UK’s Brown and King re: failed auction

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Brown ‘Terribly Fragile’ After Bond Auction Flops

by Robert Hutton and Mark Dean

Mar 26 (Bloomberg) — The first failed British bond auction in more than seven years leaves Prime Minister Gordon Brown’s reputation for economic competence even more tarnished as he battles recession and a rising tide of voter anger.

Brown, who had the backing of 30 percent of the electorate in a ComRes Ltd. poll last week, must now cope with what amounts to a vote of no confidence by investors in his ability to end the recession. Bank of England Governor Mervyn King, his ally for much of the past decade, warned a day earlier that there’s no more money for further spending.

Wrong! Spending is not inherently constrained by revenues.

King must not understand how the monetary system works.

“The notion that Brown is leading us to the promised land is laughable,” said Ruth Lea, economic adviser to the Arbuthnot Banking Group Plc in Solihull, England. “He cannot get to grips with how other people see this country now, as the sick man of Europe.”

Yes, that’s how most see it, but they don’t understand how the monetary system works.

The Treasury yesterday tried to sell 1.75 billion pounds ($2.6 billion) of 40-year gilts and got 1.63 billion pounds of bids, a sign that investors are reluctant to finance his record borrowing.

No, a sign at that point in time that investors didn’t want to buy that many bonds of that maturity.

This does not constrain government spending.

“Brown’s strategy now looks terribly fragile,” said Mark Wickham-Jones, a professor of politics at Bristol University. “His situation is economically extremely uncertain, politically risky and this auction again highlights how we are now in un-chartered territory.”

He doesn’t seem to understand the monetary system either.

G-20 Tour

The auction failure couldn’t have come at a worse time for Brown, who set off on a five-day tour this week to win support for his economic-reform plans before a summit of leaders from the Group of 20 nations he’s hosting in London on April 2. He’s in Brasilia today and due to visit Chile after speaking in New York yesterday.

He does understand that he does not need their support for anything regarding the UK economy.

German Chancellor Angela Merkel has resisted Brown’s push for a new fiscal stimulus, saying her country already has committed to a boost worth 4.7 percent of gross domestic product.

Germany does have funding constraints the UK doesn’t have as per the eurozone institutional arrangements.

Brown’s Agenda

The government says the G-20 will focus on stabilizing financial markets, reforming global financial institutions and helping people get through the recession. Brown wants them to agree on a fiscal stimulus to support growth, something King warned might not be affordable.

More evidence King doesn’t understand the monetary system. ‘Affordable’ is not an applicable concept regarding nominal spending with a non convertible currency.

“Given how big these deficits are, I think it would be sensible to be cautious about going further in using discretionary measures to expand the size of those deficits,” King said in Parliament on March 24.

Brown’s spokesman Tom Hoskin said yesterday the prime minister wasn’t troubled by the auction failure. “There have been other auctions that have been uncovered in other countries,” he told reporters in London. “The underlying strength of the market in gilts is there.”

More to the point, it’s not a necessary condition for deficit spending. The economics of deficit spending are the same whether or not guilts are sold. The difference is long term rates are higher if the Treasury issues long term securities. They should listen to Goodhart and not issue or sell them at all.


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14 Responses to UK’s Brown and King re: failed auction

  1. warren mosler says:

    try to auction your car at 3am on a Tuesday and see what happens.

    point is, buyers didn’t feel like bidding, even at much higher yields that day at that time. maybe they were out playing golf.


  2. Curious says:

    Thanks Vipul, I didn’t think about that, yes, they can get more interest on the bond than on the reserves, yet the auction still failed. So interest on reserves is not the reason why the auction failed.

    So what is the reason? The only thing I can think of is, that banks don’t want the possibility of a paper loss between now and maturity (40 years from now). But they can suffer a loss on 40 years, 20 years or whatever maturity bonds.

    Does that mean that 20 years, 10 years, etc. bond auctions can fail? I can’t think of a reason why not. So it seems to me that the question “What if nobody buys our debt?” is valid.

    Warren, how can a failed auction reflect indifference level in the term structure? Someone could have bid low enough to raise the effective yield to 50% or whatever. The fact that the auction failed says that the effective yield was infinity (coupon divided by 0). If only infinite yield was high enough for 40 year bond, what is the indifferent level of interest for other terms?


  3. warren mosler says:

    vip- yes.

    and not to forget the bonds are sold at ‘auction’ so for the most part they trade at prices where at the margin prices reflect indifference levels between the entire term structure of rates

    so how does it feel to know more than most of the world’s top central bankers?



  4. vipul says:

    Right, well with qualifications. I’m not sure what the reserve requirements in the UK are. But for excess reserves (those beyond the requirement) my understanding is that the central bank is obligated to borrow those from the banks at the overnight interest rate inorder to maintain that interest rate target. Otherwise the banks would drive interest rates to zero in trying to get rid of the excess reserves.

    I think the answer in soft currency economics still applies. Let’s say that the overnight interest rate target in the UK is 1%. And the UK treasury is doing an auction of 40-year bonds that pay 3%. If a bank has excess reserves it has 3 choices. It can buy the 40 year bond, that pays 3%. It can just lend the money to the central bank at 1% for the overnight rate. Or it could do nothing and earn no interest. So like it says in Soft Currency Economics, the bank is doing the UK government a favor by refusing the 40 year bond, since that typically pays a higher interest rate than the overnight rate. At least that’s how I think about it.


  5. Curious says:

    Vipul, that makes sense. If the british CB pays interest on reserves, then they can thank themselves for the failed auction, right? Why would banks want to buy any debt, when they can get interest on reserves directly.

