commercial banks have other methods of raising money, notably from each other, but this is the primary method.

The use of gilts – British government debt – as a tool for raising short-term funds has a huge effect on their price. And their price dictates how much the UK government must spend on interest payments. Among other things, their use as a short-term means of raising money causes a strong correlation between the BoE’s interest rates and the interest rate on gilts.

As we’ve said, the 0.25% rate of interest set by the BoE is pathetic. And there are stirrings that this might change. At the same time, should a ruling party decide it’s time to borrow loads of money, the market will demand higher interest payments, as more borrowing creates more risk.

A hike in interest rates, coupled with a ruling party borrowing huge amounts of money, could be catastrophic for our nation’s already dire finances – the shackles of interest payments would tighten dramatically. More borrowing would ensue, just to stay afloat and maintain interest payments.

Tim Price, award winning fund manager and value investor, has been warning us about the risks in the gilt market for some time. He sees the storm coming, but has a strategy to avoid it – and there’s more to it than just avoiding Rolexes.

Rule Britannia

There’s a certain irony that Britannia’s sallow look was imprinted on gold and silver coins, the very metals to protect wealth from the monetary illness Britain suffers. Politics aren’t excluded from the image either – Zamit deliberately depicted Britannia facing east as an overt nod to Britain’s involvement in the EU and Afghanistan.

No wonder she looks anguished.

If you fancy some bedtime reading, the accounts from the Treasury are here. The wording should send you to sleep, but the content might give you nightmares.

Rule Britannia. I guess she still does. But these days, all we seem able to do is maintain a certain level of order at home, which isn’t anything to brag about really. I’ve certainly not heard anyone singing Rule Australia, or Rule Croatia.

I suppose we “rule” the waves to the extent that we have a global and mobile nuclear deterrent, silently carrying weapons of unimaginable carnage in the depths of the ocean, but these are only useful in addressing a nuclear threat. The entire purpose of these submarines is to remain hidden, playing on the imagination of foreign powers – as a mentor of mine used to say “Ahmadinejad needs to believe there’s one in his swimming pool.”

No matter our exploits at sea, we’re certainly not “ruling” in any of the foreign countries we’ve invaded recently, which are now considerably worse off than before.

What do you think Britannia represents these days? boaz@southbankresearch.com.

Have a great weekend!

Until next time,

Boaz Shoshan

Category: Central Banks

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