Today, I received a severe kicking, metaphorically speaking, from the Stumbling and Mumbling Blog, who tried to answer my concerns regarding the Bank of England's proposed quantitative easing.
It would be tedious to rebut every single point made by Stumbling and Mumbling. What was striking, however, was the complacency about the long term consequences of quantitative easing.
For the Bank of England, quantitative easing is nothing short of revolutionary. It intends to buy up commercial paper in order to stimulate economic activity. It will no longer be a central bank. It will, in effect, replace a large part of the mainstream banking system.
The test for this revolution will be whether the BoE can bring down lending rates for corporate borrowers. All previous attempts to kick start the economy through conventional means have failed. Despite bringing the bank rate down to just 1 percent, credit availability to the real economy continues to contract.
Bringing rates down is about to become much harder. Brown and Darling want to issue well over one hundred billion pounds of new debt; both this year and next. Already, governments across the OECD are finding it difficult to borrow. Long term yields on government paper across Europe have remained alarmingly high. CDS spreads on sovereign debt are at historically unprecedented levels.
The BoE's quantitative easing might start out as an effort to bring down interest rates for the corporate sector. It will end up as government financing. The BoE plan to buy private sector debt from commercial banks. As soon as the commercial banks receive this extra cash, they will buy high yielding government bonds. Since the corporate sector is full of high risk heavily indebted firms, commercial banks will continue to charge high interest rates and ration credit in favour of government paper, thus preventing a sustainable recovery in the private sector.
The Bank of England will quickly discover that quantitative easing will be a disappointment. Interest rates for commercial lenders will remain high, while new lending will remain low. Contrary to expectations, there will be no economic recovery. In order to counter this disappointing results, the Bank of England will begin to buy ever larger quantities of private sector debt.
The BoE may eventually conclude that direct purchases of Government paper is necessary. Remember, the key to success is bringing the interest rates down, but that damn deficit and the huge supply of new government paper will keep getting in the way.
Eventually, perhaps in 2 years time, the Bank of England will wake up to the fact that is holding uncountable billions of distressed private sector debt, while UK commercial bank balance sheets are full of government paper. Meanwhile, over in Westminster, the fiscal deficit will be structurally unsustainable, and everyone will be expecting some kind of fiscal adjustment.
Long term government yields will continue to be extremely high, reflecting the highly uncertain macro-environment. As we trace this road to ruin, the UK economy might encounter all kinds of additional dangers. For example, we might see the occasional but sudden sell off of government paper, leading to the kind of a bond market crises that are quite common in emerging markets and similar to our own Gilt crisis of 1976.
At this point, we could go one of two ways. The government might decide it is time to really clean up the mess. It will cut back on public expenditure, raise taxes and have a cleansing recession. When it happens, the adjustment will be harsh. There will be much wailing and gnashing of teeth as benefit entitlements are cut, public sector workers are fired and everyone pays more tax.
Alternatively, government could keep running up those deficits, with the Bank of England providing the financing via the commercial banks. Make no mistake, this is a template for rising inflation, which if left unchecked, will eventually lead to hyperinflation.
However, the author of stumbling and mumbling thinks the Bank of England can simply stop the quantitative easing as soon as inflation begins to pick up. By then, I fear that the Bank of England, either directly or indirectly through the commercial banks, will be responsible for funding the government's deficit. The political pressure to continue to the quantitative easing will be so great that Bank of England will be unable to resist.
(Just in case there is any misunderstanding, I think Stumbling and Mumbling is great blog. I just wish they would give me a link!)