Voluntary and Involuntary Constraints on the Conduct of Macroeconomic Policy: An Application to the UK

Abstract:

Modern Monetary Theory advocates make the distinction between voluntary and involuntary constraints with respect to operation of key institutions, such as the Central Bank and Treasury, in their conduct of macroeconomic policy. In this article we explore several episodes of UK policymaking, in order to demonstrate consistency regarding the policy coordination between HM Treasury and the Bank of England, and, in addition, highlight numerous voluntary constraints which by their very nature can be finessed when circumstances demand. In particular, we show that the use of the Ways and Means account on a number of notable occasions has meant that Government spending was not constrained by prospective tax receipts and sales of Government securities. Also, the introduction of non-convertible banknotes and other strategies, including the financing of the First War Loan, meant that the prevailing voluntary constraints were sidestepped.

Keywords::

• voluntary constraints
• Bradbury Pound
• ways and means
• currency sovereignty, gold standard

JEL Classification Codes::

• E42
• E52
• E62
• N20

Notes

¹ The UK and the Czech Republic were not signatories of the Fiscal Compact, which was signed by other EU members in March 2012. “The fiscal compact is claimed to be a step towards a true ‘fiscal stability union,’ as it aims to strengthen the fiscal governance framework in the euro area and addresses some of the shortcomings of the recently reinforced Stability and Growth Pact” (European Central Bank 2012).

² Given the inflexible nature of the Stability and Growth Pact, serious divisions have developed between member states, which has encouraged the rise of nationalist forces, reminiscent of the 1930s (Montani 2018)

³ A fiat currency has been declared to be legal tender by the Government but has no intrinsic value since it is not backed by a precious commodity.

⁴ For example, in order to counter an outflow of capital, the Central Bank would raise the policy rate to “defend” its stock of gold reserves and maintain the exchange rate via capital inflows.

⁵ For instance, William Allen (2019, 14) details that at the outbreak of the First World War, the London Stock Exchange owed large sums to London banks, with their debts representing approximately 3.4 percent of GDP and constituting 7.6 percent of bank assets.

⁶ “The failure … of an important firm, Messrs. Derenburg and Co., who were largely concerned in business with Germany, brought home to members of the Stock Exchange the character of the situation … nobody felt safe” (Keynes 1914, 462–463).

⁷ Throughout the paper, documents are referenced from the Bank of England (BoE) and British National Archives, both of which are cited with relevant volume and page numbers.

⁸ Liaquat Ahamed (2009, 31) notes that between July 31 and August 1, the Bank of England's stock of bullion fell by over $80 million.

⁹ This was a reversal of the Bank Charter Act of 1844, in which any note issue by the BoE was required to comply with the rules of the Gold Standard (BoE 1969).

¹⁰ This letter from HM Treasury was in response to a Freedom of Information request about the circumstances associated with the issue of BPs.

¹¹ The British authorities also suspended gold convertibility in 1797. With the advent of the Napoleonic War, the suspicion that the French were ready to invade Britain caused many farmers to become anxious and a bank run commenced, with the BoE suffering significant losses of bullion(Grellier 1810, 406–407). News then arrived that the French had landed in Wales on 25 February, sparking a panic. As a result, the BoE suspended gold convertibility, and issued two non-convertible “Bank of England’ notes, in £1 and £2 denominations via the Bank Restriction Act 1797 (BoE Archive, 8A245/1, 3). The new notes continued to circulate until the restoration of gold convertibility in 1821.

¹² HM Treasury announced in December 1919, that there would be a gradual removal of BPs from the monetary system. From 1920–1926, the stock of BPs in circulation was reduced to £246.9m (Johnston 1934).

¹³ Under a tap system, any securities which are not purchased by market participants are purchased by the Central Bank. In this way, the authorities simply “mop up” any excess, which allows the authorities to determine the final yield. As Keynes puts it, with the use of a tap system, “The monetary authorities can have any rate of interest they like” (Keynes 1971–1989, vol. 27, 390).

¹⁴ The British authorities also made an attempt at issuing gilts via a tender process in 1933. During the first tender on March 24, £40 million of Treasury bills and £5 million of gilts (long-term securities) were placed for auction. Yet the process was judged to be a failure. On the first tender, the price for gilts was in fact higher than had what been intended, while the price was too low in subsequent tenders (Allen 2019, 21–23).

