Quantitative Easing II – Why I’m worried

In both the UK and the US, monetary policy makers tip-toeing towards a second round of quantitative easing, already dubbed QE2.

In as much as George Osborne has a “plan B” for the UK, this is it – continue to cut spending and hope that Merv and the MPC will take up the slack by printing more cash to stimulate demand.

I am deeply concerned by this strategy.

In April last year, as QE 1 began I wrote a long post setting out my views on the money, credit and the likely impact of the policy, a policy that really was a leap in the dark.

I was half right. QE did have relatively little effect on the actual real economy. 

I suspect, given my views on credit, that the bank lending channel is one of the more important ways that monetary policy effects the economy. I also suspect that the bank lending channel is currently blocked. If I am right, QE will see an extra £75bn pumped into the economy (as gilts are taken out and cash put in through central bank purchases) and, probably, a £75bn rise in the money supply. The worry is that this will have little effect on the actual economy.

However I was also complacent.

So, should we try QE? Of course. Either it works and provides a stimulus that prevents, or lessens, a slide into deflation or it doesn’t and nothing happens. Either way it does not cause hyper inflation as some seem to suggest.

I entirely (a big failure) neglected to consider the effects on asset prices. In my defence I was working as a fund manager at the time – I had watched the near implosion of the global financial system from a ringside seat and was all too aware of what has happening in the economy, in the banking system and in the wider markets. I convinced myself that against such a backdrop, surely a bout of money printing wouldn’t lead to an asset price boom? Surely fund managers wouldn’t committ money to equity markets whilst the real ecoomy remained on life support? Surely banks, in  midst of a the burstng of a real estate bubble, won’t start lending against still over-valued property again?

I was wrong.

By the October of 2009 I was concerned. 

For all the talk of green shoots, we still have rising unemployment and collapsing investment levels. What little ‘growth’ we are seeing is  the result of companies rebuilding inventories (which will be temporary in the absence of private sector final demand) and government spending.

And yet despite this, asset prices are rising. House prices are up 3 months in a row. The FTSE 100 has rallied a massive 46% since March.

Now as someone who works in fund management, maybe I should just keep quiet and be thankful. Rising asset prices are good for my clients and good for me.

But I do have to question what is causing this?  Irrational exuberance on the likely strength of any recovery?  A side effect of quantitative easing? Future inflation worries? An excess of global liquidity, which is simply being used to purchase assets rather than help the real economy?

The economy needs to be rebalanced. But not in way that favours holders of assets over the real economy. This is raising serious questions about the manner in QE is pursued, something I shall return to in a further post this week.

I returned to the topic with another post in which I advocated using QE to finance a new National Investment Corporation.

Let’s be clear about what’s happening here. The original intention of QE was to increase the amount of money circulating in the economy and bank lending. This isn’t really working (with the important caveat that things would probably be even worse without QE). So now QE is aiming to prop up the economy via the mechanism of raising asset prices.

This allows corporates to issue bonds cheaper (in effect borrowing money whilst side stepping the banks). It also allows companies to re-capitalise themselves by issuing fresh equity cheaper. Both of these effects are helpful.

But a deliberate central bank policy to raise asset prices also poses questions. What are the distributional effects of this policy? Again let’s be clear, the policy of the Bank is to raise the raise the price of assets – this necessarily favours the wealthy over the poor and increases inequality.

For how long can asset prices be artificially supported? Do we risk a new bubble?

Economically how does this policy help the economy re-balance, how does it help small and medium sized businesses that can’t access the equity or corporate bond markets?

I’m a long term supporter of  policy of low interests to encourage investment. (See this very long post if especially intersted).

But I didn’t quite grasp back in April last year was quite how powerful finance capital could be. This is a them I have since turned to several times. Beginning here and more throughly set out here: 

A deliberate policy of low interest rates, aiming to increase the volume of financial capital and fund the ‘green stimulus’ that we desperately need, is achievable. But simply giving money to finance capitalists – essentially the current policy of quantitative easing – will achieve nothing more than supporting asset prices. What is called for is Keynes’s ‘somewhat comprehensive socialisation of investment’, with the ultimate goal of the ‘euthanasia of the rentier’. A social democratic economy requires that finance is challenged directly.

