Why Mervyn King’s defence of the politics of QE fell short
MY biggest worry about quantitative easing (QE) is that it has blurred the distinction between monetary and fiscal policy. The Bank of England is financing a substantial share of the government’s expenditure – and the majority of its budget deficit – by buying gilts using freshly-minted money. There was a time when the monetisation of such a significant part of the government’s spending would have been seen as proof of extreme economic mismanagement; these days, hardly anybody cares.
Most arguments against QE involve worries about the possibility of inflation. While I share this concern in theory, my bigger fear at this stage in the process is one of political economy: it is not healthy for politicians to be able to rely on the central bank to pay for their spending. It allows them to become far too relaxed about the budget deficit and the public finances, something we are increasingly seeing in the UK economic debate where an ever-larger group of delusional commentators believes that the deficit doesn’t matter or should even be increased substantially. The artificially low gilt yields created by QE help foster this dangerous sense of complacency.
So it was good to see Sir Mervyn King address some of these issues in his speech in Cardiff last night. He emphatically argued that the Bank is not creating money at the behest of the government to help finance its spending. To him, the independence of the Bank allows it to create money without raising doubts about its motives. He also ruled out using QE to directly finance expenditure – as opposed to buying the gilts that pay for the spending. He claimed that the Bank would never cancel any of its holdings of gilts – even though as a result of the gilt-buying programme, the central bank, a branch of the British state, is owed money by the Treasury, another branch of the British state.
For good measure, he also ruled out Milton Friedman-style QE – the distribution of freshly created money directly to households, to entice them to spend, on the grounds that such a move couldn’t be reversed.
It was a decent attempt by the governor to defend the status quo, and he is to be commended for addressing these arguments – but ultimately it was unconvincing. It is unlikely that the Bank will ever sell the gilts back to the private sector. Given the state of the public finances, notwithstanding last Friday’s surprise improvement, there will be too many gilts being issued for years to come.
But it must be hoped that his implicit attack on Lord (Adair) Turner – who wants to cancel the Bank’s holdings of gilts to reduce the national debt, and was the obvious target of King’s speech – will help torpedo the chances of the FSA chairman ever becoming the next governor. Clearly, Sir Mervyn is no Turner fan – and while I disagree with the Governor on many issues, he is right on that front. Paul Tucker, the current deputy governor, is a far better candidate, despite the Libor nightmare.
Sir Mervyn also pointed out that when banks extend loans to their customers, they create money by crediting accounts. “The usual role of a central bank is to limit this rate of money creation, so that an excessive expansion of money spending does not lead to inflation”, he added. It is a matter of deep regret that the Bank did not actually follow such a sensible strategy during the boom years and keep the money supply in check. Consumer prices remained under control, thanks to cheap Chinese imports, but excessive liquidity fuelled the housing bubble. Let us hope it is a case of living and learning.