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Avoiding waste in government – true waste, with no public benefit – is obviously a good thing. It frees up resources for productive spending or tax cuts, according to ideological

preferences, views on how the economy works and electoral mandates. True waste can arise in obscure places: not just in how governments spend but also in how they tax and borrow. In recent

years, some of the richest countries in the world, including Britain, have wasted resources in how they funded themselves, but for reasons so obscure and complex that few have noticed. I’m

going to try to explain this while there is still time to do something about it. The standard maxim, easily forgotten as it turns out, is that government should balance minimising its

expected interest costs (after inflation) with avoiding large exposures to surges in market interest rates. Borrowing at very short maturities can achieve the first, but only by opening up a

host of hazards. In consequence, most governments issue bonds carrying fixed rates of interest at maturities spread over many decades into the future. That not only avoids the horror of

trying to refinance vast proportions of the national debt on just a few days, it also helps insulate the public finances from interest rates being surprisingly high for a while. Of course,

there are moments when, in unusual circumstances, a government might want to depart from its standard debt management strategy. It is a bit like people choosing to take out a floating-rate

or fixed-rate mortgage, except on a gigantic scale, with the possibility of locking in rates for decades rather than just the few years available to UK households, and with the consequences

– good or bad – falling on all of us. A bad bet, including ignoring extraordinary opportunities, means higher taxes and lower spending than otherwise. As it happens, an extraordinary

opportunity to lock in almost miraculously cheap funding – a chance not seen for many lifetimes, if ever before – came during Covid. Long-term interest rates were effectively zero, so the

expected real rate of interest (after adjusting for inflation) would have been negative. But through a complex combination of government and central bank policies, none of the major states

locked in those rates. Governments did issue lots of medium- and long-term bonds carrying low fixed rates of interest, but they did so knowing that they would quickly be bought by the

central banks as part of a new round of what was known as quantitative easing (QE). Crucially, the central banks paid for the bonds with central bank money that carried a rate of interest

tied to their policy rates. As the policy rate can change month to month as monetary policy responds to the economic outlook, the state as a whole had in effect entered into what the City

and Wall Street call a swap: the state’s fixed-rate interest obligations had been swapped into floating-rate obligations for as long as the central bank held the bonds. Governments, having

effectively financed their Covid fiscal-support measures with floating-rate debt, were left heavily exposed to increases in short-term interest rates. When Putin invaded Ukraine and

president Biden massively stimulated the US economy, inflation rose everywhere, and central banks eventually raised their interest rates. In consequence, far from having locked in the

extraordinarily low rates of interest available in the market during 2020 and 2021, governments found themselves, via the central banks, paying unusually high rates of interest. That brought

waste on a grand scale. Without claiming spurious precision, you get a rough idea of the annual stakes by multiplying the volume of debt issued in 2020 and 2021 (roughly £700bn in the UK)

by, say, 3 or 4 per cent (until, roughly, the purchased gilts mature). So, the big question is whether that was a price that had to be paid in order for the central banks to avoid the

economy completely unravelling during Covid and afterwards. The answer is no. There are two kinds of argument about this. Some of us believe, first, that little QE was needed during Covid,

with governments’ own fiscal measures sufficing to help families and firms. But even after the pandemic rounds of QE went ahead, the subsequent splurge in debt-interest spending was not

inevitable. This, the second argument, is where things get complicated, I’m afraid. The key point is that central banks did not need to pay their policy rate of interest on all of the money

they created when making those QE purchases. To explain this, some mechanics need to be sketched. While people and businesses bank with a range of commercial banks, the banks themselves

pretty much all bank with the central bank, where their transactions-account balances are known as reserves. When the Bank of England buys something, such as government bonds, from, say, an

insurance company, the Bank pays by sending money to the insurance company’s bank, and that commercial bank’s reserves balance at the Bank of England increases accordingly. So far, nothing

unusual is going on. The important bit comes next. Most of us are paid little or nothing on our current accounts. By contrast, over recent years, banks have been paid the central bank’s

monetary policy rate (in the UK, Bank Rate) on the totality of their QE-swollen reserves balances. This first arose – introduced in the UK by me, as it happens, during the early 2000s when

the amounts were comparatively tiny – because for monetary policy to affect the economy in the intended ways, the central bank needs to ensure that the rate of interest prevailing in the

private market for overnight money is very close to Bank Rate. But the central bank does not need to pay Bank Rate on the whole of each bank’s reserves balances to achieve that. In

economists’ jargon, it needs to do so only on the marginal pound. This means, roughly, it could pay zero on balances in excess of the amount of reserves that, in aggregate, the banking

system wants to hold. In recent years, that would have allowed central banks to pay zero interest on many hundreds of billions of pounds: having peaked at around £875bn, total reserves in

the UK are now roughly £650bn. For every £100bn of excess reserves, the annual saving might be of the order of £3bn or £4bn. Some other central banks have started introducing such

tiered-reserves systems, as they are known. It must be emphasised that strong central bank independence is absolutely vital for this not to be abused, since paying zero on hundreds of

billions of reserves makes expanding QE very attractive for any government. Here in the UK, meanwhile, the complaint has instead been that any such move would tax the banks. But they would

pass it on, making it important to distinguish between bankers (the people) from banking (the services provided to customers). If the windfall has so far been passed on to the bankers

themselves, we might not worry too much about reform depriving them of bumper bonuses. If, by contrast, the banks passed on the reform’s cost to their borrowers, the central bank’s policy

rate could be set lower than otherwise to mitigate the effect of tighter credit conditions on the economy as a whole. In summary, Britain would be less fiscally constrained if during Covid

it had locked in ultra-low interest rates for many decades. That moment passed, but it is not too late to make savings by tweaking the Bank’s reserves policies. Even if the authorities

rejected doing anything now, the Treasury and the Bank certainly need to get on with working out how debt management and monetary policy implementation can fit together better if QE is

someday revived in response to a new crisis. With political legitimacy fragile and world order strained, it makes no sense for the resources available to government – whether used on

defence, alleviating poverty, health care, education, tax cuts, or elsewhere – to be squeezed by avoidable debt-servicing costs. It is not for a former unelected official to suggest how any

savings should be deployed, but it matters that potential savings might not only be found in departmental budgets.  _This article first appeared in our Spotlight on Child Poverty supplement,

of 23 May 2025, guest edited by Gordon Brown. _