James Gillray, a popular caricaturist, drew the above cartoon in 1797. In it, England's Prime Minister William Pitt the Younger is fishing through the pockets of the Old Lady on Threadneedle Street -- the Bank of England -- for gold. At the time, England was in the middle of fighting the Napoleonic wars and its bills were piling up.
According to its original 1694 charter, the Bank of England was prohibited from lending directly to the Treasury without the express authority of Parliament. Over the years, the Bank had adopted a compromise of sorts in which it provided the government with limited advances without Parliamentary approval, as long as those amounts did not exceed £50,000. In 1793 Pitt had this prohibition removed and in formalizing the Bank's lending policies, imposed no limit on the amounts that could be advanced by the Bank.
Thenceforth Pitt made large and continuous appeals to the Bank for loans. Without the traditional Parliamentary check, there was little the Bank could do except satisfy Pitt's demands. As Pitt liberally spent these borrowed funds in Europe, gold began to flow out of England in earnest, a pattern that was compounded by an internal gold drain set off when a small French force invaded Ireland in early February 1797, causing a crisis of confidence in banks. Pitt suspended convertibility of Bank of England notes into gold on February 26. England would not go back onto the gold standard until 1821, some twenty-four years after Pitt had taken it off.
Having removed both Parliament and the gold standard as checks, Pitt had effectively turned the Bank of England into the government's piggy bank. Thus the inspiration for Gillray's caricature of a groping William Pitt. To some extent, Gillray's worries were borne out as a steady inflation began after 1797. However, the Pound's inflation over that period came far short of the terrible assignat hyperinflation that had plagued France only a few years before. The fears so aptly captured in Gillray's caricature were never fully realized.[1]
Back to the future: Ways and Means advances
Pitt's robbing of the old Lady on Threadneedle street illustrates an episode in which the traditional English divide between Bank and State was removed. Both the Treasury and the Bank of England were effectively consolidated into one entity with the Treasury calling the shots.
The last decade or two illustrate the opposite -- the re-erection of walls between Bank and State. If you browse the asset side of the Bank of England's balance sheet, for instance, you'll notice an entry called Ways and Means advances to HM Treasury ("Her Majesty's Treasury"). Ways and means advances are direct loans to the government. They are generally short term, designed to provide the government with temporary financing to plug gaps between expected tax receipts.
Ways and means advances provide the government with an extra degree of freedom because they offer an alternative avenue for funding. Rather than relying on the bond market or the taxpayer for loans, the government can tap its central bank for money. Ways and means advances are very much like banking overdraft facilities. Unlike a regular loan, the borrower needn't provide a detailed account of what the overdraft will be spent on, nor do overdrafts require specific collateral. They are provided automatically and without fuss.
While overdrafts typically come with specified limits and must be paid back on schedule, they don't always turn out that way. William Pitt's machinations secured for himself what was effectively an unlimited overdraft facility to fund the war against Napoleon. A chunk of the British government's WWI expenses were funded by Bank of England Ways and Means advances and though supposedly of a short term nature, these advances took years to pay down. [2]
While any sovereign would welcome the opportunity to directly borrow from a central bank, from the perspective of the lending bank, overdrafts are risky. First, they are illiquid. Other central banking operations, say open market operations, bring a marketable asset onto the central bank's balance sheet, giving the bank the flexibility to rid itself of that asset whenever it sees fit. Secondly, overdrafts are uncollateralized. Should the borrower go bankrupt, the central bank lacks a counterbalancing asset to compensate itself for its loss.
While the Ways and Means overdraft amount to a piddling £370 million, or 0.1% of the Bank's portfolio of assets, in times past it was very large. See the chart below, cribbed from this Bank of England publication.
At various points in the late 1990s, The Bank's Ways and Means overdrafts amounted to as much as £20 billion. Given the fact that the Bank's note issue then stood at around £25 to £30 billion, Ways and Means advances provided as much as 80% of the backing for paper pounds! Insofar as the value of currency is set by the assets that back the issue, the purchasing power of the pound during the 1990s depended very much on the quality of these Ways and Means advances.
Why did Ways and Means advances contract?
In 1997, the government decided that it would cease using the Bank of England as its source for short term financing and instead would turn to money markets. The final changeover occurred in 2000, at which point the Ways and Means balance was fixed at £13.4 billion, and eventually paid down to £370 million in 2008. Thus ended the Treasury's ability to turn to the Bank of England for financing. As for the Bank, it had earned for itself a larger degree of flexibility -- a large and illiquid asset no longer existed on its balance sheet.
There seem to be a few reasons for ending Ways and Means advances. To begin with, the Treasury was already in the process of handing over its control of monetary policy to the Bank of England. Prior to 1998, the Treasury had been responsible for setting rates. Subsequent to 1998, the Bank of England's Monetary Policy Committee has set rates. The decision to freeze and eventually pay down Ways and Means advances went hand in hand with the Bank's increased independence in setting monetary policy.
