11.2Financing the psncr

To understand recent concerns about the size of both public sector decits and the

public debt, we need next to look at the question of the nancing of the PSNCR.

Government borrows by selling a variety of types of securities. The most import-

ant of these are gilt-edged securities (marketable government bonds), treasury bills,

National Savings (which are non-marketable and include National Savings certicates

and deposits with the National Savings Bank), and various types of local authority

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debt instruments. These nancial assets are held by: (a) the UK non-bank private

sector (M4PS), which consists of the personal sector, non-bank nancial institutions

and non-nancial rms; (b) the UK banking sector; or (c) overseas institutions. The

important issues concern:

l	what the government needs to do in order to encourage the holding of increased government debt; and

l	why it matters to whom the government sells its debt.

11.2.1The psncr and interest rates

Since the second half of the 1970s, the nancial markets and hence governments

have worried about the interest rate consequences of nancing the PSNCR by bond

sales that continually add to the stock of bonds. To understand this concern, we begin

by assuming that nancial markets are in equilibrium and that people are holding

just the amounts of the different types of nancial assets to maximise utility, given

the level of wealth in the economy and the qualities of the various assets (including

the time to maturity, associated risk and the present yield). It follows that, if nothing

else changes, government will be able to increase its sales of securities (nance a

larger PSNCR) only by making them relatively more attractive than other assets. The

obvious way to do this is by increasing interest rates payable on them.

Thus, we have the simple idea of a link between the size of the PSNCR and interest

rates in the economy. To sell more debt, the Debt Management Ofce (DMO) – the

government ofce responsible for the management of government debt since 1997

– raises interest rates on new bonds, which now become more attractive than old

government securities, leading to increased sales. Prices of old bonds fall, forcing up

yields on them until they are again competitive with newly issued bonds. Equally, yields

on other nancial assets rise. Interest rates are pushed up all round. However, our dis-

cussion in Chapter 7 suggested that general interest rates would not be likely to change

much through this mechanism in the absence of any change in short-term interest

rates by the MPC of the Bank of England. In any case, we have seen (in section 6.2.1)

that the DMO sets the coupon rate for new bonds and then accepts the market price

for them. Thus, the market sets the yield on new bonds. This approach has applied

since 1979 when the sale of bonds by tender was introduced (see below).

Fortunately for the DMO, it may be able to increase its sales of bonds without

raising interest rates on bonds relative to those being paid on other nancial assets.

At the very least, in a growing economy, the level of real wealth and the total hold-

ing of all assets steadily increase. With no change in interest rates, we would expect

people to be willing to hold more of each type of asset, including more govern-

ment securities. Thus, as long as there is a positive rate of growth in the economy,

real incomes rise, and real savings increase, government should be able to nance

a higher PSNCR each year without causing interest rates to rise. We show this effect

in Figure 11.1 with the demand curve for bonds shifting outwards with increasing

income and wealth, allowing the supply curve of bonds to shift to the right without

necessarily inducing any rise in yields (fall in prices).

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Figure 11.1

We can go further. The ability to purchase nancial assets depends on the level of

nominal wealth and this in turn depends on what is happening to nominal incomes

and nominal savings. Thus, the ability of government to sell securities is inuenced

by the rate of ination. If we assume that ination does not inuence the choice

between real and nancial assets, we can deal with both issues here by looking not at

the level of nominal PSNCR but at the ratio of nominal PSNCR to nominal GDP. As

nominal GDP rises (either because output increases or because of ination), govern-

ment should be able to sell more securities without causing interest rates to rise.

Yet this too rests on an assumption that cannot be sustained. Clearly, ination does

inuence the choice people make between nancial and real assets. We considered

this question in section 7.1 where we calculated real interest rates by subtracting the

expected rate of ination from nominal rates. To keep nancial assets (including

government securities) competitive with real assets during ination, nominal interest

rates must rise in line with ination. Nonetheless, it remains that, as nominal incomes

rise during ination, government is able to nance a higher nominal PSNCR without

having to force up real interest rates.

We can go further. In section 7.2.1 we argued that as ination reduces the real

value of past savings, people need to save a higher proportion of current income in

order to preserve the real value of their assets. This is the idea of ination acting as

a tax. We can apply the notion to the public debt. With ination, the real value of

government securities already held by the public falls (the real value of the public

debt falls). In order to maintain the real value of their total holdings of government

securities, people need to increase their purchases of new securities. That is, even at

unchanged real interest rates people save a higher proportion of current income and

buy more government securities.

To sum up, we can say that during ination, the government may be able to nance

a higher PSNCR without causing an increase in real interest rates in the economy for

two reasons:

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l	nominal incomes rise; and

l	the real value of nancial assets falls, leading to an increase in the propensity to save out of the now higher nominal incomes.

Economists have attempted to capture this second effect in two ways. One has been

by calculating the ‘real PSNCR’. This adjusts the nominal PSNCR by the amount to

which the real value of the existing public debt is reduced by the effect of ination.

A second approach has been to consider what is happening not so much to the

ratio of PSNCR/GDP discussed above but to that of the stock of public debt/GDP. It

is argued that the PSNCR/GDP ratio may be rising but through a range of values such

that, given the rate of growth of nominal GDP, the public debt/GDP ratio may still be

falling. In such a case, it is suggested, a rising PSNCR/GDP ratio may be associated

with a falling interest rate.

We have already said enough to suggest that the link between the size of the

PSNCR and nominal interest rates in the economy is complex and uncertain. Yet

there is more. Plainly, government securities can be made more attractive other than

through increasing the yield on them. In addition, marketing techniques can be

developed to persuade people to hold more bonds at the existing yield. Let us look

at these possibilities more closely.

