Opinion: Quantitative Easing would be a grave mistake

The recent comments from Bank Of England Governor Mevyn King , regarding the possibility of quantitative easing make little sense in the context of the Coalition’s current economic strategy and are contrary to broad Lib Dem principals.

The pre-election debate on the economy centred on whether the recovery was strong enough at present to sustain cuts, it is the opinion of Lib Dems, and a view I agree with, that the economy is strong enough to sustain such an action.

This view can be boiled down to believing that the level of aggregate demand in the economy has reached a point where the economy is in danger of overheating, and tipping into inflation. Government cuts will reduce the level of aggregate demand, but the theory is that the level of demand is strong enough to allow growth to continue at a rate that is strong enough for the economy to develop but that demand will be reduced by a large enough margin to prevent unstable levels of inflation occurring.

In recent months the Bank Of England have written to the government to apologise for the fact that the rate of inflation was higher than the government target of 2%. The Bank of England Monetary Policy committee have consistently been doves when it comes to inflation, believing that a low rate of inflation will consistency occur in the coming months, indeed they believe that deflation will be a bigger threat than inflation in the medium term.

The Banks response to the rate of inflation being higher than they expected, and higher than the government’s 2% target, was to say that they ‘didn’t know’ why the inflation rate was so high. The fact that inflation was running above target seems to indicate that the government’s view concerning the level of aggregate demand in the economy is the correct one.

And so to quantitative easing. Injecting cash directly into the economy is an inflationary measure, as the more cash there is swirling around the less real value that cash will have. Obviously if the government believe that the level of aggregate demand is to high, pumping demand into the economy to increase demand further would run counter to the government’s economic strategy at present. It is also a supply side economic policy, when the vast majority of Liberal Democrats are Keynesian in Economic outlook, and thus believe that supply side measures such as quantitative easing are ineffective.

The idea appears to be to use the newly printed currency directly to pay the holders of United Kingdom sovereign debt. This would reduce some of the supply side inflationary pressures which are present in the UK economy as a result of the high levels of debt forcing the value of the British currency down relative to some of its international peers. While this could have a positive effect on the economy, it will also inject inflation as prices in the domestic economy on non imported goods are increased, while the whole whole point of the government’s strategy to date has been to reduce inflationary pressures.

A difference in overall aims and objectives between the Treasury and the Bank of England is never likely to have a positive impact on the economy, and could mean that the current wave of cuts are in vain, and the legacy of this coalition will be a double dip recession.

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29 Comments

  • Anthony Aloysius St 21st Oct '10 - 11:07am

    “… it is the opinion of Lib Dems, and a view I agree with …”

    Oh dear. Apparently Lib Dems now have only one opinion – and one that the party leader said was “completely irrational” only 6 months ago, to boot.

    Has LDV taken office space in Minitrue?

  • Most of what the Lib Dems are agreeing to is “against broad liberal democrat principles” so you’ll have to come up with a better reason.

  • toryboysnevergrowup 21st Oct '10 - 11:22am

    “The economy is in danger of overheating” On what do you base this statement – could you please provide some evidence to support this assertion. Many things can drive price inflation (e.g. commodity prices, indirect taxes etc.etc.) as well as the level of effective demand I’m afraid.

    QE is not the same as directly injecting cash into the economy. Could you please also tell us where Keynes did not see a role for monetary policy as well as the management of effective demand?

    The vast majority of LibDems are Keynesian in outlook – unfortunately this does not include those that are in government however.

  • david thorpe 21st Oct '10 - 11:34am

    Lib dems have an offical party policy. thats what I was referrring to. I dont agree with all of the offical party policies though., which is why I made the distinction

  • Well all the Lib Dems might agree now (!) but your leader wasnt back in May……

    Clegg May 1st 2010…………..

    “My eight-year-old ought to be able to work this out – you shouldn’t start slamming on the brakes when the economy is barely growing. If you do that you create more joblessness, you create heavier costs on the state, the deficit goes up even further and the pain with dealing with it is even greater. So it is completely irrational.”

  • david thorpe 21st Oct '10 - 11:44am

    @ thanks all for the comments.

    First of all, I think Cable and Huhne particularly are keynesian, vince is regarded as an expert on the subject.
    Price inflation is an indiciator that the economy is in danger of overheating.
    Keynes did see a role for menetary policy, but he was less keen on supply side solutions.
    @ norfol boy…
    examples please

  • david thorpe 21st Oct '10 - 11:46am

    as keynes said
    “when the facts change I change my mind, what do you do Sir”

    And thge facts changed as the economic situation changed

  • QE will (and already has) lead to higher inflation. This will destroy the standards of living of many pensioners and those on fixed incomes. A very bad thing.