Secondly, the third stage of European and Monetary Union (EMU) requires that all member nations cease to lend directly to their government. While the United Kingdom is a signatory to EMU, it never proceeded to the third stage, so it was not required to end Ways and Means advances. Nevertheless, given the possibility that it might proceed to the third stage at some future point in time, it probably made sense to plan ahead by ensuring that the government had already established a viable short term financing alternative to the Bank of England.
Dormant, but not dead
While Ways and Means advances are no longer used, the mechanism isn't dead. The interactive chart below illustrates the Bank of England's balance sheet since 2006. Let's remove all component assets except for ways and means advances, the purple series, and see what we get.
As the chart illustrates, after being paid down in early 2008, Ways and Means advances spiked briefly in late December 2008 to £20 billion only to fall back by April 2009 to £370 million. According to this Bank of England report, the explanation for this spike is that the Treasury briefly borrowed from the Bank to refinance loans that the Bank had earlier made to the Financial Services Compensation Scheme and to Bradford & Bingley.
Bradford & Bingley was a failing bank that was nationalized by the UK government in September 2008. The Bank of England had lent around £4 billion in emergency "Special Liquidity Scheme" funds to Bradford & Bingley as it coped with withdrawals. The SLS had been established earlier that year to improve liquidity of the UK banking system. All Bank of England funding via the SLS was indemnified by the Treasury, so any loss that resulted from supporting Bradford and Bingley up until nationalization would have been absorbed by the Treasury, first by taking on the loan itself and funding that loan via ways and means advances from the Bank of England, and then paying the Bank back by April.
The FSCS, the UK's deposit insurance authority, was able to make good on B&B's deposits through a short term loan from the Bank of England, which was quickly replaced by a government loan financed by Ways and Means advances, which in turn was paid down by the government by April.
Just as Ways and Means mechanism provides the government with the ability to meet sudden spending requirements during war, it provided the same during a period of financial crisis.
Where does the Bank of England stand relative to other central banks?
Although the Bank of England has secured itself a significant degree of financial independence relative to the 1990s and Pitt's era, compared to the Federal Reserve/US Treasury relationship the Bank of England/HM Treasury is much tighter. The Fed has been legally prohibited from granting overdrafts to the government since 1980, as I've outlined here. While Bank of England Ways and Means advances are no longer the modus operandi, they haven't been legally struck out of central bank law as they have in the US. Direct advances to the government could be back one day, with a vengeance.
Compared to the Bank of Canada/Department of Finance relationship, the interface between the Bank of England and HM Treasury is fairly tight. As I've outlined here, the Bank of Canada has the ability to directly lend significant amounts to the government over long periods of time. Indeed, the Bank of Canada is currently purchasing record amounts of bonds in government debt auctions, providing the Finance Department with a continuous overdraft of sorts. Few governments in the western world have the ability to harness their central bank in such a manner.
In general I think it's healthy to establish well defined boundaries between a nation's central bank and its executive branch. Ever since John Law's Banque Royale was nationalized in 1718 and then looted by King Louis XV, scholars have been attuned to the dangers of excessive state control over the issuing power of a nation's monopoly monetary body.
That being said, central bank overdrafts needn't necessarily lead to the sorts of hyperinflation seen in Law's day. The Bank of England provided overdrafts to the Treasury for centuries without igniting prices. The gold standard acted to discipline excess use of the overdraft facility, but in modern days a well-publicized inflation target should be sufficient to reign in any silliness. Absent the discipline imposed by inflation targets, the ability to enjoy central bank financing may be too tempting for a sovereign to forgo. Strict limits or all-out bans on overdraft facilities may provide a needed degree of redundancy.
[1] Most of the information concerning the Pitt era comes from Eugene White and Michael Bordo's British and French Finance During the Napoleonic Wars, as well as Henry Dunning Macleod's excellent Theory and Practice of Banking, Volume I.
[2] I get this from Sayers's The Bank of England, 1891-1944.
A quibble with an otherwise fine post:
ReplyDelete"a small French force invaded Ireland in early February 1797, causing a crisis of confidence in banks."
It was actually the French landing at the Welsh fishing village of Fishguard that set off the bank panic.
From Wikipedia's description of the Battle of Fishguard:
"Two forces would land in Britain as a diversionary effort, while the main body would land in Ireland. While poor weather and indiscipline halted two of the forces, the third, aimed at landing in Wales and marching on Bristol, went ahead."
Everyone's favorite part of the story:
"It is thought the French troops may have mistaken local women like her, in their traditional tall black hats and red cloaks, for British Grenadiers when they stood on the cliffs above the British force lined up on Goodwick Sands at the surrender. The story sounds legendary and improbable but a written version of it was in existence as early as 25 February, the day after the surrender, and so the story may contain an element of truth."
Thanks, Mike. I didn't know that part of the story.
Delete"Absent the discipline imposed by inflation targets, the ability to enjoy central bank financing may be too tempting for a sovereign to forgo. Strict limits or all-out bans on overdraft facilities may provide a needed degree of redundancy."
ReplyDeleteMaybe, but can the central bank refuse to clear payments? It is still not good enough if essentially the Treasury can still spend but has to pay interest. In fact, interest spending could cause more inflation.