More economic woes: are we drinking at the last chance saloon?

So the drunk has been given the shot of whisky to get himself to the next pub, is he about to enter the last-chance saloon?

Another shot for our drunk economic system?
Simon Miller
On 7 October 2011 15:55

On Thursday, the Bank of England (BoE) decided that it would launch another round of quantitative easing (QE) increasing the amount by £75bn - £25bn more than expected. As a result the pound fell sharply.

Eventually, the Bank will end up with nearly a third (32%) of government debt. In essence the government is printing money to buy its own debt, monetising that debt; a dangerous and desperate strategy. 

I have a major problem with QE; I don't think it works.

The effects appear to be minimal and the resultant inflationary risks grow ever larger. The cash that is meant to flow into the system does not seem to appear as banks shore up their own positions and not those of business and the rest of the private sector. 

And why should they? Banks are stuck between a rock and a hard place.

On the one hand they have the government, businesses and potential homeowners desperate for them to loan money but at the same time, that same government has not only adopted the inherently sensible proposal of an 8 percent capital ratio but is looking to gold plate this by an extra 2 percent through the recommendations of the Independent Commission on Banking. 

You cannot demand money be kept while demanding loans in a risky economic climate; they do not balance out. 

What we have here is a liquidity issue where money is not available. And QE2 is unlikely to push liquidity through. 

In addition, BoE officials admit in their own studies that QE increases inflation by around 1.5% against a 2% gain on GDP. Is that gain good enough when inflation is already running at over 5%?

Inflation hits prices, pensions and savings. Yes inflation can signal growth but inflation through printing money - which in turn conveniently drives down government debt - hurts people and is unlikely to get the consumer moving as the BoE hopes. 

It is entirely possible that the recent commodity spikes that have contributed to higher inflation have eased off, and could ease off enough to offset inflationary pressure from QE2, but that is due to a downturn in demand as global growth tails off.

Less demand leads to further recessionary pressures which will again hit the UK as a major global trading country.

Indeed, that slowdown makes the further fall in sterling a mite pointless. Exporters might always appreciate a weaker pound but if demand isn't there then the competitive advantage disappears. In fact as a major importer, costs in energy, goods and produce go up, once again adding to inflationary pressures.

I feel a good degree of sympathy for the Bank.

With their colleagues in the European Central Bank displaying the economic policy of the madhouse by once again refusing to lower interest rates, and the Fed having to contend with the slow grind of US politicking that occurs near election year, the BoE obviously thought that something had to be done to prevent a vicious downturn over here.

With rates at the lowest they can basically go and a huge liquidity issue in financing, the BoE was limited in what it could do.

However, the questions that have to be asked are whether a) this was too soon and shows a degree of panic? And b) is the blatant abandonment of price stability in the hope that events will offset the inflationary pressures involved in QE2 a sensible policy to follow when we know global economics has yet to fully play out this current game?

You see the Bank is in a vicious circle. The very offsets could become the very causes of high inflation which could lead to the rise in interest rates that could place the UK in an even more dangerous situation.

The drunk has swigged his whisky in the form of QE and is staggering to the next pub in the hope of a better atmosphere - but there is a risk that the next pub will be even worse.

And if that next venue is bad, there is no guarantee there will be any more whisky. If that happens, how will we get to another place? Indeed, would we actually want another shot?

Or maybe the only choice will be to sit down in the road and hope sobriety comes along before we get run over.

Simon Miller is the Editor of Financial Risks Today. He tweets at @simontm71

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