And this is why I’m worried – we are about to do it all over again – hand over billions of pounds to finance capital and keep out fingers crossed that some of it leaks into the real economy.

I’ve got a long essay in Renewal on this topic (here, but not free online – you should all read Renewal though, it’s excellent). I’ll finish with an extract from it:

A Tale of Two Economies

Perhaps the most vivid example of the decoupling of physical and financial capital identified by Keynes can be found in the period from March 2009 until March 2010, the year of quantitative easing. The Bank of England’s decision to essentially print £200 billion of electronic money and inject it directly into the financial system by buying government bonds from banks.

            During that year lending by UK banks, themselves the recipients of much of the £200 billion, to financial companies rose by £81.0 billion whilst lending to non-financial firms contracted by £21.4 billion pounds, whilst the financial sector found itself with ample liquidity, the real economy was starved of credit.

The results were striking. Unemployment, by the International Labour Organisation definition, rose from 7.3 per cent to 7.7 per cent – an extra 200,000 people out of work. Business investment, the primary driver of future prosperity, fell by 7.7 per cent. Industrial production recovered by a modest 0.6 per cent. The real economy struggled forward in March 2009 – March 2010 with sluggish growth, falling investment and rising unemployment.

In the financial sector things were very different. The FTSE 100 index of leading shares rose by a staggering 44.7 per cent. House prices (as measured by Halifax) rose by 5.5 per cent. Bonuses returned, with an estimated payout of £6 billion to staff, up from £4 billion in 2008.

Although a temporary tax was charged on bank payrolls (raising £2.5 billion pounds) little attempt was made to ensure that the £200 billion of ‘new money’, created by the State, found its way into the real economy. Gordon Brown announced the creation of a new National Investment Corporation in his 2009 conference speech although nothing of substance emerged from this. Even nominally state-controlled RBS continued to make excessive payouts to staff in the ‘Global Markets’ division. In short little attempt was made to challenge the power of finance capital, despite the mess it had made of the economy and the near universal public distaste for bankers evident throughout 2008-2010.

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The UK Economy enters the Danger Zone

Yesterday, whilst most the commentariat was focusing on Ed Miliband’s big speech, we got revised numbers for UK GDP from the ONS.

As the headline growth numbers were not changed this generated little interest from most commentators. However there were substantial changes to the components of GDP, changes which paint a mixed picture of the state of the recovery. The FT reported it in a broadly positive light, whilst Bloomberg was more negative.

To me the revised Q2 numbers paint a picture of a strong recovery built on fragile foundations – foundations that Mr Osborne is about to demolish. The UK economy is entering the danger zone.

Taking the good news first; the contribution of inventories to growth was lower than expected and the contribution of private investment was higher. Inventory rebuilding can only ever be a temporary prop to growth – eventually companies will stop stockpiling if final sales don’t improve. The less dependent the recovery is on inventory building, the better.

The increase in investment is also obviously to be welcomed, as I’ve often argued the collapse in investment has been the real driver of the recession. If this increase is repeated and built upon in the coming quarters, I’ll be a lot more sanguine about our economic prospects. However, if final demand doesn’t improve I struggle to see why businesspeople will keep investing.

On the negative side Bloomberg tellingly choose the headline “U.K. Growth Fueled by Jump in Government Spending”. Remember back in July when the first estimate was released George Osborne said:

“Today’s figures show the private sector contributing all but 0.1% of the growth in the second quarter, and put beyond doubt that it was right to begin acting on the deficit now.”

It turns that Government actually (directly) contributed the most to growth since since 2008. And the large jump in construction spending (the biggest since 1963) was probably also heavily dependent on the public sector.

As Commerzbank economist Peter Dixon argues (in the Bloomberg report):

“The more the contribution of government now, the more we’re going to miss it when it’s taken away, we’re going to see much slower growth.”

Potentially more worrying was the reliance on consumption, which contributed about one third of the growth. Households increased their spending by 0.7% in the quarter even whilst their incomes fell by 1.6%. This was possible as the saving rate (the amount of income saved by households) fell to 3.2%. As the FT notes, the level of household savings has now fallen to near pre-recession lows. The OBR expects this rate to rise in the coming quarters as households rebuild their balance sheets. IT certainly can’t fall much lower, so in future the growth in consumption will be more closely linked with the growth in household incomes. Incomes that will be hit by the January rise in VAT.

