Thursday, 6 August 2009

Quantitative easing - the ticking timb bomb

The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%. The Committee also voted to continue with its programme of asset purchases financed by the issuance of central bank reserves and to increase its size by £50 billion to £175 billion.

So far, quantitative easing has done little to revive the economy. Corporate sector lending is falling, with many firms paying back loans on a net basis. Consumer lending is also weak. Government bond yields remain stubbornly high. The mortgage market is the only sector where the architects of QE can claim any degree of success. Approvals are up and house prices have stabilized.

The initial results have been disappointing, and so the Bank of England have decided to pour in another £50 billion, bring the total amount of new money up to £175 billion. In terms of GDP, that amounts to about 12.5 percent of GDP.

Think about that for a moment. Since February, the Bank of England has printed a pile of cash that is equivalent to one eighth of the entire output of the economy. Imagine, if each one of those pounds was spend just once. Could the UK economy immediately increase output by 12.5 percent to meet this new demand? Or would it be the case that firms would simply raise prices, leading to a sudden surge in inflation?

So why haven't we had any inflation. So far, quantitative easing has not led to an increase in aggregate demand. Banks have sold their assets to the Bank of England, and deposited the cash back into the central bank. As of now, there the cash idly sits.

However, here is the killer question - will it sit there forever? Or will the banks start to use this cash and begin to extend credit? My feeling is that one bright day, the banks will wake up and realise that they excessively liquid, start lending and the economy will take off like a rocket.

But isn't this what the Bank of England wants? Yes, but don't think for a second that they know what they are doing. Outside of hyper inflating economies, no central bank has ever tried this trick before. Perhaps the kindest description of quantitative easing is to say that it is an experiment.

If lending does start to increase rapidly, the only thing the Bank can do is unwind their huge holdings of government debt. In other words, it needs to reverse quantitative easing.

When it begins this huge roll back of liquidity, the Bank of England may find that interest rates become extremely volatile as it unloads this debt in a desperate attempt curb lending. Unwind too much, and they could push the economy back into a recession, unwind too little, the banks could keep lending, and inflation could pick up.

However, this could be someway into the future. It could be a year or two before the banks start to change their credit crunching ways. The MPC aren't thinking that far ahead. Nor is the government for that matter. The future belongs to someone else. Today is what matters. If QE boosts GDP by the end of the year, paving the way for a half hearted New Labour election boost, then the policy will be a raging success.


Keiko said...

My understanding is different. Didn't Japan try this? And didn't it fail? Here the zombie banks stayed alive, but demand for loans never increased as asset prices continued to tumble. The difference in Japan was that people still had savings, so the government could merrily borrow from the state pension fund, but because of the demographic bomb Japan will soon face it's Waterloo.
In the case of Britain the bank is buying gilts from banks, which bought them just before, so we see a rise in bank profits. So wouldn't the inflation show up as it is caused by government spending?
At some point we must get a currency collapse, with the decline in tax revenues and the increasing size of the state. There was a beginning, so there must be an end.

sobers said...

Japan didn't get the effect of the QE because we in the West borrowed a lot of the money at 0% and spent it on mad schemes here (the carry trade). Such as private finance bids for companies, and building pointless shopping centres, and financing ever higher house prices. Due to the nature of the world economy at the moment I doubt there's a queue of foreigners wanting to borrow in sterling right now. So all that QE money will eventually end up in the UK economy, when bankers get their confindence back and start hosing the cash around. Cue higher prices all round.

Anonymous said...

it's over get your bag I am taking you home(where ever home is)in the words of the great pte frasier"where all doomed"

Fred said...

I guess it depends on what you think caused the problems.

Rick said...

I think if it were so easy it would have worked in the past, however, every scheme seems to have ended in disaster since John Law in the early 18th Century (think of a crazy Scotsman getting a nation to invest in a giant ponzi scheme and printing money to stop it from collapsing) - actually what is it with Scots creating ridiculous schemes that lead to national bankruptcy? I think William Patterson (founder of the Bank of England and a man who played an instrumental part in the creation of the BoS) may have been the first with the Darien Scheme which sent Scotland to the verge of insolvency and had to be bailed out by England through the act of Union.

.......And then there's that one eyed zombie.......

Steven_L said...

Globalisation and weak trade unions - that's why you won't see a traditional spat of price/wage inflation.

Commodities price inflation? Aseet price inflation maybe, but I have my doubts over a price/wage spiral.

Anonymous said...

AC: "However, here is the killer question - will it sit there forever?"

Yes, I agree, that is the killer question.

But here is another aspect. I may be wrong, but didn't the government take onto the public books much of the shite securites and pay the banks the market price for them.

Andrew said...

Yes, we are facing years of unpleasant consequences a number of levels. So, in a contrarian sense, would it not be better for the mad Scotsman & chums to be returned with a small majority. Their fumbling the fix would ensure a shortly thereafter Con government had a relatively free hand. It would also place the barking party to their well-deserved wilderness.

Anonymous said...

the person responsible for all this mess is Gordon Brown. When the economy was strong he squandered the nation's wealth by increasing public spending. Now the country is bankrupt and Gordon's answer is to print money. I think a madman is leading the country and he needs a psychiatrist to certify his madness and lock him up before he destroys the country further

Wag the Dog said...

Why QE ain't working - basically QE would solve a liquidity crisis but not an insolvency crisis. Many who are piling into real estate today and have prematurely called a bottom are thinking this is a crisis of credit and not what it really is - a crisis of the credit worthy. The BoE can buy back as many Gilts as they'd like from the banks, but that credit ain't going anywhere fast as long as deleveraging/deflation/resetting continues unabated in the real economy. Everyone seems to be working to old models in a new world.