Mervyn King, Governor of the Bank of England, recently acknowledged that we are facing “the most serious financial crisis we’ve seen, at least since the 1930s, if not ever.” The Governor’s observation was made while he was discussing the latest conclusions of the Monetary Policy Committee.
To no one’s great surprise, the MPC had concluded that the most sensible policy to address this historic crisis is steady as she goes and a bit more of the same: maintain interest rates at historically low levels, and print some more money. They are seriously misguided.
The current historical lows in the Bank base rate of 0.5 percent are crucial to an “aggressive policy” designed to deal with a “once-in-a-century” financial crisis, according to Charles Bean, Deputy Governor of the Bank of England.
In practical terms, these very low interest rates have seen a net transfer of £8 billion per year from savers to borrowers. That is comprised of a £26 billion reward for borrowers, and an £18 billion loss of interest income to savers.
“What we’re trying to do by our policy is encourage more spending, ideally we’d like to see that in the form of more business spending but part of the mechanism that might encourage that is having more household spending so in the short term we want to see households not saving more but spending more.”
In short, the MPC believe that the best way of dealing with a problem widely recognised as being caused by excessive spending and debt is to engineer a substantial transfer from the prudent to the profligate, and to encourage yet more spending and debt.
The current base rate of 0.5 percent has remained unchanged since March 2009 yet, as Mr King argued in his October letter to the Chancellor, economic conditions have continued to deteriorate dramatically. Both consumers and businesses have failed to respond and return to the pre-crisis growth in economic activity. This should have come as no surprise. Consumers are deeply in debt, their incomes are increasingly insecure, and their assets are being devalued. Businesses see the fall in demand and constrain their activity and investment accordingly.
With no scope remaining for further interest rate cuts, and firm in their resolve that more spending and debt are the best solutions to the current economic difficulties, in an act of desperation the wise men of the MPC agreed to redeploy their last weapon — print more money. This is sheer folly. They printed £200 billion in 2009 and there is no credible evidence that it worked then. Nor, indeed, did printing money work when the Japanese tried it earlier in the decade, or when the US Federal Reserve tried it more recently. There is no reason to expect that printing a further £75 billion will work this time — at least not in the way that has been suggested.
There is a very long world-wide experience with the consequences of printing money and it is not a happy one. Printing money does nothing to add value in an economy. It debases the currency and, to the extent that it supports demand, it causes an increase in domestic price inflation. With such dubious credentials, the first thing central banks did was to rebrand it: gone is “printing money”; in is “quantitative easing”, or QE. Whatever it’s called, why have the monetary authorities responsible for maintaining the integrity of the currency advocated using it, how is QE expected to work, and what do they hope to achieve with it?
The first thing to understand is that monetary policy is not set to address current economic conditions but the conditions expected to arise over the coming year or two. No doubt, the Bank would argue that economic conditions now would be far worse in the absence of the policies they put in place, but the view of the MPC remains that the economic outlook is now so dire that price deflation is the real challenge. They maintain that despite the fact that inflation has substantially exceeded the 2 percent target set by the government every month for the past two years. That the general economic outlook is difficult is not questioned, but the long-standing expectation of the MPC that that will lead to excess productive capacity and falling prices has been consistently wrong.
Its policy of easy money through very low interest rates has done exactly what should have been expected: it has served to support inflated asset prices — especially in the housing market — and has devalued sterling, thereby increasing inflation through higher import prices. Is this the best that we can expect from an independent central bank?
The recent proposal of the MPC to print £75 billion is even more dubious. With remarkably convenient timing, the Bank’s proposal to print more money was accompanied by research published two weeks earlier in the Q3 edition of the Bank of England Quarterly Bulletin. In agreeing to that proposal, the Chancellor especially noted that that research showed that QE was effective “in particular in supporting demand”. The MPC argue that, by thus supporting demand, QE will counter a “sharp fallback in inflation next year”, and it expects that inflation will undershoot the 2 percent target in the medium term. In the light of those expectations, and “in order to keep inflation on track to meet the target over the medium term, the Committee judged that it was necessary to inject further monetary stimulus into the economy”.
It is certainly true that the Bank’s research paper concludes that QE has had “economically significant effects”, adding perhaps 1.5 to 2 percent to GDP and, as a result, 0.75 to 1.5 percent to CPI inflation. A careful reading of that paper, however, suggests that that conclusion is not justified.
