Quantitative easing: the sobering reality that faces the UK.
Unfortunately, QE is the only policy available at present. Without it, in the worst case scenario, we could enter a liquidity crisis.
As commentators line up one by one to condemn the latest wave of quantitative easing (QE), it is worth taking a step back and considering why exactly we’re embarking on a second wave of QE, and what the implications of doing nothing really are.
The £75 billion of extra “quantitative easing” announced by the Bank of England (BoE) will go towards the purchase of government debt. Indeed, £198 billion of the £199 billion spent already has been spent purchasing government bonds to keep yields (the percentage paid in interest) low.
The reality is this: without quantitative easing to buy government bonds, the UK government would pay more to borrow. And that’s the optimistic scenario. In the worst case, it actually struggles to borrow and it becomes embroiled in a liquidity crisis.
The BoE has been forced (let’s be clear- this is an extraordinary measure) to absorb an incredibly large amount of the UK government’s deficit- currently close to 20 percent.
Now, let’s cast an eye across to Europe at governments with similar financing requirements. Spain actually has a smaller government deficit than the UK, yet its government’s yields have touched five percent. It is estimated that QE has reduced yields in the UK by around 1.25 percentage points. That presents a saving to the taxpayer in the long run, and contributes to managing our debt.
The difference in the European states is that the European Central Bank has not intervened with a similar attempt at monetary easing. Inflation is comparatively lower at three percent, but there are few who are prepared to say this policy has been a resounding success.
Bond yields of governments with large financing requirements have soared. Why? Part of the explanation lies in that financial institutions are being required to re-build their capital-loan book ratios. It is clear that governments cannot insulate them from another crisis via bailouts, and so it is imperative that banks protect themselves from this risk by reducing the assets they hold, and increasing the amount of cash they hold in reserve.
Adding to the woes, we have the fact that banks have seen the value of the sovereign bonds (particularly the bonds in Greece, Italy, Spain, and Ireland) and mortgage backed securities they hold called into question as an asset class.
This is part of the reason why we still have a financial crisis engulfing banks. The assets they previously ranked as some of the most valuable and dependable on their balance sheets -- and thus most able to exchange in return for cash in the event of a crisis -- are now proving difficult to exchange for cash.
What’s more, the market is becoming increasingly swamped with a growing pool of government debt. Financial institutions would struggle to rise to this demand even during the best of times. The fact that they are actually looking to increase their holdings of cash, rather than assets, makes this even more difficult.
Yes, quantitative easing has induced a small, albeit manageable, amount of inflation. But had it not been induced, it is possible that the UK could be facing problems financing its debt at manageable rates.
As the fear over the size over debts gains ever more prominence, it is likely investors would begin to examine the UK and ask: is the UK truly immune from default? For a nation with the largest deficit in the G20, it is likely that many investors would begin to panic if yields crept anywhere near the five percent mark, which would cause additional stress on the UK taxpayers’ ability to repay.
The problem is further compounded by just how hard it is becoming to reduce the deficit within the planned timetable.
In the medium to long term, the reduction of debt levels is crucial. It is, however, extremely risky to consolidate the debt quicker than the present sensible pace. To move quicker would allow very little time for the economy to “adjust” to the shortfalls in overall spending, and would risk heightened social unrest. Both are strong deterrents to investment, which requires both certainty and stability.
In the short term though, it is indeed imperative that the debt is managed to the largest extent possible.
The interest payments on debt already stand at over £2,000 per head, per annum to service. The impact of growing yields on the vast quantity of new bonds would amplify this, and leave investors asking whether the UK tax payer would be capable of servicing its government's borrowing requirements.
Moreover, if the government does not act to reduce its deficit, then that is precisely when we would be begin to see inflation amplified even further.
A further benefit of acting to hold down yields is that investing, rather than holding on to the growing mass of government bonds, is encouraged. In particular, it helps support property and share prices. This, in turn, assists in supporting consumer confidence.
Had asset prices been allowed to go in to free fall, this would have had a disastrous effect for those with savings. Yes, the inflationary effects and low yields of government bonds are not ideal for pension funds. But plummeting share prices and property values -- the backbone of most peoples’ retirement provisions -- would be even more disastrous.
As BoE Governor Mervyn King has already stated, it is not in the interest of pensioners for the economy to falter back into recession.
Still, there are those who suggest that QE is single handedly responsible for the devaluation of sterling. This is a dubious assertion. It has undoubtedly been a contributing factor, but it is not the sole reason for investors’ reduced appetite to hold the pound.
Far more important in understanding why a currency becomes devalued is to view currency as you would any other commodity which is regulated by principles of supply and demand and ask: why would you increase or decrease your demand for sterling?
To answer this question, it helps to revisit the case of the dollar, which went through one of the largest pre-crisis devaluations. Between the years 2000-2008, the US dollar fell by 37 percent against the Euro, and 17 percent against Sterling. This was without any quantitative easing.
In the case of the US over that period the current account deficit mushroomed. The public debt soared to levels usually unimaginable in peace time. All of these made dollar holdings less attractive, and the US demand for foreign currency increased. This resulted in a large scale devaluation of the dollar. A similar event happened with Sterling post 2008, as our deficit soared and our economic health deteriorated.
In light of this, it is clear that our policymakers at the BoE face an unenviable task.
Every meeting is scrutinized, and investors are ever looking to the central banks to be reassured that expansionary monetary policy will support the economy during fiscal consolidation. They walk the tightrope of trade-offs between support for the wider economy and inflation, knowing that the wrong decision will see the economy topple without a net to catch it.
Unfortunately, quantitative easing is the only policy available to policy makers at present. Sadly, it can’t even be described as optional.
Like antibiotics, it might not taste nice to some. Likewise, it is possible that an “immunity” to it may develop further down the line if the financial crisis becomes a currency crisis.
Like it or not though, this is the only medicine available to keep the current disease under control and to give the patient a fighting chance of a healthy recovery.
Luke Springthorpe is a member of the Conservative Party and works for Charles Stanley Wealth Management. He writes in a personal capacity.
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