Bank of England hits the panic button

By Jeremy Warner in The Telegraph on 7/10/11

Who was it who said that QE – printing money by another name – is the last resort of desperate governments, when all other options have failed?

As Labour's Ed Balls gleefully points out, it was indeed George Osborne, the current Chancellor. It is the sort of thing politicians say in opposition and then bitterly regret when they get into government and have to take the decisions.

Yet in a sense, his words are even truer today than they were then. You wouldn't choose further to expand the Bank of England's purchases of government debt unless you were desperate, and all other options had been exhausted. The Chancellor condemned it then; now he welcomes it.

Since nominal interest rates are already as low as they can realistically go and the Government has, rightly, ruled out easing back on deficit reduction - more QE is about the only thing left in the locker as the world slides, inexorably, towards depression.

As regular readers will know, until quite recently I've argued steadfastly against QE2, but on the never say never principle, I was always careful to add some riders. When faced by an extreme deflationary threat, almost anything can be justified, and that's precisely what we are seeing now. As the Governor of the Bank of England, Sir Mervyn King, put it on Thursday, "when the world changes, we must change our response".

Long-standing supporters of more QE will say that it has been obvious for some while that the economy was stalling anew, requiring some form of fresh stimulus.

I can't agree. No growth for nine months is not the same thing as a sudden lurch back into the abyss, a threat which thanks policy paralysis in Europe and the related upsurge of stresses in the banking system, is now only too evident. These dangers have risen markedly over the past two weeks, which explains why the Bank of England has acted both earlier than had been expected and, with £75bn of further asset purchases now sanctioned, more boldly. Sir Mervyn went further than he has ever done before on Thursday by saying that this is "the most serious financial crisis since the 1930s, if not ever". For the sake of appearances if nothing else, something had to be done.

Not that this seems to have been obvious to the European Central Bank (ECB), whose failure to cut interest rates on Thursday was almost as surprising as the Bank of England's decision to act so precipitously and pre-emptively.

At his valedictory press conference, the outgoing ECB president, Jean-Claude Trichet, announced some further "non-standard" initiatives to ease the European banking system's funding crisis, but it was small scale stuff, and frankly isn't going to make a great deal of difference.

Bizarrely, the ECB still seems to be looking in the wrong direction – ever vigilantly searching the horizon for the ghost of inflation – even as the noisy locomotive of economic catastrophe bears down on it from behind. Even for such a compromised institution, with 17 masters to answer to, the incompetence of the policy stance is quite breathtaking.

Glowing though the tributes have been to the departing Mr Trichet, I doubt the judgment of history will be kind.

There are big risks in what the Bank of England is doing, which despite its protests to the contrary, is as close to monetisation of the national debt as you can ever get without doing it outright.

By the time the new bout of asset purchases is over, the Bank of England will own nearly half of the market in three to 25-year gilts, or 32pc of the total stock of UK government bonds. Even when steeped in the economics of quantitative easing, this looks mad, and when things look mad, they generally are.

Let's get this straight. By switching on the printing presses, the Bank of England, which is 100pc owned by Her Majesty's Government, is buying up a third of the debt owed by Her Majesty's Government. The Treasury is becoming ever more in debt to itself. It's as strange as that.

To be doing this even as inflation is about to breach the 5pc mark makes the Bank of England's position more uncomfortable still. Let's not have any of this nonsense about how QE is not inflationary. By keeping the pound low, the inflationary impact is all too obvious.

Even the Bank of England's own analysis puts the inflationary effect of QE to date at between 0.75 and 1.5 percentage points. The same study finds that the addition to real GDP is just 2pc. That doesn't look a particularly good trade off to me.

Evidence from the US, moreover, is that the second bout of QE is both less powerful and shorter-lived than the first. It's like a drug; the more you take, the less potent it is. Yet most galling of all is the damage it does to savers, who are being further plundered to bail out the debtors.

If you are coming up to retirement, forget it. The price of an annuity just got a whole lot more expensive. What remains of our sadly depleted final salary pensions industry is toast. Companies will have to pay even more for the pension promises they have made, and so will the taxpayer, on the hook as he is for the unfunded pension pledges of the public sector.

The Governor says he shares the saver's pain. There is nothing he would like more than to return interest rates to "normal", and begin the process of making over-indebted Britain a nation of savers once more.
But right now you might as well do what he wants, which is spend your nest egg or blow it on higher risk assets, because with rising inflation, it will be worth less tomorrow than it is today.

I'm not saying the Bank of England is wrong to be doing this. There are no good choices left to policymakers. Europe's failure to resolve its debt crisis is creating a vicious downward spiral of contracting credit and economic activity. The Bank does indeed have little option but to react in the way it has. The almost suicidal, depression economics of the eurozone leaves it no choice.

When half the country is up to its neck in debt, and therefore cannot provide the demand necessary to get the economy growing again, the least worst option is to force-march those with the balance sheet strength to withstand it into the shops and the unknown returns of business investment.

If the Bank can drive yields on "riskless" gilts even lower, then those with the money might be more inclined to spend it or invest it, rather than lending to the Government. Even just leaving the cash on deposit with the bank ought to help ease credit conditions a little. That's the idea, anyway.

Whether QE2 works out that way is another matter. All too likely, it will merely end up feeding another investment banking bonus bonanza. Hey ho.