¹⁵ Minimum prices were also imposed during the Second World War from June 1940. Sales of gilts were issued through a tap system, in which the final yield was fixed (Allen 2019, 47).

¹⁶ “In order to prevent a stoppage of the public services, which may arise by insufficiency of revenue or other disturbing emergency, power is given to Treasury … to borrow temporarily … on the credit of ‘Ways and Means’” (Wormell 1999, 118).

¹⁷ The British public also accepted the non-convertible “Bank of England notes” in 1797. According to Albert Feavearyear (1931, 170): “a resolution was passed unanimously, and subsequently published in the press bearing the signatures of many hundreds of leading business houses, declaring that they would not refuse to receive Bank notes in payment of any sum of money to be paid to them, and would use their utmost endeavours to make all their payments in the same manner.”

¹⁸ While the British Government financed part of its operations through Ways and Means advances during the First World War, Treasury officials resisted assistance from the BoE during the Second World War. Nonetheless, the advent of the conflict brought about a range of other challenges, which required extensive coordination between HM Treasury and the BoE. As with World War I, a large proportion of the British Commonwealth's war purchases abroad would be payable in gold, under the terms of the “cash-and-carry” deal as agreed with the United States (Draper 1979, 143). To preserve all gold stocks, the Government announced that “it would be necessary to bring, directly or indirectly, every available ounce under Control” (BoE Archive, M5/534, 410). Then with the threat of Nazi invasion, officials were instructed to draw up plans for the removal of all the country's gold reserves and securities. All of Britain's gold reserves were then successfully shipped to the Bank of Canada for safekeeping for the entire duration of the conflict (see, for instance, Switky 2013; Taber 2014).

¹⁹ A third condition is lack of exposure to foreign currency debt, which is a problem that faces many emerging economies. However, countries can hold foreign currency assets and also hedge foreign currency to counter their exposure to losses. Anthony Rush, Dena Sadeghian, and Michelle Wright (2013) analyze Australia's foreign debt exposure.

²⁰ A good example of the policy constraints imposed by high foreign debt exposure is Turkey, which has a free-floating exchange rate regime but suffered a severe speculative attack in 2018. This led to a large depreciation of the Turkish lira and inflationary pressures. Turkey has significant private (corporate) debt denominated in U.S. dollars, so the depreciation caused major repayment problems for the private sector, which led to the Central Bank raising the policy rate from 17.75 percent to 24 percent.

²¹ There is a growing literature about alternatives to credit creation by commercial banks (see, for example, Dyson, Jackson, and Hodgson 2014; Dyson, Hodgson, and van Lerven 2016; Positive Money 2016; King 2016; Etzrodt 2018a, 2018b), but engagement with this debate is outside the scope of this article.

²² Thus, the textbook “money multiplier” which is based on deposits driving loans is a “common misrepresentation” (McLeay, Radia, and Thomas 2014, 15; see also Minsky 1986; King 1994, 2016; Stevens 2008; Constancio 2011; Carpenter and Demiralp 2012).

²³ For simplicity, we ignore the use of credit cards.

²⁴ Although, typically, the government appoints the members of the Central Bank Committee which sets the target interest rate. Moreover, Central Bank operational independence was challenged by President Trump.

²⁵ Phillip Inman (2018) reports on claims made by two former senior staff at the BoE about the lack of policy coordination between the Bank of England and the HM Treasury.

²⁶ The issue of consolidation has caused some confusion in the literature, but also within the “blogosphere” and on social media, such as Twitter, where many do not recognize the complexities of prevailing institutional arrangements.

²⁷ Analogously, to prevent downward pressure on the interbank rate, the Central Bank must also offset any purchases of foreign exchange if a managed or fixed exchange rate were to be maintained. For example, following the abandonment of direct gold convertibility in 1931, the Exchange Equalisation Account was established in 1932 to manage the Pound. To insulate domestic monetary policy from foreign reserve flows, any purchases of gold and foreign exchange were offset through the sale of gilts (Allen 2019, 34).

²⁸ Under a corridor system, banks may wish to hold increased reserves following the increase in economic activity, which would reduce the extra holdings of debt by the non-government sector following OMO.

