Have We Seen The End Of Sound Money?

'Sound money' has been a key policy objective in the UK for over 150 years. What this means in practice is a combination of relative household thrift (savings being slightly larger than consumption), public sector thrift (taxes running slightly ahead of government expenditures), a slight positive external balance, and corporate investment just running ahead of corporate profits. This policy, given shape by Gladstone in the nineteenth century, has been the cornerstone of public finances ever since. There have been deviations from this policy over the years, but it has always been the guiding principle to which we have aspired to return when conditions allow. 

Is that still the case? The pandemic has swollen the levels of public borrowing to levels that are very high by historical standards. Borrowing at current levels are normally associated with wartime levels of expenditure. The gap between tax receipts and public expenditures is something that has the potential to destabilise the system. One wonders how they have been funded? By and large, the public debt has been funded by household savings exceeding consumption expenditure  - at least, the household savings of the wealthy and employed - and the business profits - of those businesses still operating - running ahead of business investment. We have achieved temporary stability like this, but it does not augur well for the future.

At some point in the near future we can expect the household savings glut to fall away. A combination of resumed discretionary consumption and a softening of household incomes - as the present levels of disguised unemployment become apparent - will reduce the levels of household savings. The anticipated reduction in the level of business activity is likely to reduce the level of business profitability, putting a dent into corporate savings. That creates a perilous future for public sector finances.

If the private sector is running at a lesser surplus, then only two possibilities can result. Either overseas lenders make good this reduction of funds or the public sector reduces its need for funding. The reliance upon overseas sources of funding creates an internal pressure for the exchange rate to appreciate. An appreciating exchange rate may create a need to adjust interest rates upwards to compensate overseas lenders for the reduction in the base capital value of their lending. This could have problems of its own.

Alternatively, the government could hope to reduce the need to borrow. There are two traditional routes here - tax increases and reductions in public spending. Together these are known as austerity. However, austerity can be self defeating, as we saw between 2010 and 2015. Austerity may attempt to place a cap on deficit financing, but it also reduces levels of economic activity that seriously impairs the tax base.

This leads us to a very interesting place. On the one hand, a return to sound money would suggest a period of austere conditions. Profits would be low, incomes constrained, and expenditures subdued. The political appetite for this future is very restricted. The austerity of the Osborne years is now seen as a mistake not to be repeated. On the other hand, the present policy of an expansive public sector, fuelled by borrowing, is one that resonates politically. Sadly, this leaves us vulnerable to the vagaries of overseas funders and a hostage to domestic inflation. If either of these were to occur, then we would be forced back onto a policy of sound money.

It may appear that we have abandoned sound money as a way to organise our affairs. If this could be a long term solution, then I am sure that it would be satisfactory. The problem is whether it could be a long term stable solution. On this, the jury is out. Despite appearances, it is probably too early to take the view that we have seen the end of sound money.

Stephen Aguilar-Millan

© The European Futures Observatory 2021