    Soft Currency Economics answers the question “What if nobody buys our debt”, but that answer assumes no interest being paid on reserves. Now that the Fed (or the british CB) pay interest on reserves, that answer no longer applies. Am I understanding it correctly?


  6. Mr. Magoo says:

    “Assuming that bankers in the UK prefer to earn interest, there must be some other reason why the auction failed. Can someone explain this?”

    If you are a greedy banker or a george soros and want to move a few billion around, why would you buy 5% paper if you think that if you stop showing up for the auctions they will eventually offer you 10% or 20% paper? Perhaps the people offering the auction don’t like george soros and his tactics so they start inflating, so then doesn’t it get down to a game of chicken? Who has the REAL power?

    It seems in japan the course they took was to keep printing. Ms. Watanabe didn’t want to buy any japanese assets, she knew what skeletons were hiding there, so she took all that new money and like christopher columbus started exploring the new world.


  7. vipul says:

    It’s how Warren explains above, the banks just didn’t want to buy 40-year bonds. So they kept them as reserves and UK Central Bank probably borrowed them at whatever its overnight interest target is. Otherwise interest rates in the UK would have gone to zero.


  8. Curious says:

    How can a government auction fail?

    Soft Currency Economics explains that purchasing government securities is just a way for banks to convert non-interest bearing assets (reserves) into interest bearing assets (treasuries, i assume that’s what gilts are in the UK)

    Assuming that bankers in the UK prefer to earn interest, there must be some other reason why the auction failed. Can someone explain this?


  9. Seychelles Zorro says:

    Seychelles – most indebted nation?

    Last year, as tourism and fishing revenue began slowing, the Seychelles defaulted on a $230 million, euro-denominated bond that had been arranged by Lehman Brothers before its own bankruptcy. The IMF came in in November with a two-year, $26 million rescue package, and the country has since taken a series of emergency steps: It laid off 12.5% of government workers (1,800 people), floated its currency (the Seychelles rupee, which has fallen from eight to the U.S. dollar to 16, effectively doubling the prices of imports), lifted foreign exchange controls and agreed to sell state assets.

    Hey all you ivory tower types – why did the seychelles have to do this? Why couldn’t they have given the middle finger to the IMF and kept thier state assets for thier own population instead of the international community? It is the same with detroit selling houses to UK investors while they have a large homless children problem – it doesn’t make sense to me.

    On the one hand Warren says for people like Brown not to think internationally and of what outside people with think of the debt and spending because they are not revenue constrained, but it is obvious from brown to seychelles – they are very WORRIED what the external people think.

    Another passage from the article:

    “The IMF has given a thumbs-up to the initial progress, but it warned that the economy would contract 9.5% this year. The government of Australia is sending tax experts to help overhaul the revenue collection system and audit local companies.”

    GOOD LORD! Now we got people from australia gonna tell these folks how to ARREST and IMPRISON thier citizens if they don’t honor tax law – and perhaps like here in the USA those citizens can get SHOT and MURDERED if they don’t comply. So how have we evolved beyond MONKEYS? If I don’t do what the larger group of monkey’s wants me to do – they imprison of even KILL ME? Why is this a good thing? God tell me in my heart this is VERY EVIL. Where is the zorro gonna come from to get these common people to rise up against these EVIL external forces on this island nation?

    PS they are gunning to be an offshore tax haven, just how many damn offshore USVI clones does this world need? Disgraceful!


  10. Scott Fullwiler says:

    Thanks for the link, Winslow. Will read ASAP.

    Other cbs of course issue their own debt . . . it’s not that uncommon, just not done by the Fed.

    Here we have another general principle of central banking at work that is not well understood. Returning to the failed auction, consider a cb that issues debt along the term structure. Is there any doubt that this simply lends support to interest rates (keeps them from falling) at those maturities? Similarly, is their any doubt that the cb can set the rates it pays on those securities at any level it wants, and that the “cost” of not purchasing such securities is simply the difference between those interest rates and the remuneration rate on reserve balances? Finally, is there any doubt that where the cb sets these rates anchors Tsy rates (assuming the Tsy also issues . . which is actually redundant)?

    All of these are consistent with the framework originally put forth in soft currency economics . . . cbs set interest rates, and bond sales are interest rate support (not financing) operations. And again, note how much simpler this is than is the view that markets set interest rates while taxes/bonds finance spending.


  11. Winslow R. says:

    This article works in my paradigm where the Fed gains a bit of strength over the banks/shadow banks as well as fiscal policy…..see any problems?

    Fed Seeks Power to Issue Own Debt When Crisis Ebbs, Yellen Says

    Giving the Fed power to issue debt “would make them more comfortable that they could raise rates without being too disruptive in terms of having to dump assets into the markets,” said JPMorgan Chase & Co. economist Michael Feroli, a former Fed researcher.


    Mike Norman Reply:

    While it’s functionally just another reserve maintenance tool it’s a terrible idea because it will be widely misconstrued as, “the Fed is out of money.”

    And we’ve seen how incapable Fed officials are of even explaining the most simple concepts dealing with monetary operations and reserve accounting. Most of them don’t even understand it themselves.


    Scott Fullwiler Reply:

    Sad, but true. All the more so since it has the potential of making monetary operations so much simpler and simpler to understand, too.


  12. Mike Norman says:

    Ironic. The belief that they are spending constrained is exactly why the bond auction “failed.” Spending would have provided the funds to pay for the gilts. Reserves have been falling precisely because fiscal and monetary policy have allowed that to happen. The same could happen here.


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