“This is the most serious financial crisis we've seen at least since the 1930s, if not ever," said Sir Mervyn King, on the day that the Bank of England decided to increase QE by £75 billion.
For those of us who had been at the Conservative Party Conference, this apocalyptic conclusion about the state of world finance would come as a bit of a shock. Both George Osborne and David Cameron’s speeches were relatively ‘blue-sky’ and there were a very limited number of fringe events that focused on the economic challenges gripping us. In fact, most were about ‘rebalancing the economy’ or ‘getting our economy going again.’ The tagline of the whole event - ‘Leadership for a better future,’ now looks increasingly detached from the stark nature of reality.
Whether there is genuine belief that these challenges are being dealt with, or else an unwillingness to spell out the gravity of events, there seems to be a dearth of original thinking in addressing these forces. Those who follow the BBC’s Paul Mason on Twitter will know what I am talking about. He forever laments the vacuum of political and economic leadership on display – longing for the great thinkers of the past to attempt to make sense of the unique characteristics that have characterised this recession. Without them it seems that policy makers are still working under the assumption that the policy aims of the past are desirable: house prices should continue to increase, employment is always good and small businesses would be investing were it not for an inability to access credit.
And so to the two big developments this week. First, in George Osborne’s speech we had the announcement that the Treasury is working towards developing a policy of ‘credit easing.’ This would see the Government directly buying corporate bonds to circumvent the banking sector, or else buying securitised small and medium sized enterprise loan packages. The rationale for this is clearly that small businesses are finding it difficult to access finance and so Government guarantees would lead to lenders being more liberal in the distribution of growth-inducing finance.
But the simplicity of this solution should in itself trigger deep questions. We must first ask why the banks are unwilling to lend to these small businesses in the first place. Is it really that credit is simply too tight, or are businesses making the rational decision not to borrow because of the uncertainties facing them? If the latter, then the policy is unlikely to be successful.
But a deeper concern, as brilliantly highlighted by Allister Heath in his City AM column, is the risk that Governmental guarantees would generate a market in sub-prime small business debt. With a UK government buying bonds of smaller companies, and actively encouraging them, the private sector ‘would have little incentive to check their quality’ and we’d be entering a repeat of the dodgy mortgage lending which triggered the whole crisis in the first place.
And we haven’t even mentioned the potential damaging effects to economic efficiency of the state picking businesses or sectors to support.
Despite all that, you can see why the Government is keen. With fiscal policy rightly constrained, they are facing increasing calls from all angles to ‘boost the economy,’ and with little apparent appetite thus far for wide-ranging supply-side reforms, expansionary monetary policy is the only weapon in the cupboard. It’s in this context that the Monetary Policy Committee decided to increase the level of Quantitative Easing by £75 billion following its monthly meeting yesterday.
The MPC is convinced that there is enough spare capacity in the economy so that the increase in the supply of money will not have significant inflationary effects. In fact, they are still warning that a bigger medium-term problem will be deflationary pressures. But over the past two years they have consistently underestimated inflation, harming not just savers but eating into real incomes – reducing demand in the process. With inflation already creeping towards 5 per cent, the downward pressure on the pound resulting from a further increase in the money supply will exacerbate the problem. In fact, even under the Bank of England's analysis of the effect of QE, they say it has added 0.75 to 1.5 percentage points to CPI inflation for a maximum gain in real GDP of 2pc.
The fact that the MPC has taken the decision now, despite inflation being so far above target, suggests that they are expecting some sort of further crisis or the likelihood of sovereign defaults in the Eurozone, which could be expected to sharply decrease the money supply. In this instance further QE may well be desirable. If so, this is a particularly worrying development. But the consequences of such action must be fully explained.
It’s a difficult scenario. Conservatives out there are united on the fiscal response, but divided on the appropriateness of monetary policy. Policy makers are walking a very thin tightrope – attempting to re-stimulate economic activity whilst avoiding the damaging consequences of spiralling inflation. They want to support business borrowing to create jobs but must be wary of the potentially damaging incentives that this will create. And they want to improve the tax and regulatory incentives for businesses without taking tough decisions to row back regulations which will make employment more flexible.
What’s the bigger risk – inflation or a deep recession? This is the judgement call the MPC is trying to make. Only time will tell if they are choosing the right path. But we must heed the lesson of good policy that we have acquired over many years - state directing of the economy creates distortions and adverse incentives which can have extremely damaging consequences.