Monetary policy: QE2 or the Titanic?
â€śThose whom the gods would destroy, they first drive mad.â€ť â€“ the words of a wise Roman thinker (or was it a Greek central banker?). At any rate, the gods certainly seem to have no benevolent intentions with regard to this country, judging by the statements coming from the Bank of England, in particular the calls for another round of quantitative easing from one member of the Monetary Policy Committee and the cry of â€śSpend, spend, spendâ€ť from another.
The view emerging from the Bank and the Monetary Policy Committee is that the country is in the grip of a slow-growth recession, facing the threat of Japanese-style deflation and a double-dip recession, and that this grim situation requires near-zero interest rates, supported by QE2 if necessary, in order to restore consumption and lending (including mortgages) to pre-crisis levels.
As soon as anyone compares the UK and Japanese economies and finds similarities, I start to worry about their sanity. Leaving aside the massive differences in labour market flexibility, the key difference is that Japan got itself into a mess single-handedly in the late 1980â€™s, largely because of its unsustainably high levels of saving and investment. Indeed, for the last 20 years its massive stock of accumulated savings have largely insulated it from any sense of urgency. Its fiscal policy consists of running enormous Government budget deficits which are funded out of this stock of private sector assets, so that its expansionary fiscal policy simply serves to offset the excessive thrift of its overprudent households – hence, Japanâ€™s ability to borrow well over twice its GDP without generating any sign of market nervousness about its ability to repay and with a buoyant Yen exchange rate.
Somehow, this does not sound to me like Britainâ€™s current predicament. If we face years of stagnation, it is because of a debt overhang, the absolute opposite of Japan. Yet the Bank – no doubt in line with the majority of the UK economics profession â€“ is convinced that Japanese-style demand weakness is our problem.
Take the deflation threat first. For all the worries, Britainâ€™s inflation rate fails to follow the script. Not only does it repeatedly exceed the Bank of Englandâ€™s own forecasts, but at over 3% it is still well above â€“ not below â€“ the inflation rates of every other major economy and double the Eurozone average rate. In particular, Germanyâ€™s inflation rate is only 1% and the USAâ€™s is 2%.
What about unemployment? Again, it is far from obvious that the UK is in any way out of line with the rest of the industrialised world, given that our unemployment rate is still only 7.8% compared to 6.9% in Germany, 10% in France, and 9.5% in America (and 5.2% in Japan).
As far as household saving and consumption are concerned, the conclusion again depends on what yardstick you use. At 7.7% of disposable income, the UK saving rate is higher than it has been for a few years â€“ it was barely 2% in 2008 â€“ but this is still extremely low compared to well over 13% in the Eurozone and over 15% in France and Germany, not to mention 30%-plus in the Asian tigers. Only the USA has similarly low savings rates.
As far as the saving of the other two sectors is concerned, the British Governmentâ€™s deficit is far higher relative to national income than in any other major economy except the USA, leaving the corporate sector as our only net saver.
The total of the three sectors combined is, by definition, the current account of the balance of payments. It is of course heavily in deficit, albeit by less than in previous years.
Of course, it is perfectly true that the direction of change for UK consumption appears to be downward, that unemployment is likely to increase over the next year or two, and that inflation may well continue to fall (though I wouldnâ€™t bet my mortgage on it). But we have to hope that, in the absence of domestic demand, UK exporters â€“ manufacturers, mainly â€“ will take advantage of the robust growth in world markets, especially in the Far East.
The pre-crisis world was characterised by asset bubbles directly related to the enormous imbalances in the global economy. What is needed now in order to eliminate those imbalances is for deficit countries to save more and surplus countries less.
Now it is true that surplus countries show little sign of delivering their half of this deal, though monetary union has complicated the European picture beyond anything politicians could reasonably be expected to handle â€“ the Germans in particular are caught between the need to spend so as to rebalance their own economy and the urge to save so as to cover the cost of bailing out the ClubMed countries. Most obviously, the Chinese need to reduce their savings rates, which is not straightforward, since their level of thrift is largely driven by insecurity in the absence of a welfare safety net and a demographic time bomb vastly more threatening than any Western country has to face.
All of which makes two points clear. Inspite of Gordon Brownâ€™s posturing on the global stage, it is plain that Britain is at the forefront shoulder-to-shoulder with the USA, leading the wayÂ â€“ into a cycle of competitive devaluation, which is exactly the outcome all the major players are ostensibly committed to avoiding. Since 2007, the Pound has fallen by over 20% against the Dollar, the Euro and the Hong Kong Dollar, by 35% against the Swiss Franc and by well over 40% against the Yen. Most of those falls occurred in 2008 and 2009, but this year so far it has gained very slightly against the Dollar and Euro. Unintentionally or (my suspicion) intentionally, the pronouncements from the Bank are giving the markets a further push so as to get the slide restarted. With the Japanese openly intervening to push down the value of the Yen, and the Americans indifferent to the value of the Dollar, it is no wonder the gold price is rising.
You could call the Bank of Englandâ€™s policy cynical â€“ or you can call me cynical for interpreting its motives in this way. But I certainly think savers would be well advised to take Charlie Beanâ€™s words very seriously indeed, because in the end it confirms what I have written many times before. British policy may not be explicitly aimed at inflating away our debts, but at the very least it is biased by the judgment that a rerun of something like the inflation-ridden 1970â€™s is preferable to Japanese-style stagnation.
Incidentally, if we are to take the prospect of deflation so seriously, we might well ask (and ask the regulator) why Britainâ€™s commercial bank cartel is being allowed to charge such astronomic rates to retail borrowers â€“ probably the highest real interest rates and almost certainly the widest spread between borrowing and lending rates ever seen. Driving borrowing rates down might do more to restore consumer confidence, if that is indeed what is required, than simply haranguing savers to change their ways.
But of course that might throw sand in the wheels of the high street banksâ€™ money machine â€“ so thatâ€™s ruled out from the start.