Salvation through inflation: The British way out
Accusing policymakers of acting out of sheer desperation is a pretty standard jibe by critics trying to put them off their stride.
Unfortunately, the latest round of QE came wrapped in comments from the Governor of the Bank of England which amounted, more or less, to saying: “Look! I’m staying calm – but it’s taking a hell of an effort, believe me!”
As the world economy teeters on the brink of relapse, Mervyn King’s action amounts to saying: “Forget the danger of inflation… we’ll settle for anything rather than a rerun of 2008”. He and his opposite numbers in Frankfurt and Washington are haunted by the fear that the history books may say the 21st century’s Great Depression happened on their watch.
The latest measures are probably not going to work and may make matters worse because the mess we are in is a matter of the distribution of real wealth – positive and negative i.e. net worth – and hence is unlikely to be improved very dramatically by printing money. Specifically, the economy is grinding to a halt because, internationally and domestically, even locally, those who save have accumulated wealth which they would normally feel inclined to lend or invest. But since the majority of would-be borrowers are already indebted to unprecedented levels, and investment opportunities are unattractive given that the output they generate would need to be sold to the same overindebted consumers, wealthowners are opting for the relative safety of Government debt, guaranteed bank deposits, gold and even, it seems, blue-chip real estate and agricultural land.
Like the self-similarity of a fractal, this same pattern is repeated at the largest and the smallest scale.
At the global level, the largest creditors – China and its neighbours, the Gulf Oil producers, Germany – feel understandably reluctant to keep adding to the trillions of dollars they have already lent to the debtor countries, nor are they overwhelmed by the attractions of direct investment in these countries, especially as the juiciest opportunities are often ruled out by political considerations (imagine a Chinese bid for Intel or Apple, for example).
Similarly, at the domestic level, there is a yawning gap between borrowers and lenders – on the one hand, the so-called squeezed middle, with mortgages, credit card debt and other unsecured loans still at or near record levels, on the other hand, so-called High Net Worth individuals at the top of the wealth distribution who are wary of lending or investing for anything other than prohibitively high rewards (just look at the yield on blue chip stocks). The market stalemate seems inescapable: those who have funds can find no trustworthy, low-risk borrowers. Never has the old adage seemed truer: only lend to those who don’t need the money.
In the corporate sector, we see the same deadlock. The good news is that, on the whole, British companies (along with most of the global giants which dominate the world economy) are awash with cash. Against that, the bad news is that they show no inclination to spend it on investments of the kind which will expand production and create jobs in the immediate future. Moreover, the small business sector, which is the lifeblood of the domestic economy is being starved of funds for reasons which are hotly disputed, with the banks claiming a lack of demand for credit and the SME’s complaining that they are being refused loans.
In between the borrowers and lenders, the banks writhe on the horns of a dilemma which could be described as cruel, if it were anyone but the banks. With QE and other measures, Western Governments and central banks are pumping the commercial banks as full of liquidity as a supermarket turkey, but then making contradictory demands on them. On the one hand, banks are expected to increase their lending to housebuyers and, more importantly, to SME’s. On the other hand, in order to restore confidence in the solvency of the banks, the regulatory authorities are setting ever stricter capital adequacy standards, requiring them to keep higher reserves against bad debts and raise more equity i.e. to hold on to the additional money flowing in.
What can a poor banker do, forced to ride this endless money-go-round? Nothing but concentrate on preserving his precious bonus, however far the bank’s share price drops, however far its profits shrink or however low its credit rating falls.
If this were not bad enough, the banks are now being forced to take a bigger haircut on Greek Government debt than the 21 percent originally agreed back in July. What this means, in terms of who will actually end up bearing the cost of the write-down, is almost impossible to say, because in any case a number of the banks who are the main creditors of Greece will need to be recompensed for their losses, otherwise they will go bankrupt. It follows that the call by Frau Merkel for the private sector creditors to take more of a haircut is somewhat meaningless – as usual, taxpayers will end up picking up the bill, whether for bailing out Greece directly or bailing out the banks which have lent to it. At most, it could be a matter of how much of the burden is borne by the taxpayers of each individual Eurozone country – something which we can be sure European leaders will take care to conceal from us by every possible means at their disposal (and which, to be fair, will anyway be extremely difficult to compute, given the complexity of European finances).
Where will it all end? How can we exit this seemingly endless crisis?
It is hardly surprising that the hair-of-the-dog cure for the post-Lehman hangover has failed. It never seemed likely that we would be able to spend our way out of an overspending crisis. The attempt to reinflate the lending bubble was doomed to failure because the imbalances which caused it to burst in 2008 are not only still present, but in some respects are actually worse than ever, and are being exacerbated by expansionary monetary policy and slower growth in the real economy.
As far as Britain is concerned, however, the only possible escape route, given the political constraints, is a shameful, dishonest default-by-inflation, the same expedient we used to pay for World War II. The fear amongst many of my professional colleagues was a Japanese-style deflation, which would lock us into a vicious cycle of falling prices, increasing debt burden, falling consumer confidence and hence further deflation. Instead, Britain has an inflation rate approaching 5 percent, the highest in Europe.
Given that 10-year gilts currently yield about 2.25 percent, a back-of-the-envelope calculation suggests that the real burden of the national debt is being eroded by around 2.5 percent per year, which means that on its own inflation will reduce the value of £100 borrowed today to only £80 in ten years – or, to look at matters from the point of view of fiscal policy, at the current inflation rate we could run a budget deficit of 2.5 percent of GDP without for free.
Ironically enough, it is Britain’s good fortune that so many of our competitors, especially in Europe, are in such a mess. It is only because of the comparison with the euro zone that gilts look relatively attractive to bond market investors, who are forced faute de mieux to buy them on a negative real yield. Otherwise, they might look at our inflation rate and the size of our outstanding debts and demand a more normal yield of 2 percent above inflation (i.e 7 percent) – something which may yet happen, of course.
In the meantime, however much British policymakers may wish out loud to see the euro zone crisis resolved, they would do well to whisper a silent prayer: “Lord, give Europe stability ….but not just yet.”
Image — A sign which reads “Kill Inflation not Savings” is left outside following a protest outside the Bank of England in the City of London October 6, 2011. REUTERS/Suzanne Plunkett