Updated: Dec 6, 2020
With the spread of the virus resulting in a global lockdown, the government was left with no choice but to spend billions on health, wage subsidies, small business grants and universal credit. Without the decisive action and generous support measures, millions more people in the UK would be left in financial ruin. But where is the money coming from?
Right now, they are borrowing it from the Bank of England – adding to the national debt – but it will eventually need to be paid back. A new era of austerity would be a political disaster, so does that mean we’ll see taxes increase? Some might – as already hinted at by Rishi Sunak (pictured) during his announcement of support for the self-employed – but governments only really have a deficit problem if they have a growth problem, and radical tax reform could hinder this.
To the dismay of savers, the central bank slashed already low interest rates from 0.75% to 0.5% and then 0.25% as the measures were announced. Although the Chancellor promised to pay back his 'temporary' overdraft to the Bank of England by the end of the year, the cheap borrowing may prove far too useful to dispense with in the current circumstances.
The most likely scenario is that the government will instruct the central bank to print more money so they can keep spending it. This is known as quantitative easing. Unfortunately there are consequences to simply injecting more money into the system – it causes inflation.
In the short-term we might not notice. With everyone in quarantine, demand for oil, shoes, and various other things not required for staying indoors has fallen, so prices are going down. That might seem great for consumers, but it means falling revenue for businesses and less money flowing through the economy. The worst case scenario for savers is that if the recent interest rate reductions aren't enough to get people borrowing and spending more, the Bank of England could be forced to follow other European countries in introducing negative interest rates; which means actually charging people and businesses to keep their money in the bank.
However, as markets return to normal, the quantitative easing would mean an increased amount of money is in circulation. Why does this matter? Let’s say the cost of a widget is £10. If there is more money circulating, more people can buy them (more demand). However, the supply of widgets (and materials to produce them) has not increased, so their price 'inflates' to £20. If you have £100 in your pocket, it would have previously bought you 10 widgets but can now only buy you 5, so your money is essentially worth less in real terms than it was before.
So won't the bank just raise interest rates again to prevent inflation? Don't bet on it. As long as interest remains below the rate of inflation, the money that the government eventually repays is worth less than it was when it was borrowed. An extremely effective strategy in reducing the value of debt, known as financial repression.
Financial repression is arguably a stealth tax on savers. Money sat in the bank simply erodes in value, just the same as debt. The only way to protect savings will be to invest in assets that outperform inflation, such as property.
Furthermore, rising prices and low interest rates incentivises spending (and borrowing) from people and businesses alike. The government of course wants this to happen to keep the economy growing.
Do you agree with this prediction? Let us know in the comments below.