After the Bank of England launched a new plastic bank note, John Redwood, Charles Stanley’s Chief Global Strategist, looks at paper money.
The Bank of England has issued its first plastic bank note. I am all in favour of the new material for the notes. It sounds as if they will be easier to keep and longer-lasting than the screwed up and damaged pieces of paper which emerge from some pockets.
This news item provides us with a timely moment to ask why the bank notes say what they say, and what they now mean. On the £5 note Chief Cashier Victoria Cleland said: “I promise to pay the bearer on demand the sum of five pounds”. Long gone are the days when you could take your bank note to the Bank and ask for its value in gold. Today, the Bank would offer you nothing in exchange for your note. Its value rests not so much on the Bank’s pledge but on the willingness of millions of other people to accept it at face value. Anyone may give you £5 of goods or services for it. Because that is true you trust the note. The Bank is owned and controlled by Parliament and government on behalf of UK citizens. The wider government will exchange your bank note for a different claim on its resources. You could have an entry in the National Savings electronic ledger and receive interest on your investment instead of bank notes. You can buy a government bond with bank notes and enjoy a regular income from the state that way. So the government’s IOU on the bank note can be swapped for other IOUs issued by the state.
Governments and central banks are testing new bounds with the way they create and treat our money. The US, UK, the Euro area and Japan have all in recent years announced major programmes of new money creation. The authorities simply create electronic money in an account, and then go out and buy government bonds or other financial assets with it. No advanced country government has yet used this newly created money to build roads or pay welfare bills, nor to offer the public a tax cut or a direct cash payment, but they could do so if they wished. An inner sense of convention or a strange view of prudence has restrained them from this ultimate reflationary move.
The results of their quantitative easing labours have boosted the wealth of rich savers who own government and other bonds and shares, and to undermine the savings incomes of everyone else as interest rates have plunged. They have boosted the capital values of pension funds, but left them apparently worse off as actuaries claim the deficits have gone up substantially with the fall in interest rates. They reach this conclusion because the pension funds need to buy so much more bond investment to get to the levels of income required to pay the pensions. Some describe quantitative easing as simply switching the term structure of the state’s obligations. Instead of owing specified people money back at specified dates on the maturity of bonds, the state owes unspecified people money which is a perpetual claim on the state which will not be settled. Cash is interest free for the state, though the state does incur the cost of issuing the notes and paying the Chief Cashier’s salary to sign the notes.
In the last week there has been a frisson running through the major bond markets of the world. Investors have asked themselves why they are holding government bonds in the Euro area, Japan and some other locations, which provide them with a negative rate of interest. The lack of any good answer to this question has led us to avoid bonds on negative yields for clients. The only possible answer is you buy a bond on a negative yield because you think someone else at some date in the future will buy it off you at a higher price, meaning an even more negative yield. All the time the Japanese and European authorities are buying in bonds, this might be possible.
The decision of the main Central Banks to drive rates down so low and to take them negative in some cases has led to a general search for higher income. Buying US or UK government bonds gives you some income, where German and Japanese bonds provide little or nothing. Buying company bonds can offer a bit more income than government bonds. Buying higher risk company bonds will pay substantially more income all the time the companies can afford to pay what they owe, but you could lose heavily if they go bankrupt.
Recent events in the bond market are a timely reminder that bond prices are artificially high, taken there by Central bank intervention. We do not think Central Banks are about to stop buying yet, so bonds can stay higher for longer all the time the new money is pumped in. Once it becomes known that the Bank props are removed we should expect a nasty sell-off in the bond markets. This will be bad news for holders of bonds, but will be better news for most savers, as it will mean you will get a better rate of interest on your savings when this happens.
The above article by John Redwood, Charles Stanley’s Chief Global Strategist, was first published by Charles Stanley on 16th September 2016.