The recovery so far has been built around three pillars – government spending, a sudden rebound in investment and consumption fuelled by falling savings. George Osborne is about to directly remove the first of these pillars and possibly undermine the third. Whether investment will continue to rebound is now the big question.

I’m not alone in being worried as we enter the danger zone. Adam Posen, of the Bank of England’ MPC, seems equally concerned.

The UK faces a long period of sluggish growth, with high unemployment and falling prices, unless the authorities act quickly to stimulate the economy, an influential adviser to the Bank of England has warned.

Sounding the alarm over the possibility of years of stagnation, Adam Posen, an external member of the monetary policy committee, rejected the upbeat arguments issued on Monday by the International Monetary Fund about the economy’s nascent recovery

Against this background (and with the prospects for exports, Osborne’s preffered panancea, looking increasingly ropey), I’m afraid I can’t agree with Kitty Usher’s call for Ed Miliband to become more hawkish on the deficit.

Yes Labour need to show how they would go about reducing the deficit in the medium term, but the real risk now isn’t the deficit, it’s the propect of a renewed slump.

Living Wage

I’m really glad to see Ed talking so much about the Living Wage in his speech.

From the NPEN ebook (page 44):

In the 1920s much of Labour’s economic thinking was rooted in

theories of under-consumption. The argument was that as one

becomes wealthier, one tends to save a greater proportion of one’s

income; so that vast disparities in wealth lead to too much saving in

the economy as a whole, and not enough demand. Social liberal and

liberal socialist thinkers such as J.A Hobson, E.F Wise and J.

Strachey, associated with the Independent Labour Party, made the

case for a more equal distribution of income not only on moral

grounds, but also on economic grounds. A redistribution of the

economy’s wealth towards the working class would lead to higher

consumption and hence higher employment.

This insight still holds true. As we argued at the beginning of this

e-book, the impact of rising inequality has been masked for the past

three decades by increased borrowing by those further down the

income scale. But increased personal indebtedness has proved

unsustainable, and, given this difficulty, if living standards are to be

maintained a solution will have to be found in greater wealth

equality. Government intervention will be required – whether

through increasing the minimum wage or using the power of public

sector procurement to enforce a living wage – as will changes in the

tax system to reduce taxes on low earners.

 

Labour’s Economic Team

There has been an awful lot of debate on the Shadow Chancellorship over the past 48 hours. All of the three leading candidates have strengths.

Ed Balls is an obvious choice – I’ve outlined the case before.

David Miliband, as I’ve argued, has outlined a policy-heavy, detailed alternative Social Democratic model of political economy for Labour.

Yvette Cooper is another strong contender – an excellent economist, possessing relevant experience and a strong media and Parliamentary performer. On Budget day, back in June, she was very impressive – actually sitting down with a copy of the Red Book and helping party staff go through it.

Aside from these three, we shouldn’t forget Liam Byrne who is, yet another, strong media performer with an excellent knowledge of the economic brief. (And that note was clearly a joke – move on).

As I argued yesterday, I think the extent of division on deficit reduction has been overplayed. That makes sense in the context of a leadership election, but now is time to unite around what we all agree on – Osborne is cutting too fast, too much and is a danger to growth.

But in all this talk of the Shadow Chancellorship, we seem to be forgetting the over big economic role – BIS.

I’d like to see a “big name” getting that brief – in many ways outlining Labour’s growth strategy is going to be more important than the traditional job of the Shadow Chancellor. And it will require a great deal of political skill – shadowing Cable is a lot more complex than shadowing Osborne. We need someone in this role who can both develop a pro-growth strategy and has the ability to critically engage with Cable, rather than blindly opposing him – supporting him at times and backing him against the rest of the Cabinet.

With one of the four above at the Exchequer and another at BIS, together with a fresh face as Shadow Chief Secretary, Labour would have a very credible economic team in place. But whoever is in that team, we need to learn from the experience of the Blair/Brown years – economic policy shouldn’t be he intellectual reserve of the Shadow Treasury team, the entire party (not least the Leader!) need to be kept closely involved.

The real economic dividing lines

Today’s FT tells me that the Milibands are divided on deficit reduction and this will be the first big fight, post Ed’s leadership.

