Thursday 10 May 2012

Buying gilts is not the same thing as stimulating the economy


It is a welcome relief that the Bank of England has ignored calls for a further round of QE gilt-buying.  Indeed, it is important for the Bank to reconsider its academic assumptions that pushing down long-term interest rates is an expansionary policy.  Especially once rates have reached such low levels, any benefits of forcing them down further are bound to be diluted.  And the damage done to pension funds and annuity rates must not be ignored.  So far, the Bank has also consistently ignored inflation overshooting and insisted the evidence suggests QE has ‘worked’.  This blind faith in a massive monetary experiment is dangerous.

Where is the evidence that low gilt yields has provided economic stimulus?  The economic reality is that UK is suffering from a double dip recession, weak bank lending, falling consumer confidence, credit card and overdraft interest rates at or above pre-crisis levels, rising mortgage rates and small companies unable to access credit on reasonable terms – or at all.  Large corporates have plenty of cash, having raised money in the bond markets at great rates in recent times, but they are not spending it due to lack of confidence.  Where is the stimulus from low gilt yields then?

QE has actually damaged many areas of the economy.  Conversely, QE has created inflation (well above the Bank's target) which has damaged consumer confidence and reduced real incomes.  It has also has decimated corporate pension funds, forcing some firms into bankruptcy while others have had to divert resources into supporting their pension schemes rather than business expansion. On top of this, QE has reduced over a million pensioners' incomes via annuity and drawdown income falls.  These effects destroy jobs or growth.

QE benefits the banks, but this does not boost the economy.  The big beneficiaries of QE are, of course, the banks (– and those borrowers on tracker mortgages).  QE has certainly shored up bank balance sheets, but this does not help the economy when banks are failing to lend on reasonable terms and there are no realistic alternative sources of finance for job-creation in the SME sector. 

The longer the wrong medicine is applied, the worse the damaging side-effects of QE become.  It is time to revisit the rationale for QE and find better ways to operate monetary policy than relying on a transmission mechanism that is so clearly failing.  It is important to quantify the damage to savers, pensioners and pension funds and how these negative effects on growth may be outweighing any positive effects of helping the banks.

Buying gilts is not the same as stimulating the economy. Particularly given the UK’s demographics, QE could well damage growth and employment, rather than boosting it in an ageing population.  Worsening income prospects and high inflation for older generations have caused them to retrench. QE has not even ensured rising bank lending as banks prioritise margins over lending. 

Better ways to stimulate jobs and growth.  It may well be that we need a new policy tool that can help boost the economy.  Monetary policy – via both short and long-term interest rate changes – has run out of firepower. Fiscal policy is constrained by past deficits leaving additional public spending less of an option.  But there is a mechanism for creating jobs and growth that could use the billions of pounds that is currently in UK pension funds to finance infrastructure spending and to underwrite small company lending.  A far better use for newly created money would be to create a fund to help guarantee returns to pension investors, that would allow them to move away from their reliance on gilts, while also directly creating jobs. 

QE could be aggravating a dangerous financial bubble in the gilt market.  In reality, more QE might merely compound an unsustainable financial bubble in the supposedly 'risk-free' asset, with catastrophic consequences when the bubble bursts.  At a time when gilts are already in desperately short supply as foreign investors are fleeing to gilts due to Eurozone fears, and pension funds and insurance companies are forced to hold gilts by regulatory constraints, further official buying should be avoided in the interests of financial stability. It is clear that gilt yields do not reflect the UK’s economic fundamentals and all financial bubbles burst sooner or later.

Someone should be shouting from the rooftops about the dangers of all this, before further damage is done.


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