The Big Easy
Having dropped its overnight interest rate to 0.5%, the Bank of England also announced a package of quantitative easing, of some Â£75 to 150 billion worth:
It will create Â£75bn and use it to buy government bonds (gilts) and corporate debt over the next three months to boost the flow of money in the economy. The Bank has been given permission by Alistair Darling to spend a total of Â£150bn on asset purchases. The Â£75bn figure includes Â£50bn previously allocated to the Bank for asset purchases to restart credit markets.
This additional step of money creation is new and important. True, the US has engaged in some fairly radical measures on the monetary front, although technically they have supplied money to banks with assets of dubious quality as collateral, whereas the Bank of England will actually be making purchases. The Canadian government has also been buying mortgages via CMHC from the banks, but this is not the same as printing money through the central bank (we had a good debate on what might be going on following this post).
All of which makes me wonder how effective this policy will be (special hat tip to Nick Rowe for his thinking on these dynamics, among others, like Arun Dubois). On fiscal policy, the UK government gaffed when it put way too much emphasis on tax cuts (reducing the VAT), an expensive and largely ineffective way to stimulate consumer spending. Will they get the monetary policy right? And what does “right” mean, given that we are navigating waters last surveyed seven decades ago from a ship that was a rickety wooden boat compared to our modern yacht? And what does this suggest for the Canadian context?
Short-term rates on government bonds are extremely low right now, so money is a rough substitute, and purchases of bonds would appear unlikely to change the behaviour of banks much if their problem is heaps of toxic assets on their books. In the UK, it is an insolvency problem not just a liquidity problem, and buying the relatively liquid short-term government bonds would only reduce yields on those bonds further, making them even closer substitutes for money. In Canada it would appear that insolvency is less an issue, though the federal government’s creation of a $200 billion facility to buy up assets does make one wonder what whether the banks are as solid as they want to project to the world.
The Bank of England might be more success with purchases of longer-term government bonds paying higher interest rates, which might push down rates on other long-term debt. Or not. Buying up corporate debt is probably the best option of these three, given that is where the credit crunch is most acute, and if companies cannot roll over their financing we could see a wave of job losses on top of the current increase. Buying other asset types gets more problematic when determining their value is extremely difficult.
There are two broad objectives here that are generally being considered at the same time and perhaps are getting mixed up. One is to get credit moving by loosening up the financial markets. The other is to get the real economy moving. An underlying assumption in many an analysis is that doing the first will lead to the second. I’m more doubtful and would almost put it the other way: supporting demand in the real economy will create conditions where borrowers want to borrow money for whatever reason, although there may be distinct things we want to do in the financial sector.
I still favour going harder on fiscal policy to focus more on bolstering demand, and less on the banks. With continued weak demand, monetary policy alone is not going to be sufficient. An alternative policy would have the Bank finance (monetize) large government deficits, with a good chunk of those deficits going towards income transfers to low- to middle-income households that will go out and spend the proceeds right away, and to finance infrastructure projects that create jobs. This seems to me to be the surest way to prop up demand in an economy where consumer spending and business investment are tanking. It would have beneficial social outcomes as money would flow to those who need it, and without implicating higher taxes or reduced public services for the next generation.
That may be a better way forward in Canada, but the object of quantitative easing in the UK is shoring up the financial system not shoring up demand. The problems with the financial system, in the US and UK anyway, may ultimately require their own, more radical process of temporary nationalization to clean things up. That may well happen if this round of quantitative easing fails.
Re the Bank of England creating extra money by quantitative easing, I am not 100% sure this is true. The B of E announced about a month ago that initialy its quantitive easing would consist of buying corporate bonds and sterilising the money supply increase buy selling government securities. It said it would move on to real money creation a month or two later. Perhaps the B.of E. has changed its mind.
Marc claims that the UK government’s VAT reduction was a “gaffe”. There is actually a study by the Institute of Fiscal Studies which claims this move was reasonably effective. Also, it strikes me Marc’s point here rather conflicts with his claim later on that governments should feed additional funds direct to households (which I quite agree with). On the other hand I suspect a tax or national insurance contribution reduction would have been better than a VAT recution: people notice the former but not the latter I suspect.
Supporting the idea that funds should be fed direct to households include the following. IMF report (para 18):
http://www.imf.org/external/pubs/ft/spn/2008/spn0801.pdf. Some research by Markit which claims that corporations world-wide are primarily short of demand rather than credit:
And finally, a witty article in The Guardian:
Thanks, Ralph, I will look for that IFS study.
The problem with VAT cuts is that they are not going to get people to spend when they are in retrenchment mode. High street retailers in the UK are putting on sales of 25% or 33% off or more to get consumers to spend. An extra drop of 2.5% due to the VAT is not going to have much impact.
The same amount of money would be much more stimulative by directly channeling it into the hands of low- to lower-middle-income families who would go out and spend it right away.