  • Anthony Aloysius St 21st Oct '10 - 12:40pm

    “Lib dems have an offical party policy. thats what I was referrring to.”

    Are you saying that “early cuts” has been officially adopted as party policy, rather than just being in the coalition agreement? If so, I’d be interested to hear details of precisely what the party has signed up to.

  • Anthony Aloysius St 21st Oct '10 - 12:43pm

    David

    “And thge facts changed as the economic situation changed”

    Surely you didn’t miss Clegg’s admission that he privately changed his mind before the election, but carried on publicly pushing the old policy regardless?

  • toryboysnevergrowup 21st Oct '10 - 12:51pm

    But David the facts have not changed fundamentally – the deficit was confirmed by the OBR as being pretty much the same as it was at the time of the last Labour budget and if anything growth forecasts has been reduced rather than increased, which hardly points to the economy being on the verge of overheating.

  • Richard Hill 21st Oct '10 - 12:57pm

    I think that there are plenty of influences on the world stage, like competition from places like China to make sure that we do not get into an iflationary spiral. A bit more quantitative easing, if necessary, if needed to keep the economy growing at the right rate might not be a bad thing in the present cicumstances. The bBank of England appear to be getting it as close to right as anybody can at the moment and I would sooner trust them than a lot of people.

  • DAVID THORPE 21st Oct '10 - 2:26pm

    YOUR RIGHT GEOFFREY, BUT IT WASNT A randomn thought which changed clegg and cables mind, it was the events in greece.
    The inflation rate is above the bank of england target, mervyn king worte to the treasury apologising for this and saying he didnt know why it was above target. So inflation is alreday a problem, and thats according to the Bank of England
    I didnt say the lib dems ever passed a motion as being opposed to QE, the mebership may like it.
    But the membership alos view themselves as keynesian, as keynes was a believer in demand side rather than supply side economics, and QE i supply side.
    Anthony,

    I did see that, Clegg changed his mind as the facts changed.
    But didnt tell people during the campiagn.
    He was right to change his mind, worng not to tell people.

    @SmcG

    wELL SAID, but it harmn everyone, workers will have to pay mroe for things.

    Also the idea od cuts now is to prevent further supply side inflation, in the aftermath of yesterdays announcemnets sterling strenghtened against its peer currencies, which will help to prevent supply side inflation

  • Anthony Aloysius St 21st Oct '10 - 3:30pm

    That wasn’t a rhetorical question about whether “early cuts” has been officially adopted as party policy. If it has, can you tell us the details?

  • “The idea appears to be to use the newly printed currency directly to pay the holders of United Kingdom sovereign debt. This would reduce some of the supply side inflationary pressures which are present in the UK economy as a result of the high levels of debt forcing the value of the British currency down relative to some of its international peers.”

    What does this mean? I think it might be the single most economically idiotic comment I have ever read.

  • “The fact that inflation was running above target seems to indicate that the government’s view concerning the level of aggregate demand in the economy is the correct one.”

    No it doesn’t. You’d need more information – much more information – and when you look for other indicators, there aren’t any.

    Inflation doesn’t necessarily suggest demand is increasing; it can mean supply is restricted.
    In most sectors, the automatic response by business to an approaching recession is to reduce volumes. (Better to be smaller and profitable than bigger and bust)
    Price inflation does not take account of volumes, throughputs, units sold.
    The various stimulus measures make year-on-year inflation figures difficult/impossible to interpret.
    Ditto – year-on-year demand.

  • david thorpe 21st Oct '10 - 10:46pm

    @ Matt

    The bank of england have mentioned buying the debt back from bondholders. This woukld reduce the amount of the debt and increase the confidenc of the markets, this will cause sterling to strenghten making imports cheaper abd thus inflation on the supply side reduces.
    @ anthony
    I suppose to the extent that it was in the manifesto it was official policy

  • It doesn't add up... 21st Oct '10 - 11:25pm

    QE is simply not financing government spending through borrowing or taxation, but through printing money. It is quite wrong to view QE as buying gilts from the market: what happens is that via a series of transactions new gilts are swapped for existing ones so that there is no increase in the stock of gilts held in the market, and the Treasury is given printed money to spend instead of borrowed money. Given there is a £200bn backlog of unfinanced spending (the Asset Purchase Facility’s stock of gilts) the credibility of adding further to this is minimal: it suggests that the government is intending disguised default on its obligations – the threat already applies to the equivalent of 20% of gilts in issue that now total £1 trillion. Unwinding QE would mean trying to borrow twice over, or dramatic increases in taxation or cuts in spending to create a net PSDR. In practice, increased money supply influences price inflation over a distributed lag that is a couple of years wide. We won’t have the complete effects of the big QE of 2009 until next year at least. Consumption taxes such as VAT and taxes on business activity such as the bank levy and green taxes will all add to inflationary pressures as businesses pass them on to customers. Adding more fuel to the fire with a further round of QE will severely impact living standards, because it won’t be matched by increased incomes after tax and benefits for most people, since QE makes no difference at all to government spending – only to how it is (or isn’t) financed.

