In the “yah boo” of British politics, this is embarrassing for the
Government. Plans for the Prime Minister to proclaim proudly that he had led
the country out of recession had to be quietly shelved. But in the broad
scheme of things, it matters little, particularly since it may well turn out
that our economy has indeed pulled out of recession and the figures are
wrong. What really matters is the sustainability of the upturn both here and
As you can see from Graph 1, some sort of turning point has been reached. The
similarities between the main developed economies are more notable than the
differences. Anyway, the past is past. While there are a host of reasons to
be critical of the Government’s policies, what matters is how, given the
difficult position we are starting from, we manage the recovery.
That issue comes up this week, for the Bank of England has to decide what to
do about “quantitative easing” (QE). Most of the agreed £175bn has
been used up, so does it pump in more? And, if so, how much?
The monthly meeting of the Bank’s monetary committee is on 5 November, giving
rise to standard jokes about gunpowder, treason and plot. There are people
who believe having the Bank buy government debt on the scale it has is akin
to treason, in that it is complicit with the Government in a plot to conceal
the scale of the fiscal catastrophe that the latter has wrought. If, the
argument goes, the Government had to sell its debt to genuine savers instead
of have the Bank in effect print the money to do so, it would not be able to
run what looks like being the largest deficit in the world relative to GDP.
Our children and children’s children would not have to pay the price for
Gordon Brown’s folly.
The alternative argument is that QE is a classic, if exceptional, response to
an exceptional situation. The authorities need to expand the money supply to
ensure the near-paralysis of financial markets did not turn recession into
depression by making it impossible for normal economic activity to recover.
It, and other central banks, had cut the cost of money, but that was not
enough and rates could not be cut further. So, in addition, the central
banks had to increase the money supply and the textbook way of so doing is
to buy government debt.
This is not, to be clear, a purely British issue. Both the Federal Reserve and
the European Central Bank have schemes designed to have the same effect,
though for various reasons they are technically different and on a somewhat
If there is controversy about the theoretical underpinnings of the scheme,
there is also a wide divergence of views about its effectiveness. Critics
argue that the prime aim of the policy (to boost money supply) has not been
successful, for money, broadly measured, is only up 2 per cent year on year,
and bank lending is actually down. Some of those critics, such as Capital
Economics, then argue that you should do more of it.
Supporters of the Bank counter this in two ways. One is to say that things
would have been even worse had there not been QE. That seems fair enough.
The other is to point to a series of things that have happened that suggest
it has had some significant impact. These include the fall in gilt yields,
which has helped revive the corporate bond market, and the turnabout in
share prices since spring. The argument here is that maybe companies are not
getting more money from the banks, but if they get it instead from the
capital markets, that is fine. It may even be that the revival in the
housing market has been a function of the policy, and that in turn should
support a rise in consumer demand and hence real output.
What happens next? The financial markets expect some further expansion of the
scheme will be announced this week, and given that the recovery, if it
exists, is fragile, common sense would say that this does not seem the time
to pull the plug. But looking ahead, this cannot go on for ever. You cannot
just go on printing money without a catastrophic loss of confidence in the
currency. It is arrogant for any central bank or government to assume it
will be trusted whatever it does. Already sterling is wobbly. So there has
to be some kind of exit strategy, and at some stage that has to be spelt
I think we are getting near to that point. A lot of people who would give
general support to the Bank’s carrying on the policy a little further worry
about how it will extract itself from this mess. The financial markets are
starting to think about the timing, not just of the ending of QE, but of the
first rise in interest rates. The trend has already begun, with Australia
and Norway moving upwards. India is expected to increase rates soon. Over
the next couple of years, Europe and America will increase rates and, of
course, we will too. The financial markets are already pricing in a rise in
sterling rates, and you can see the implicit profile of the rise next year
in the smaller graph.
Capital Economics, which produced the graph, believes however that there will
be no rise in 2010. We will see. The Bank acknowledges that eventually the
QE policy will result in inflation. When that starts to become evident,
rates will have to go up. My guess is that the first rise in rates will come
before the end of next year, but it is hard to see the timing.
What is clear is that QE has to end soon. Once growth is re-established, there
can be no justification for continuing it. We also need to know how
government stock held by the Bank will be sold to proper investors. In other
words, it is not just a question of when to stop the policy; it is also how
to unwind it.
Behind all this is a bigger question. It is to what extent is the present
recovery ? first, in financial markets and, now, in the real economy ? an
artificial creation of exceptional policies? It is a fiscal issue ? how far,
for example, was the American growth the result of the US government’s
boost? And it is a monetary issue ? how far have house prices here recovered
merely on the back of QE?
So when these policies are withdrawn, and I have seen no suggestions they can
continue beyond 2010, will there be self-sustaining growth? The history of
economic recoveries tells us that they are usually bumpy. The history of
recovering from major policy errors tells us that it will take at least the
full economic cycle to correct the errors of the past one. But, more
encouragingly, the history of such cycles also tells us that growth does
re-establish itself. So maybe the common-sense response is to expect a
disappointing couple of years but not utterly depressing ones.
It’s better to buy a house to let than have cash languish in the bank
If quantitative easing has indeed turned-round the housing market, as
suggested above, that would be an achievement indeed. So at last, according
to Nationwide, house prices are up year-on-year instead of down ? but this
was news greeted with a fair degree of caution by most economic
A typical response was one from Global Insight, which predicts at least a 5
per cent decline by the end of 2010. Unsurprisingly, estate agents were
rather more upbeat.
So what can be said? First, if this is the bottom of the market, it will mean
it has fallen on average by a little less than 20 per cent from the peak ? a
huge fall, but well within the margins of the early 1990s.
Second, it is worth pointing out that during the 1990s there were three to
four years after the market bottomed before prices really began to take off
again. During this time prices held more or less steady in nominal terms but
were still falling in real terms, as other prices inflated.
Third, we still have some way to go before prices get back to below four-times
average earnings, which many see as a long-term sustainable level. So you
could argue that prices are still about 20 per cent too high, and assuming
flat prices and three years of nominal wage growth of, say, 3 per cent, we
could still have a very fully valued housing market in three years’ time.
That would not be the basis for another bull market in houses.
But, fourth, I have a feeling that given the wild gyrations of other asset
prices over the past 18 months, the idea of a house as a store of value will
persist. Better to buy a property and rent it out than have the money on
deposit earning half nothing. It is going to be hard to raise money for
buy-to-let projects so anyone who has cash and wants to get into that market
will have an opportunity that less secure investors don’t. The
store-of-value argument should put some sort of floor under prices.
Put all this together and it seems to me that the 1990s are not a bad template
for what might happen next: sideways for three or four years, then a gradual
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