Why Mervyn King is wrong about QE
IT was strange for Mervyn King to claim yesterday that the financial crisis may yet turn out to be worse than the Great Depression. The world faces monumental challenges. But the mass unemployment, protectionism and rise of fascism of the 1930s has so far been avoided and many emerging markets are still buoyant. Over-using apocalyptic language isn’t the cleverest thing a central banker can do. But King’s real mistake was to back another £75bn in quantitative easing (QE).
The rationale for QE is that it increases the money supply (new liquidity is created by the Bank, in return for it buying gilts) that can be spent on goods, services, and assets. In an economy with spare capacity, this boosts demand and output (otherwise, it just boosts prices). It also increases asset prices and collateral values. It cuts yields on government bonds, and reduces the risk-free rate of borrowing, helping corporate and individual borrowing and equity valuations.
Supporters of QE argue that it is necessary because there is insufficient money in the economy to support sustainable growth – and that without it inflation would soon fall below target. They rightly remind us that a collapse in the money supply in the US in the 1930s turned a recession into a depression. Sometimes, QE is indeed vital.
But what are the facts today? The money supply rose only 2.2 per cent in the year to August, with a 2.3 per cent annualised increase over the last three months. This was below the rate of inflation, which means that real money balances fell. This was also well below historical growth rates – it rose by 6.3 per cent a year between 1998 and 2003, when consumer inflation was much lower than it is today.
But as Simon Ward of Henderson – somebody who should be appointed to the MPC at the earliest possible opportunity – points out, it is not just the amount of money that matters – the rate at which it circulates from person to person matters just as much. Economists call this velocity – and it has shot up since early 2009, as testified by the fact that nominal GDP (as opposed to real GDP) is growing quickly as a result of elevated inflation. Interest rates are so low that nobody wants to keep hold of cash for long. Equally crucially, the official figures underplay liquidity by excluding money substitutes such as foreign currency deposits, Treasury bills, National Savings instruments and repos by the Debt Management Office. A broad liquidity measure devised by Henderson incorporating these rose 4.5 per cent in the year to August, up from 0.9 per cent a year ago.
This kills off the case for QE – especially in the context of high consumer price inflation, which loves nothing more than excessive money to embed itself. Yesterday’s QE is equivalent to an extra 3.7 per cent on broad liquidity. The Bank has massively underestimated inflation over the past two years so its present warnings of looming deflation should be ignored, especially given that there is far less spare capacity in the economy than it thinks. Commodity prices are falling – but it would be astonishing were the Bank to meet its target in 2012. More QE will also mean renewed downward pressure on the pound, boosting import prices even further (they are still going up from the previous devaluation). The effect on the money supply this time (and hence inflation) will be greater than earlier rounds because UK Plc is in better shape: last time’s effort was partly cancelled out by capital-raising and loan pay-downs. Given that the £200bn of QE to date has boosted prices by 0.75-1.5 per cent, according to the Bank, this isn’t good for savers, for whom yesterday’s news is tantamount to a declaration of war. Given that inflation is the biggest drag on demand in the UK at present, as a result of falling real wages and wealth, QE right now makes no sense at all.
Further purchases of gilts will make them even more expensive (prices will rise and yields fall further to even more ridiculous levels), fuelling a crazed and ultimately doomed bubble. Lower yields will add to pension fund deficits and make annuities even more expensive. It will mean that the state-owned Bank of England will own a third of the stock of the state’s debt. This is a huge political economy issue. The government is lending money to itself in a deeply unhealthy merry-go-round; it no longer really has a budget constraint. What next? Will the Bank eventually cancel the gilts it owns, thus permanently monetising much of the national debt? These hugely sensitive issues must be debated urgently.
The biggest mistake is that the authorities believe they have the power to engineer perpetual growth by creating ever more money whenever activity grinds to halt. This is ridiculously hubristic. Sometimes weak growth just can’t be avoided. It is a shame we live in a society so arrogant that it cannot ever admit this.
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