Few people have heard of the Debt Management Office. It is not just bond traders and pension fund managers.
This obscure part of the Treasury plays a crucial role in dealing with Britain’s ever-growing mountain of debt. But, like many other things in Britain today, it appears to have lost its way.
The DMO used to pride itself on its ability to carefully manage the gilts markets to achieve a debt profile that was particularly long-term by international standards. Today, the DMO’s strategy is exposed.
The national debt is out of control, and has now reached more than 100pc.
This responsibility is entirely the responsibility of the politicians, who decide on taxes and expenditure.
It is not the DMOs fault directly that the cost to service this debt has reached record levels.
The reason for this is partly because the coupon rate on a large portion of that debt – around a quarter – is linked to the inflation rate.
The DMO has been complicit with allowing this aspect of the national debt become so dominant.
The spike in inflation is partly due to Britain’s exposure in these index-linked gilts, or “linkers”, which are driving debt service costs through the roof.
Fitch Ratings has calculated that the UK’s debt interest payments will be slightly higher than 10% of its government revenue this year, which is around PS110bn.
Even Italy, which has a debt load even greater than ours, is nowhere near as high. No one else has such a high level of exposure to “linkers”.
It is not necessary to say that money spent on bondholders’ service does not allow for other uses.
It is worth noting, that the debt service costs for this year would more than double the defence budget.
We are locked into a situation where we can’t control how much money is spent on interest.
How did we ever get here? The first “linker”, in the UK, was issued in the early 80s while Geoffrey Howe still held the position of chancellor.
At the time, it seemed like an excellent idea. Pension providers and insurance companies were looking for assets to match liabilities that could be guaranteed against inflation.
It was also a relatively inexpensive form of debt financing for the government compared to the alternatives. The demand was so great that each issue would command at auction a substantial premium over the face value.
In essence, buyers were paying the Treasury in order to be insured against inflation.
The DMO and other people involved in the decision to structure the country’s debt thought it was a good bet, since inflation had been declining by early 1990s and there was a consensus that we would enter a new and most likely permanent disinflationary era.
It was, until it wasn’t. In our increasingly shambolic economy, we have accumulated and spent the short-term savings of debts that appeared to be cheaper without considering the inflation risk.
The advent of inflation target led to a growing confidence in the ability of the inflation rate to remain low for an indefinite period of time. This increased the demand for inflation-linked gilts. The market was created and it needed to be continually sated.
This surge was also motivated by an ex-post explanation that was suspect. The government had a lot of skin in the game, and was therefore committed to maintaining low inflation.
The Government must make putting the inflation in its place their number one priority . We are already perilously close in terms of debt sustainability; an extended period of inflation could push us over the edge.
With the benefit of hindsight, everything is clear. If Treasury and DMO could have predicted today’s inflation, they wouldn’t have issued so many links.
They did not. They never imagined that the debt would be so high.
As the public finances began to recover from financial crisis devastation, the pandemic arrived to further derail the situation.
The Treasury had a “oo-er moment” shortly before the pandemic of 2018, or perhaps a late recognition that the linkers weren’t under control.
Their issuance was significantly curtailed by the screeching noise of brakes being applied violently. It was too late. The train had already left.
The linkers are particularly dangerous because they protect not only the coupon against inflation but also the principal.
The ratchet effects occur as the principal value increases. Although the linkers represent “only” 25% of the primary issue, they become a larger share of the debt liability in the end.
According to the Office for Budget Responsibility, debt interest should fall as a percentage of government revenues as inflation declines.
This is still much higher than the European average and the UK long-term average over the past 20 years.
The DMO/Treasury miscalculated linkers, but this dire situation is not entirely attributable to them.
The second part of the story involves our friend Quantitativeeasing. Its effect was to exchange Bank of England Reserves paying the Bank of England’s official rate of interest for long-term loans.
It was great when the Bank Rate was near zero. This was extremely beneficial to the public finances. The debt servicing costs dropped significantly, even though the debt mountain was growing.
With today’s inflationary surge the Bank Rate is now higher than the rate for long-term debt. The effect is reversed and debt service costs are once again on the rise.
We have spent and banked the QE windfall gains, but now we must pay for it.
In other words, debt management is a prime example in Britain of “live Now Pay Later”.
Some people say that if you take care of the present, the future will look after itself. It is a nice saying, until the future comes in unexpectedly.