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!)
31 comments:
It's very hard sometimes to know whether Dillowbert is just teasing. Perhaps, as a Marxist, he agrees with Lenin, as alluded to by Keynes, that the way to fell capitalism is to debauch the currency. Anyway, it's positively caddish of him not to give you a link.
Its not fair, I gave him a link.
Alice
In today's Telegraph it says that the BoE has decided to buy government debt!
WHAT!!!!
But Mr. Bean promised!!!!
I'd question your timeline. I thought the crash would come this year, I suppose I was thinking we'd do an Iceland, rapid crash type thing.
They wouldn't be able to help themselves. just a bit longer,just a few more billion,just till the election.......oh dear.
Alice,
You don't need a link if CD devotes a whole post! But you have to bear in mind The Bank of England is now involved in a process of credit easing rather than quantitative easing. The objective of which is to improve liquidity and access to credit within the economy and the banking system in particular given the repatriation of foreign lending.
The test of the process is not the “rate” but availability of credit. Reducing interest rates have had little impact short term given the credit and demand shocks within the global system. These things take a little time.
JKA
The bank isn’t “buying up commercial paper”. Under the scheme, the BOE swops commercial bills for more marketable treasury bills. It isn’t “buying” commercial debt, it’s a time limited swop, reversible within a defined period.
The businesses have a chance to trade the T-bills or enter into a cash swop. They do not “use the cash to buy government bonds, they already have the T-bills. The key to success is not the rates on the credit but the availability.
JKA
Not so fast; a swap is a loan.
In any event, how is the BoE going to get these T bills? Buy them from the government, which is central bank financing of the deficit.
Swapping commercial debt for T-bills doesn't change the story.
Alice
The process of QE or CE is not the same as "printing money". As liquidity returns to the system as in inevitably will, the BOE repatriates the T-bills returning the corporate debt or the banks residential mortgage backed securities to the private sector.
This is easier than collecting the currency dropped from the proverbial helicopter and does not have the same inflationary impact.
JKA
I really didn't intend to give you a kicking - sorry if I gave that impression.
I confess I'm confused by what you're saying.You say: "contrary to expectations, there will be no economic recovery." But in this case, surely gilt yields will stay low (I don't see how 10 year yields of 3.5% are "alarmingly high"), as will inflation.
I agree that if the Bank keeps financing the deficit - and yes, it will probably buy gilts - that would eventually lead to hyperinflation. But eventually is a very long way off. Long before then, the increased money supply will stimulate activity - money's not neutral in the short-run, is it? - and QE will stop.
I'm not at all complacent that QE will be effective - it might fail to stimulate the economy in the short run and/or lead to higher inflation later. But this is because of similar problems that cause conventional monetary policy to go wrong - uncertainty about lags, transmission mechanisms and forecasts.
PS - I'll stick you on my blogroll, not that it'll do any good.
PPS - distinguish between the Asset Purchase Facility and QE. In the first instance, the APF is not QE, but rather the swap of T-bills for corporate assets. But I grant that it'll extent to buying gilts and an increase in BoE reserves.
I've just clicked through from the link at Fumbling and Bumbling. No cad he.
Chris, JKA
I am worried about the interaction of monetary and fiscal policy, coupled with an insolvent banking crisis. The BoE is about to start pumping out liquidity, while HMG is about to borrow unprecedented amounts of money. This will lead to a classic case of crowding out, with our insolvent banks being the conduit.
There is something in this story that I haven't expressed, largely because when I try, my blog posts run into thousands of words. However, I expect this crowding out to be accompanied by a very nasty negative supply shock. As the economy slides into recession human and physical capital will be destroyed, leading to a contraction of the UK's long run growth potential. The NAIRU will shift upwards, and once this happens we will see inflation return with a vengence.
Alice
Blimey, this is fun.
Bernanke tells us QE is out and Credit easing is in. We are all credit easers now but no-one told Charlie Bean. APF may not be QE but it surely is CE as the Governor admitted last week.
The BOE "gets" them by expanding the balance sheet activity. It takes RMBS, an asset and issues T-bills (or other term notes) as a liability. Returning the RMBS at the end of the term and calling in the notes.
Alice,
We are all concerned about the potential inflationary impact in the medium term and the enormous government borrowing that is the result of any financial crisis. History tells us this Reinhart and Rogoff.
http://jkaonline.typepad.com/jkaonline/2009/01/history-warns-there-is-no-swift-recovery-in-2009.html
but this is an extraordinary global phenomenon the like of which we have not seen.
As for the supply side, don't worry the 1980 slow down did real damage to the capital structure. Now plants such as Honda are being mothballed not shipped to the Far East as was the case then. As for NAIRU it belongs in the dustbin of economic thought along with the J curve and "devaluation leads recovery".
Thanks for stimulating a great exchange. Congrats on the link!
JKA
Printing money will be a disaster. It distorts the free markets pricing mechanism, and through consistent use leads to poverty. You can't magic savings out of thin air. People need to prospone current consumption, save, and put these savings into stengthening the productive structure. Alas this will not happen. We are no different from Zimbabwe invoking policies like these, we are just starting from a higher base. At least we have democracy (at the moment) which at some time in the next 5, 10, 15 years will end these terrible policies, and we will have a further depression even worse than the one we are going into now.