    It is worth noting that since the Coalition came to power overseas investors have been major buyers of gilts, accounting for over £30bn in Q2 alone, funding 75% of borrowing. Instead of taking large sums out of the economy, not indulging in QE has been bringing large sums into it. When QE was announced, overseas investors became sellers of gilts (and probably of other UK assets). More QE would almost certainly send the tide of foreign investment money into reverse again, probably accompanied by further capital flight from UK domestic investors – adding to pressure on the pound, and leading to further devaluation caused inflation.

    I agree with David Thorpe that the BoE should really concentrate on delivering its inflation target, and not attempting to debase the currency while pretending not to do so. The risks with QE include that we move closer to the edge of a real crisis, with a need for Black Wednesday style interest rates that would severely damage the economy. It’s much better to keep those foreign funds flowing in for now – at least they aren’t being used to add to the stock of mortgages, as they were over 2000-2008.

  • Ok, I was being a little harsh. But only a little – QE doesn’t not reduce the supply of bonds, it does not lead to a strengthening currency, it is not supply side deflationary.

  • david thorpe 22nd Oct '10 - 11:37am

    Your right Matt, it certainly doesnt lead to a streghteing currency, the opposite is the case, which causes inflation.
    The government cuts n the CSR lead to a strebn#gntening currency, as was seen on the day the cuts were announced.

  • david thorpe 22nd Oct '10 - 12:12pm

    so to then have quantat#titive easing and weakne the currency agin would be counter productive and the cuts woud be in vain

  • david thorpe 22nd Oct '10 - 12:14pm

    @ It doesnt add up

    Yes borrowing birngs money in when its from overseas investors, but it also takes money out when the repaymnets have to be made, and even before that it takes money out as the overseas investors sell the debt on, weakeniong the currency.
    Also Im not sure that overseas investors are the biggest investors. I know pension funds are the second biggest holders of the debt

  • It doesn't add up... 22nd Oct '10 - 3:36pm

    You can check the figures at the DMO site: overseas holdings of gilts increased by £30,870m in Q2 2010 (latest data) compared with £41,691m of net issuance – 74%. When overseas investors buy gilts, they have to buy sterling first. When they sell them, they have to sell them back to UK holders to become net sellers of sterling (otherwise they are selling to another foreign buyer, who has to buy sterling to match the sterling the seller gets when he sells). Of course, they will receive interest while they hold the gilts, but at present yields that is not a big giveaway. If they hold a typical gilt until redemption then that means they won’t be repaid for 14 years on average – we’re not like the Greeks who have to roll over debt every two years. Overseas holdings account for 29.9% of the total as at end Q2 (nearly £275bn).

  • It doesn't add up... 22nd Oct '10 - 3:49pm

    Perhaps I should point out that over 2000-2008 the “customer funding gap” – the difference between domestic deposits and domestic loans – increased from zero to £750bn. Essentially it funded the entire increase in the stock of outstanding mortgages, which now stands at £1,240bn – and all of it was various forms of overseas financing, ranging from short term deposit accounts (£300bn!!) through sales of mortgage backed securities. When Lehman (a major conduit of funds to the UK mortgage market) went bankrupt there was a large substitution of foreign borrowing by emergency BoE funds. The funds were repatriated, leading to the very sharp fall in sterling. Banks have to re-finance some £800bn of BoE and other commercial funding over 2010-2012 (nearly two thirds of our mortgages!). I think we need all the foreign funding we can attract.

  • david thorpe 26th Oct '10 - 9:23pm

    my view that the economy is in danger of ioverheating was further boosted by todays growth figures indictang that growth, in common with infalation is above forecasts

  • david thorpe 27th Oct '10 - 11:23pm

    @ steven W
    very well sid.

    and todays times fornt page article highlights agin what Ive been saying

  • david thorpe 10th Nov '10 - 2:23pm

    todaysd inflation figrues and bamnk of england comments back up what ive said on this blog and elsewhere

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