Here we go then with the first great battle between union placeman “Red Ed” and David “Tong Blair continuity candidate” Miliband. Or at least this is the narrative the media seem to want. The problem with it is that’s rubbish.

Yes Ed and David Miliband disagree on some details of deficit reduction but the divide is much smaller than that between, say, George Osborne and Vince Cable.

Both agree that George Osborne is cutting too fast, both want a greater proportion of the balance to come from tax rises and both understand that growth is the most important element in any deficit cutting strategy.

And both know that there is far more to economic policy than simply reducing the deficit.

The rebalancing of the economy, the taming of finance and, most of all, a strategy for job creation – these are the really big issues in economic policy, and here to (as with the Living Wage) the two Milibands (and Ed Balls) agree on far more than they disagree.

It seems to me we have a choice, we spend the next two weeks sniping at each other or we focus on George Osborne and David Cameron,

For what it’s worth – I’d favour sticking to a four year blue print, emphasising the flexibility in our approach and moving towards a 50/50 split between tax rises and spending cuts.

But what I’d favour most of all is moving the debate away from a fairly sterile discussion of structural deficits and public sector borrowing requirements and onto the real issue – jobs.

Keynes Quote of the Day

… you will never balance the Budget through measures which reduce the national income. The Chancellor would simply be chasing his own tail – or cloven hoof!  The only chance of balancing the Budget in the long run is to bring things back to normal, and so avoid the enormous charges arising out of unemployment.

Keynes, radio talk, 4 January 1933

Ed Balls & Alistair Darling on Ireland

I voted for Ed Balls, and whilst I hope he wins, it looks like we’ll be having a Miliband as leader. I think both of them would be excellent, so I’ll not be too upset either way.

The post of Shadow Chancellor will be crucial. Today Ed Balls gave us a preview of how he’d handle it. Compare and contrast the statements from Ed and Alistair Darling today.

Alistair:

“Today’s data showing that the Irish economy has fallen back into recession demonstrates very clearly the risks with the approach being followed here in the UK.

The coalition thinks that cuts, however big, will always support growth. In times like these this is plain wrong. Ireland has gone through major cuts and tax rises, but because growth has been hit getting the deficit down is harder not easier. The coalition is going down the same road, and their risky gamble risks hitting confidence, growth and jobs.”

Ed:

“These figures are a stark warning to governments across Europe including our own. An austerity programme of deep cuts now, when our economic recovery is not secure, risks lower growth and higher unemployment.

“That is not a credible economic strategy because lower growth and fewer people in work and paying taxes ultimately leads to a bigger deficit not a smaller one.

“As I have argued, we must challenge the idea that the coalition’s ideological and reckless cuts are unavoidable and set out a credible alternative which puts jobs and growth first with a steadier deficit reduction than the counter-productive cuts the coalition is forcing through.”

“Demonstrates very clearly” versus “stark warning”.

“Risky gamble” versus “ideological and reckless”

Ed would take the fight to Osborne in an aggressive manner, just as he’s spent the Summer taking the fight to Gove.

Iain Martin thinks the Irish experience will prove a blessing for Labour. I think he’s right (and indeed have been pointing this out for the past year). Ireland can be our Greece – an example of what our opponents policies can lead to.

Banking Models

Once upon a time, in Autumn 2004 whilst working at the Bank of England, I went on a 3 day course entitled “Analysing Banks’ Accounts” or some such.

We had an external trainer (who also did a lot work for investment banks, training their analysts) and learned about bank balance sheets, wholesale funding markets, the inter-bank market, etc, etc.

As a case study throughout the course we looked at Allied Irish Bank – an excellent example of the “new banking model” with innovative use of securitisation, an extremely efficient balance sheet and booming profits and loan growth.

Today Allied Irish Bank is on the verge on default.  

I wonder what case studies that course is using nowadays?

Britain’s Broken Economy – And How to Mend It

The New Political Economy Network (Npen) is today publishing an ebook “Britain’s Broken Economy – and how to mend it”. You can download it, for free, here.

I’ve got a post explaining some of the background on Liberal Conspiracy today.

Jonathan Rutherford and Aditya Chakrabortty have a longer piece in today’s Guardian.