Markets never lie. There is no free lunch. The best thing governments and central banks can do is nothing.
Ding Ding! Seconds out! Round 1.
My money is on Alice 'The inflation crusher' Cook.
I find Chris Dillow tedious. I used to read the Investors Chronicle and could never understand why he got so much print space.
Alice,
I recommend you read the Ticker Guy:
http://market-ticker.denninger.net/
He explains brilliantly why Bernanke is all talk and no action on Q.E. If you dig through his posts you find some excellent analysis.
I think the main problem for the UK is that the Chinese and Arabs are going to be net sellers and not buyers of Gilts. The issuance is going to be so huge, as we go into a depression, that creditors will see so much GDP vanish that the rate needed to be offered to tempt buyers will destroy the economy further.
I expect a total currency collapse soon.
Alice,
I recommend you read the Ticker Guy:
http://market-ticker.denninger.net/
He explains brilliantly why Bernanke is all talk and no action on Q.E. If you dig through his posts you find some excellent analysis.
I think the main problem for the UK is that the Chinese and Arabs are going to be net sellers and not buyers of Gilts. The issuance is going to be so huge, as we go into a depression, that creditors will see so much GDP vanish that the rate needed to be offered to tempt buyers will destroy the economy further.
I expect a total currency collapse soon.
Alice,
I recommend you read the Ticker Guy:
http://market-ticker.denninger.net/
He explains brilliantly why Bernanke is all talk and no action on Q.E. If you dig through his posts you find some excellent analysis.
I think the main problem for the UK is that the Chinese and Arabs are going to be net sellers and not buyers of Gilts. The issuance is going to be so huge, as we go into a depression, that creditors will see so much GDP vanish that the rate needed to be offered to tempt buyers will destroy the economy further.
I expect a total currency collapse soon.
Alice,
I recommend you read the Ticker Guy:
http://market-ticker.denninger.net/
He explains brilliantly why Bernanke is all talk and no action on Q.E. If you dig through his posts you find some excellent analysis.
I think the main problem for the UK is that the Chinese and Arabs are going to be net sellers and not buyers of Gilts. The issuance is going to be so huge, as we go into a depression, that creditors will see so much GDP vanish that the rate needed to be offered to tempt buyers will destroy the economy further.
I expect a total currency collapse soon.
Alice,
I recommend you read the Ticker Guy:
http://market-ticker.denninger.net/
He explains brilliantly why Bernanke is all talk and no action on Q.E. If you dig through his posts you find some excellent analysis.
I think the main problem for the UK is that the Chinese and Arabs are going to be net sellers and not buyers of Gilts. The issuance is going to be so huge, as we go into a depression, that creditors will see so much GDP vanish that the rate needed to be offered to tempt buyers will destroy the economy further.
I expect a total currency collapse soon.
Alice,
I recommend you read the Ticker Guy:
http://market-ticker.denninger.net/
He explains brilliantly why Bernanke is all talk and no action on Q.E. If you dig through his posts you find some excellent analysis.
I think the main problem for the UK is that the Chinese and Arabs are going to be net sellers and not buyers of Gilts. The issuance is going to be so huge, as we go into a depression, that creditors will see so much GDP vanish that the rate needed to be offered to tempt buyers will destroy the economy further.
I expect a total currency collapse soon.
I'm inclined to believe the whole QE thing is moot because it puts the cart before the horse. We are taught to believe the BoE drives monetary expansion by creating base money which fractional reserve banks can lend out x10.
This simply isn't true.
Banks create commercial money thru deposits and loans, and THEN try to find the reserves either on the wholesale market or at the BoE.
Banks are now drastically cutting money and no amount of BoE printing will reverse it, hence the huge excess reserves.
Deflation. BoE is impotent.
Alice, do you look at the Institutional Risk Analytics blog? This is good:
"Many of the bond holders of the large banks are foreign governments, central banks and investment funds and not a few of these sovereign names are in really serious financial difficulties. Since the receiverships for Lehman Brothers and Washington Mutual, where bond holders took a near total loss, these foreign investors have been vocal in demanding that US taxpayers protect them from further harm.
But to deflect these cowardly, expedient arguments, the US government must be willing to lead by example to show that there really is only one way to restore confidence in zombie banks: use receivership to wipe out the common and preferred shareholders, conserve the deposits and sell the good assets to new investors, and then restructure the remaining operations of the bank to maximize recovery to the bond holders and other creditors."
As a newcomer to this site, and as someone who knows absolutely nothing about finance, high, low, or in between (I have that much in common, apparently, with our leading bankers) I would be much obliged if someone could answer a question, and I apologise in advance for its simplistic nature.
Is the problem with our banks one of liquidity or insolvency?
ex-apprentice
Insolvency.
Alice
Thank you, Alice. In that case are there not only two ways to go: full nationalisation, in effect receivership, or do nothing and let the fatally wounded die?
"full nationalisation, in effect receivership, or do nothing and let the fatally wounded die?"
I believe according to company law, it is illegal to trade while insolvent.
The banks that aren't solvent ought to be declared bankrupt and closed. Domestic public deposits could be protected in line with the deposit protection scheme.
The bankers creditors can fight over the carcass(es).
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