Now that some of the fanfare has subsided, perhaps we can try and understand quantitative easing
its meaning and likely consequences.
Quantitative easing is a newer term, for what was always a normal part of Central Banks open market strategies.The only significance is the scale of this effort. The general objective is to decrease the long term interest rates and increase the liquidity in the economy, aiming for two results. Firstly and probably primarily it is to create a devaluation of the currency. Secondly to encourage banks to be less stringent about their lending policies as they become awash with non-income earning assets.
To the extent that the securities are being bought from Banks, the mechanic does not amount to money creation, simply a restructuring of the banks balance sheets, assets which were income bearing are changed into currency or non-income earning assets. As we can see this does not create any new money, but does possibly put pressure on the banks to increase their lending,which in turn amounts to creating money.
Obviously if the purchases are from private individuals or the non banking sector, this does on the face of things result in money creation. The real question that needs to be answered, is how is this money going to be used?
Is it going to result in increased consumption?
At the moment it would seem that the UK and to a lesser extent the USA have stimulation of demand as their main object, a sort of head in the sand approach, if the people simply start spending the good times will return. If this does happen they will be right, and they would have succeeded in papering over the cracks without taking any of the medicine needed to sort out the problem.
That seems unlikely, the major holders of Government bonds are investors and savers not the bulk of the population. These bodies or people tend to be traders of securities rather than consumers per se. The inducement for these bodies to take this up would only be a capital gain as a result of The Bank of England buying up these bonds based on interest rates below existing market rates. After a short while the interest rates in the market will have dropped and there will no longer be the inducement for institutions to sell these securities as they would realise the same price in the market.
In probability this policy will result in a short term stimulus to the markets. If there were a lot of new flotations taking place, then the policy would make sense to me, as it would be channelling money into the productive economy. At the moment I only see it as fuelling the speculative economy which does nothing for for consumption.
The Japanese experiment concentrated on increasing the liquidity of their Banks putting them in a better position to withstand any runs. This also failed to kick consumption back into gear … the squirrel instinct in people was far stronger.
So what are the objectives?
Are they aimed at providing a stimulus to the stock market?
Keep in mind, as I have said above, that the main holders of Government Bonds outside of the banking system are the pension and hedge funds. Both of these tend to be traders of securities, and one would imagine that they could offload easily enough if they had a need for liquidity.
Or is the appetite for these securities waning in the market?
Are we perhaps trying to hide a difficulty in placing Government Bonds in the International Markets?
Creating a way for the Government to simply print money?
Was Mervyn King’s warning about not embarking on further fiscal stimulus, simply a way of telling Gordon Brown that Central Bankers around the world were loosing their appetite for UK securities?
There could be a lot of unintended consequences.
We say we are trying to prevent deflation, in an earlier blog I pointed out that a certain amount of deflation, is simply a correction of the excesses that have built up in an economy.
So far the talk has been that we need to defend against deflation.
I believe that to the extent that inflation has been responsible for the current crisis, creation of a housing price bubble, this should be allowed to deflate. Without normalising the property market and bringing housing prices back to a realistic level, we cannot just hope for things to go back to where they were and all signs of “the credit crunch” simply pass like a bad dream. Even if we make the banks excessively liquid, we can not expect them to re-embark on the wild lending policies that brought about the crisis anyway.
The increase in the CPI to 3.2% contrary to the expectations of commentators and economists is a warning. Our economy is dependent on a high level of imports, particularly in the area of basics, foodstuffs and the like. Also a large part of our trading economy depends on goods from overseas and the inevitable devaluation of Sterling, as a result of the current policies, will ensure that inflation continues.
In the longer term the UK needs to be increasing the size of its productive economy … manufacturing, engineering and agriculture, and reducing its dependence on the service and government sectors. We should also take note that the main thrust of the measures being undertaken by countries like Germany, China and to a lesser degree USA has been fiscal stimulus aimed at infra structure development and developing a greener economy generally. I have no doubt that these measures will stand those countries in good stead in the future enhancing their competitive advantage.