Instead of coming up with fiscal tricks that move costs around we need policies that will make a real difference
In the past five years, the UK has been through a global pandemic and a cost-of-living crisis with a threadbare state due to the austerity that preceded it. This has amplified the struggle of poverty for millions, pushed public services to breaking point and has continued the trend of living standards stagnating since 2008. Meanwhile, climate change wreaks damage across the world with 2024 so far being the hottest year on record. Instead of finding ways to fund vital investment to set the UK on a better path, the Liberal Democrats, Conservatives, and Labour party have all ruled out increases to VAT, national insurance, and income tax. Furthermore, all want to stick to fiscal rules which will constrain our ability to borrow.
If politicians don’t want to raise taxes or borrow, they may have to look to cut spending – an ominous prospect given the state of public services. However, there is fortunately one area ripe for savings. In 2009, the Bank of England changed its monetary policy operations to transmit interest decisions by paying interest on all reserves, the money commercial banks hold with the Bank of England. However, this change in operations has become very expensive in recent times due to higher interest rates. Since 2021, the Bank of England has sent the banking sector £70bn[1] through interest on reserve payments. As interest rates have risen these payments have ramped up quickly. In 2022 and 2023, Barclays, Lloyds, NatWest and Santander received £13 billion in interest payments. Going forward, the Bank of England is scheduled to send over a further £120bn in the next five years.[2] To put these figures into context, just £12bn could retrofit 7 million houses to bolster energy efficiency and keep us warm in winter, £70bn is almost the whole yearly budget for universal credit and £120bn is three quarters of the NHS’ annual day-to-day budget.
These interest payments are supposed to be funded by the Bank of England, however, in recent times, the Bank has made a loss on these operations. Furthermore, the Bank also makes a loss when it sells off government bonds that were bought during quantitative easing (QE) at a lower price than it paid originally. Due to the financial relationship between the Bank of England and the Treasury, taxpayer money and extra borrowing has had to fill the gap, amounting to £50bn since 2022 and expected to be over £110bn in the next five years.
These large sums have already attracted political attention. For example, a group of 44 Conservative MPs suggested that quantitative tightening (QT — selling off the bonds bought during QE) should be slowed to stop losses from accumulating so quickly. They point out that this is the approach of both the US’s Federal Reserve (the Fed) and the eurozone’s European Central Bank (ECB). If the Bank of England took this approach, it would “save” about £100bn until 2033. However, it would simply move the cost to years beyond, with any real savings depending on how bond prices change over the next few years. Stopping, rather than slowing, QT could genuinely deliver savings, but such a policy may be harder to achieve politically without being seen to break central bank independence.
Another proposal following the Fed and ECB, would be to change the financial relationship between the Bank of England and the Treasury and not pass on losses to the Treasury. The Fed and ECB do this through a “deferred asset”, a loss that builds up on the central bank’s balance sheet until profits accrue and pay it down. Such a system in the UK would save the Treasury around £20bn a year until 2029. However, if the central bank returns to profitability these “savings” will be paid for by cancelling payments from the Bank of England to the Treasury in the future. This can be significant, given the Treasury received £125bn from the Bank of England between 2012 and 2022 when interest rates were low. In this sense, the Treasury cannot avoid the expected lifetime loss of £105bn from QE and QT, as this would be paid for with a loss of future income for the Treasury. Furthermore, if central banks do not return to profitability, it is likely they will demand costly recapitalisation as they may be afraid to keep a loss on their balance sheet just like the Swedish central bank demanded recently. The reasons why central banks try to avoid losses while being able to create money will be explored in future NEF work.
However, we should also question why we must pay these costs at all. The above measures are merely “fiscal tricks” that move costs around. At the end of the day the banking sector will still receive a large subsidy worth £100s of billions. Fortunately, as we have argued at NEF since 2022, there is an alternative – tiering the interest paid on reserves. In 2023, the European Central Bank put the policy into practice, showing that it is not necessary to pay interest on all reserves. We calculated that forcing banks to hold some reserves (via reserve requirements) that pay no interest could save up to £55bn in the next five years, while still allowing the Bank of England to implement monetary policy to tackle inflation. As the Bank would still have full control over interest rates it is harder to argue such a policy would harm central bank independence, as former deputy governor Paul Tucker has explained.
A growing number of economists, including ex-central bankers, other think tanks and former prime minister, Gordon Brown, have endorsed the idea. Furthermore, political parties have started to talk about the issue too. Reform UK have proposed to scrap all interest paid on reserves created from QE which they estimate will save £30 – 40bn a year. For sure, this would remove the subsidy to the banking sector almost entirely. But removing interest payments without other changes to monetary policy, which Reform do not detail, alongside their explicit suggestion that tiering would not be necessary, risks breaking how monetary policy works and losing control of inflation.
Rachel Reeves, Labour’s prospective chancellor, opposed the idea citing that paying “interest on reserves is part of the monetary policy transmission mechanism”. This criticism may be relevant to Reform UK’s proposal; however, tiered reserves are designed to protect how monetary policy can be passed through. In our work at NEF, we modelled the impact of tiered reserves using international and historical examples of central banks use of reserve requirements as guidelines. From this we see savings up to £11.5bn a year could be achievable. We believe even further progress could be made towards a monetary policy system that does not subsidise banks, but it is sensible to approach such a system slowly to reduce adverse and large effects on financial markets.
Other major political parties have yet to engage with even more moderate proposals. The reason for this could lie in our fiscal rules. As we have noted in the past, tiered reserves would not currently show up adequately in the fiscal headroom that our fiscal rules define due to the timing of savings. The fiscal trickery of delaying and moving around losses may be more popular to politicians as it can have a bigger direct impact on meeting the fiscal rules. However, this is exactly the weakness in our fiscal rules – their arbitrary design, which in this case prioritises fiscal trickery over actual economic reform.
At NEF, we have proposed replacing fiscal rules with fiscal referees. Experts (without policy-making powers) who can assess risks to debt sustainability more holistically, understating the complex determinants of fiscal risks and make suggestions that respond to context. Fiscal referees would be well placed to highlight that fiscal trickery doesn’t really save costs and ensure proposals, such as slowing QT or changing the financial relationship between the Treasury and Bank of England, are assessed purely on how they distribute costs over time.
The needs of the UK are clear: we need to revitalise our public services, protect people from the cost-of-living crisis and combat climate change. To do this we will need a government unafraid to find ways to raise revenues and replace our broken fiscal rules with referees that can account for our everchanging economic context. Instead of coming up with fiscal tricks that move costs around we need policies that will make a real difference. Tiering reserves will be attractive to politicians who have created self-imposed limits on tax pledges and bound themselves with flawed fiscal rules. However, tiered reserves would reduce unnecessary subsidies for the banking sector, and on this merit alone, it should be considered.
Notes
[1] NEF analysis of Bank of England data
[2] NEF analysis of Bank of England data, assuming £40bn per year active selling of bonds continues to 2029. Lower amounts of active selling will lead to higher estimates.
Image: iStock