To begin with, the average holding time of long-term bonds in the UK is quite

short, suggesting that the market is dominated by people principally interested in

capital gains. Such people are more interested in changes in interest rates (and hence

bond prices) than in the absolute level of interest rates. We have seen in Chapter 6

that this means that the demand curve for bonds is likely to shift in response to short-

term expectations about future interest rates. Indeed, expectations have been so

important that the authorities have sought to exploit them in the bond market.

For example, in the 1950s and 1960s it was feared, on the basis of very little evid-

ence, that bond holders held extrapolative expectations – that is, a fall in interest rates

led people to believe that they would fall further (and that bond prices would rise).

Extrapolative expectations:The belief that the price of a nancial asset would continue

to move in the same direction as it was currently moving – extrapolative expectations

are major factors in both bull and bear markets and in the development of bubbles and

nancial panics.

The signicance can be seen in Figure 11.2. We begin in equilibrium with bond

prices at P. The authorities then sell more bonds to nance a budget decit. The stock

expands, the supply curve shifts to S′S′and the price falls to P. The fear was that exist-

1

ing bond holders, having experienced falling prices and capital losses, would fear yet

more. Thus they would be less willing to hold bonds at all prices and yields and the

demand curve would shift to D′D′. As drawn, this pushes the price to a new equilibrium

at P, but it is obviously possible, if the fear of capital losses is sufciently strong, for

2

the market to become completely unstable. These anxieties led the authorities to a

policy of ‘leaning into the wind’. Whenever prices showed signs of changing signic-

antly, the Bank would buy or sell bonds as appropriate to offset the price/interest rate

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				11.2 Financing the PSNCR

Figure 11.2

change. This meant a policy of stable interest rates and a level of debt sales that was

constrained to whatever the market would bear at prevailing prices. Neither interest

rates nor open market operations could be used for monetary control purposes.

In 1974, however, the authorities introduced a more aggressive approach to the

selling of gilts, known as the ‘Duke of York’ tactics. These required interest rates to

be raised articially, leading to a view in the market that they must soon fall again

(and hence bond prices must rise). As bond sales increased in the pursuit of capital

gains, interest rates did indeed begin to fall. This fall, in turn, persuaded those

market participants who still held extrapolative expectations that rates would con-

tinue to fall (and prices to rise). The method, practised between 1974 and 1979,

enabled the authorities to sell large additional quantities of bonds without any

permanent increase in interest rates.

Other new approaches to the marketing of government securities followed. Before

1979, gilts had invariably been marketed using the ‘tap system’. Stock was offered for

sale at a xed price (and hence yield), pre-determined to make the stock attractive,

given the existing market conditions. When the market was unwilling to purchase the

full issue at that price, the unsold stock would be taken up by the Bank of England

and subsequently released onto the market as and when conditions suggested that the

xed price would be acceptable. From March 1979, the authorities moved towards a

‘partial tender’ system in which stock is announced for sale by tender, allowing the

market to x the price which will clear the stock. This is subject to a minimum tender

price (hence partial tender) designed to prevent a sudden collapse in stock prices should

the authorities miscalculate the timing and attractiveness of the sale. If the minimum

price is set realistically, the price is determined by the market and the authorities can

be certain of selling given quantities of debt at pre-determined intervals.

In December 1980, the Bank introduced taplets(also known as ‘tranchettes’) – the

practice of issuing relatively small amounts of a number of different stocks rather than

a single tap stock. For example, in July 1982 eight different long-dated stocks were

issued, amounting to a total of £1,200m. In May 1987, following the 1986 reorgan-

isation of the UK gilts market, with the increase in the number of market-makers

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and the hoped-for increase in the competitiveness of the market (see section 6.2.3),

the Bank initiated an experiment with full gilts auctions without a minimum tender

price. To the extent that changes in marketing techniques lead to increased gilts

sales, the authorities are able to nance a higher PSNCR without causing interest

rates to rise.

The 1970s and early 1980s also saw a number of product innovations in both gilts

and National Savings, the most important of which was the introduction in 1981–82

of index-linked gilts. These are gilts that pay semi-annual cash ows indexed to the

Retail Prices Index (RPI).

We can summarise all this by saying that to the extent that non-price competition

is possible in nancial markets through product variation, the government is able to

nance a higher PSNCR in other ways than by pushing up interest rates on its own

products relative to other nancial assets.

All of this applies when we begin by assuming equilibrium in the market before the

government seeks to nance an increase in government expenditure. It is possible,

however, that in periods of budget surpluses or small decits, the market may become

short of government debt. This is because a number of nancial institutions are either

required or seek to hold a proportion of their nancial assets in the form of gilts

because of their security and because they are long-term, xed-interest rate assets.

Gilts are particularly useful for life insurance companies and pension funds, which

must match expected income from their assets with their expected nancial obliga-

tions over long periods into the future. Thus, during periods of budget surplus, the

supply of new gilts onto the market might not meet the needs of institutions of this

kind, pushing bond prices up and yields down.

We have now identied a number of circumstances in which increased govern-

ment bond sales might be possible without an increase in interest rates. These are

summarised in Box 11.4.

Box 11.4Increases in public sector decits and the rate of interest

An increase in government expenditure that causes the PSNCR to rise might not

inuence interest rates under the following circumstances:

l	if the additional government expenditure being nanced causes an increase in output, employment and real savings such that holdings of all types of nancial assets increase;

l	if the wealth of the economy is increasing, for whatever reason;

l	if ination reduces the real value of the nancial assets of savers, causing them to increase the proportion of income saved;

l	if government bonds are sold to the banking sector (monetary or residual nancing of the increase in the PSNCR);

l	if the managers of the public debt are able to sell more bonds at the existing interest rate by innovative marketing techniques;

l	if the development of new or modied products (such as index-linked bonds or strips) succeeds in enlarging the market for public debt.

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