Peter Jones: Charting the way forward is a mission impossible

Published on Thursday 5 March 2009 20:47

ANYONE who pretends to know precisely how the Bank of England's latest little trick for re-starting the economy – quantitative easing – is going to work is doing exactly that: pretending. The horrid truth is that nobody knows how, or indeed whether, it will work.

The outcome that the government hopes for is that the quantity of money that the banks are able to lend will increase, and the cost of borrowing, particularly to businesses, will decrease. But nobody can guarantee that this will actually be the result. It has become a clich, but it is nonetheless true: these are uncharted waters. No-one sailing on the leaky old SS British Economy knows whether calm seas and safe havens or nasty storms and jaggy rocks lie ahead.

As most readers will know by now, the Bank has cut interest rates almost as low as they can go. This is not having the desired effect of stimulating the economy, mainly because world demand is at low ebb. And until interest rate cuts and other measures in the rest of the world re-start other countries' economies, demand is going to stay flat.

But meantime the root cause of this recession – the financial crisis – is still with us. Banks are stuck with huge piles of bad debts, a problem which has only been partly alleviated by the insurance scheme recently announced by the government.

This means they have little money to lend precisely at the moment when, because of the recession, companies need lots of lending. So expanding the money supply by buying some of the banks' stocks of government gilts (in effect, exchanging illiquid assets for liquid cash) or even buying corporate bonds directly, is the next weapon to be deployed.

So the theory is that this increases the lending capacity in the economy and should enable more companies to survive their way through the recession. The practice, however, is fiendishly complex.

Some outcomes can be discounted. Expanding the money supply when the economy is contracting should normally produce inflation. Some fear that even hyperinflation, of the kind that is destroying Zimbabwe, might appear. It won't, because the current risk is of deflation, which would wreck the economy. And although some inflation may be a consequence of quantitative easing, the Bank, if it is alert enough, should be able to choke it off before it rises to damaging levels.

Experience in Japan between 2001 and 2006 when the Bank of Japan expanded the domestic money supply quite dramatically to counter a deflationary recession caused by the bursting of a property price bubble and a downturn in the electronics industry provides only a very sketchy chart of what might happen in Britain.

Having reduced interest rates to zero, the Bank of Japan pumped trillions of yen into the economy, buying both government and corporate bonds. But it took at least five years for this flood of liquidity to work, mainly because Japan's commercial banks also had trillions worth of worthless debt on their books. So they used the central bank liquidity to repair their own balance sheets rather than to boost their lending.

Political influence also interfered with the operation of the policy. In Japan, politicians are intimately involved with both the financial and industrial world in ways which are hard for foreigners to either discern or understand.

The important point is that banks were acutely aware that calling in loans to what were, in effect, bankrupt enterprises would incur severe political displeasure. So, while some companies, particularly in construction, went bust, a lot of dud businesses and all their duff loans were kept alive artificially.

Meanwhile the yen, having initially fallen in value, rose in 2002, partly because the dollar fell out of favour with international investors and partly because people bought lots of zero-interest yen and invested the money in interest-earning currencies. That was a major handicap for big exporters such as Sony, further delaying recovery.

The lesson from this is that the linkages between the money supply, the domestic economy and the exchange rate are extremely complex. The effects of quantitative easing will depend, for example, not just on whether international investors think that the British economy is headed towards recovery, but on their comparative views of the British economy versus the eurozone, or the dollar, or the yen.

It is possible to imagine that the additional liquidity does work in the way the government hopes, that manufacturers get the loans they need, but recovery is then choked off by a rising pound because investors have decided they don't like prospects in the eurozone.

But before we get there, you have to ask why our banks, saddled with bad debt, should expand lending to our companies when the recession may be blowing these firms on to the rocks already. Anyone who can chart the way ahead in these circumstances ought to qualify for a dozen economics Nobel prizes.

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