Nobody can accuse the authorities of standing idly by while recession bites
deep into the fabric of the economy. The Monetary Policy Committee has slashed
interest rates from 4.5% to 1%, the lowest ever in the Bank of England’s
315-year history, inside four months. At the same time, Chancellor Alistair
Darling loosened fiscal policy to the extent that even on his typically
optimistic forecast, borrowing in the coming tax year (2009-10) will reach a
record £118bn. On top of this, sterling slipped to its lowest-ever rate against
the euro. All the key levers have been pulled decisively and early into the
If conventional economic policy means anything, this will be a relatively
short-lived and shallow downturn.
Unfortunately, recession is not the only problem. While the credit crunch
neither caused nor was caused by recession, collateral damage from the turmoil
in financial services will have a major impact on the pace and strength of a
Trying to get the banking system on an even keel is taking at least as much
government time, and certainly more money, than kick-starting the economy. This
is not because the authorities like the banks particularly, or have any sympathy
for what in many cases is a self-inflicted plight. Rather, policymakers
recognise that most businesses and many households depend on a regular flow of
credit for normal day-to-day business.
Companies have to produce goods or supply services before they are paid,
while the housing market depends on a flow of mortgage finance. Without it, any
recovery could be very weak and patchy.
Even though the price of money is at historic lows, it is not helping unblock
the plumbing of our banking system. As Bank Rate falls, savings rates offered by
banks become less attractive and so, as the retail deposit base shrinks, banks
have to use the wholesale or interbank market for additional funds. This is the
crux of the problem: the interbank market has dried up and those funds that
remain available are more expensive than Bank Rate, reflecting the lack of
liquidity and confidence among banks.
In spite of the steps the government has already taken, and the
much-publicised government investment in RBS and HBOS, credit still seems in
short supply. Because balance sheets need rebuilding, the money was used to
recapitalise the banks rather than for new lending. Other steps taken by the
government involve insurance-type schemes aiming to reduce the risk to the banks
of lending to businesses.
These are sensible ideas but will take time to have an effect. Meanwhile,
confidence continues to drain away from companies and consumers, leading to
active consideration of the ‘nuclear option’. Known technically as ‘quantitative
easing’, it amounts to increasing the money supply, thus ensuring adequate flow
of credit from the banking system at attractive rates. The Japanese tried it,
the Americans are using it now, and the UK will probably be next. There are
various ways of going about it and while it is a last resort carrying inherent
risks, it should, in conjunction with the other measures, have the desired
Quantitative easing is the modern way of printing money. The aim is to get
money moving around the economy when the normal process of cutting interest
rates is not working and they cannot be cut any lower.
The most likely method is for the central bank to buy assets from the banks
for cash, assets such as government debt, mortgage-backed securities or even
equities. The money is created by increasing the size of the banks’ accounts at
the central bank, leading to a build up of excess reserves which then become
available for lending.
This is uncharted territory for UK policymakers and there are very few
comparable modern precedents elsewhere. The Japanese attempt a few years ago was
later on in the recessional cycle and the results were mixed, perhaps because
the Japanese attitude to spending and saving is quite different from the
British. The US is only just underway and it is too soon to judge its
Of course, there are risks. By buying up assets that are hard to price and
perhaps of dubious quality, the authorities could be landing future taxpayers
with an even larger bill for failure. There is also an obvious danger that the
currency is effectively being debased, which could have implications for both
the exchange rate and inflation. But, in the current climate, in which there are
genuine concerns about deflation, a little bit of inflation would be welcome. In
many ways, the mindset associated with an environment of falling prices is more
insidious and harder to counter than the usual inflationary psychology.
But how the Treasury and the MPC ensure we only have a little bit of
inflation is the crucial issue. Inflation develops its own momentum and
recognising the signs early and taking the appropriate interest rate action is a
very difficult judgement. And who makes that judgement the Chancellor or the
Bank of England? Will this whole process compromise the independence of the Bank
of England? The rules are being made almost on a daily basis.
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