²⁹ “Full funding” is still practiced in the UK (see below). The adoption of the floor system in March 2009 was not designed to enable the implementation of OMF, but to enable the introduction of Quantitative Easing (see, for example, Osborne 2016).

³⁰ Alternatively, Bank of England securities could be used for this purpose (Rule 2011).

³¹ As King (2016, 259) points out, “Australia, had managed their public finances so carefully that there was simply too little government debt outstanding to supply the demand for liquid assets.”

³² Bank reserves include their holdings of vault cash.

³³ Likewise, in Australia the Reserve Bank of Australia (RBA) operates in a similar manner. The Federal Government maintains its daily cash account with the RBA, known as the “Official Public Account’ (OPA). The Non-Corporate Entities (NCEs) (i.e., Government Departments) hold all cash reserves (generated from tax receipts and other revenue streams) within a “Consolidated Revenue Fund’ (CRF). All monies collected by NCEs are then transferred into the OPA (Department of Finance 2014). Given that there is “considerable cash flow volatility as a result of mismatches in the timing of revenue receipts and expenditures … the RBA provides an overdraft facility to the Government’ (Australian Office of Financial Management (AOFM) 2017). For example, even though during 2014/2015 the daily average balance in the Government's OPA was approximately $3 billion, the bank's overdraft facility was used (see Reserve Bank of Australia 2015). Thus, while the Australian Government via the AOFM issues and sells securities to the non-government sector, it can still create currency ex-nihilo.

³⁴ By absorbing surplus cash in Special Deposits, the government and BoE controlled the money market. The use of Special Deposits represented a substitute for OMOs (Harris 1931, 46). He estimates that about £635 million had been placed in “Special Deposits” by mid-1919.

³⁵ It is now widely established and accepted in the literature that the disparities between sovereign economies, such as the UK, and eurozone members is stark.

³⁶ Although many commentators portray QE as an innovative operation, the mechanics which underpin QE have been recognized for some time. For example, Keynes (1930, 371) prescribes that “it should not be beyond the power of a central bank … to bring down the long-term market-rate of interest to any figure at which it is itself prepared to buy long-term securities.” Likewise, “it lies within their power [the Bank of England], by the exercise of moderation … of which they have shown to be masters, to make the long-term rate of interest what they choose” (Keynes 1971–1989, vol. 21, 395).

³⁷ The BoE has also intervened to reduce long-term rates on several other occasions. For example, following the devaluation of the Pound in 1949, long-term yields increased to four percent. In response, the Bank purchased £3.75 million worth of gilts, and by 1950 yields were once again below four percent. Likewise, the Bank resisted rising yields in 1961 via gilt purchases of £120 million, following sustained balance of payment deficits. Also, the Bank instituted several rounds of purchases in 1968 (£206 million), 1969 (£322 million), 1970 (£240 million) and 1975 (Allen 2019, 71–73, 120–144).

³⁸ Both Mark Carney, who commenced his appointment as BoE Governor in June 2013, and Sir Mervyn King, the previous Governor, have pointed to the limitations of reliance on monetary policy. The inability of monetary policy to address a sharp decrease in private spending and investment since the GFC is summarized by King (2016, 347): “Many countries can now see that they have taken monetary policy as far as it can go.”

Additional information

Notes on contributors

George Pantelopoulos

George Pantelopoulos and Martin Watts are respectively PhD student and Emeritus Professor of Economics at the Newcastle Business School, University of Newcastle, in New South Wales Australia. This article is dedicated to the memory of Michael Mumford, the brother-in-law of the second author, who died in June 2020. Michael taught at Lancaster University and was a fine scholar. He also alerted the authors to the issue of the Bradbury Pound in the UK which features in this article. We thank the referee for the constructive comments.

Martin Watts

George Pantelopoulos and Martin Watts are respectively PhD student and Emeritus Professor of Economics at the Newcastle Business School, University of Newcastle, in New South Wales Australia. This article is dedicated to the memory of Michael Mumford, the brother-in-law of the second author, who died in June 2020. Michael taught at Lancaster University and was a fine scholar. He also alerted the authors to the issue of the Bradbury Pound in the UK which features in this article. We thank the referee for the constructive comments.