Simply put, under QE, the Bank buys financial assets with newly created money. Of the £200 billion created last time, £198 billion was used to buy Government gilts, thus increasing the price of those assets and depressing the yield. It is estimated that gilt yields fell by about 1 percent as a result — no doubt a welcome development for the Government as it seeks to reduce its deficit.
It is then suggested that that newly created money may be spent on other assets, raising those prices, and that it will thereby find its way into the real economy and support aggregate demand. This is called the “portfolio balance transmission channel”, the main way by which QE is thought to work.
Thus the effects of the QE policy can be broken down into two main elements: the impact of asset purchases on gilt prices and other asset prices, and the effect of asset prices on demand and hence inflation.
That the purchases of gilts led to a decline in gilt yields should come as a surprise to no one. £198 billion of gilts was nearly 30 percent of all gilts held by the private sector at the time, and gilt yields duly fell by about 100 basis points. The effects on other assets is “much more uncertain”.
Of central importance though is the effect that it may have had on the wider macroeconomy.
As the paper admits, “the wider macroeconomic effects of QE are difficult to quantify. A host of other factors have been important in influencing the UK economy during the crisis period, making it almost impossible to isolate the incremental effects of QE.” Nonetheless they give it a try.
The increases in asset prices identified by the paper “suggests an overall boost to households’ net financial wealth of about 16%”. What exactly “suggests” this is not clear. Nonetheless, it is assumed that consumers will want to spend their extra “wealth” evenly across their lifetimes – notwithstanding the fact that a key cause of the debt crisis being faced was that consumers did not use their wealth in that way. By plugging these assumptions into a “range of simple models” , the suggestion is that any increase in asset prices induced by QE is translated into a boost to household wealth, which in turn leads to an increase aggregate demand and inflation. What do the models actually show?
The models cannot show anything useful. Recall that the paper argues that the increase in asset prices was due mainly to what the paper calls the “portfolio balance channel”. Yet the paper admits that “the forecasting model used by the Bank of England, in common with most large-scale macroeconomic models, does not explain risk premia and therefore does not embody a portfolio balance channel.”
Regardless, the statistical evidence is not yet available.
One of the models used, as the paper says, “should be taken as illustrative, given the simplicity of the model and the fact that it has been estimated on a sample predating the crisis.” The other models used rely on examining more recent statistical evidence, but no available statistics could yet possibly contain the information being sought. As the paper says, “the timing of the output effects from a change in asset prices might be expected to be slower than from a normal interest rate cut, which has a peak effect on output after a year.” In other words, if the output effects occurred at all, they would only now be starting to appear in the official statistics – statistics that have been subject to greater than usual revisions.
Similarly with inflation, the papers estimates are no more reliable because they rely on a simple Phillips curve rule of thumb based on nothing more than the dubious output estimates suggested by the paper.
The paper admits that “of course, there are major uncertainties here and this sort of calculation ignores some of the transmission channels discussed earlier. It makes no allowance for any effect through confidence or any effect through the exchange rate. So it might well understate the effects.” I would say: ‘might well mis-state the effects’.
As noted, the MPC may well — and indeed do — argue that the crisis is one of a lack of demand. It is true that demand has weakened, but it is important to understand why. Only if we understand properly what is happening can we hope to develop appropriate policy responses.
Over the past 40 years or so, western economies have become increasingly reliant on the benefits of the low labour costs and high savings rates in developing economies, and on access to dubious sources of cheap credit to finance ever more affluent lifestyles. The era of easy affluence is over. Developing economies that competed only on price are increasingly competing on quality as well. The dysfunctional global finance system that enabled the excessive buildup of government and private sector debts has left itself fatally impaired by an excess of capital of dubious value, and left western economies over-burdened with debt that cannot easily be repaid.
In this time of crisis, the main effects of MPC policy are not those suggested by their complex theorising but rather the much simpler ones of confidence and the exchange rate. The weak exchange rate has contributed more to inflation than it has to providing a competitive advantage to exporters. Inflation is real and persistent, and it erodes real incomes and hence demand. At the same time, the MPC are signalling clearly and loudly that worse is yet to come. That depresses economic confidence, while the very low interest rates at the heart of MPC policy penalise the savers who are essential for business investment.
It is not the role of monetary policy to try to offset the austerity that results from a financial system awash with devalued and worthless assets, and from government and households reducing their debts. The MPC should not try.
It is time for a rethink.
dgwilkinson