And you can listen to Jonathan and Aditya discussing the book with two of Labour’s better new MPs, Chuka Umunna and Rachel Reeves, here.

As a disclaimer, I am one of the authors. So go have a look.

Ireland: A Warning

A year ago I wrote a post for Left Foot Forward on the Irish economy. I noted how, unlike Britain, the Irish Government had reacted to the global recession by cutting spending and attempting to drive down costs to remain globally competitive. I also noted this was broadly the policy pushed by the Conservatives at the time.

I assessed what had happened in the year between September 2008 and September 2009.

Nearly one year on, what has been the effect of these polices? Irish GDP is expected to fall by 12%, a staggering decline. Unemployment has reached 12.4% and is still rising. The economy is now in the grip of a severe deflation (minus 5.9%). Finance Minister Brian Lenihan openly talks of the need to “get our cost base down” in order to regain competitiveness. A policy of aiming to balance the budget and drive down wage costs is a throwback to the so-called Treasury View of the 1930s, a policy rejected then by progressives and rightly rejected now. The final irony is that, despite all of this needless suffering, the Irish Government will still be running a budget deficit of 12% of GDP this year while the ratings agencies have already cut Ireland’s sovereign bonds from AAA to AA.

In December last year, as Ireland delivered yet another emergency budget that was again praised by British Tories, I wrote an update.

Iain Dale writes that:

“The PBR the British Chancellor should have delivered, was delivered yesterday in Dublin. Hopefully George Osborne is studying it in great detail.”

The results of Ireland’s policy are plain to see:

• Irish unemployment is 12.5 per cent;

• The country is experiencing deflation at –6.6 per cent;

• GDP has fallen 7.4 per cent over the past year and 10.5% from its peak;

• And despite the cuts they have still had their credit rating downgraded.

But what exactly are the measures that the Tories are so keen to praise?

– Child benefit is being cut by 10%.

– Unemployment benefit is being cut by 4.1%, with larger cuts for those under 25.

– Public Sector workers are facing pay cuts of 5-8%.

– Prescription charges are being increased by 50%.

– Other increased health charges including A&E, inpatient and outpatient charges and a higher monthly threshold above which people cannot get free drugs under the Drug Payment Scheme.

– The Health budget is being cut by €400mn on top of previously announced cuts

– Further departmental cuts will be announced in coming days.

– €960mn is cut from the investment budget

So, a year after the first post and two years after Ireland embarked on its programme of cutting, where are we now?

Not in a good place. As the FT reports:

Ireland’s central bank governor has indicated that Brian Cowen’s government needs to go even further in cutting the forthcoming budget if it wants to restore international confidence in its management of the economy.

…

A year ago the populist Fianna Fáil-led coalition won international plaudits as one of the first EU countries to tackle the crisis head on, administering cuts in public sector pay averaging 15 per cent, and reductions in child and other benefits in the most savage budget in decades.

Yet today Ireland, together with Greece and Portugal, is seen as the most vulnerable of the EU’s peripheral economies, as it struggles with a property and banking crash that has blown a hole in the public finances and threatens the economic recovery.

As Ireland prepares to engage in (another) round of cuts, Bloomberg reports how unconvinced “the markets” are by Irish policy.

Thirty-seven percent of those surveyed say Ireland is likely to default, more than double the rate three months ago, according to a quarterly poll of 1,408 investors, traders and analysts.

Ireland is providing a vivid example that the “cuts don’t work”. As the head of asset allocation at Credit Suisse Private Bank warned a year ago

Spending cuts to be announced today by Finance Minister Brian Lenihan may end up sacrificing long-term economic growth for reducing the budget deficit, an Irish author and head of asset allocation at Credit Suisse Private Banking has warned.

Michael O’Sullivan, whose book, ‘Ireland and the Global Question’, was published in 2006, warned this week that Mr Lenihan’s expected swingeing cuts could do long-term damage. “Arguably the Irish bond market is being saved at the expense of Irish society”, said Mr O’Sullivan.

“By cutting spending you lower the trend line of growth and store up bigger fiscal problems down the line,” he added.

Cutting now reduces growth and  tax revenue and increases unemployment and welfare spending. It does not close the deficit in a sustainable manner.

Ireland, a euro member, may have little choice but to pursue this policy. The UK though does face a choice, and we are making the wrong one.