George Kerevan: Sir Mervyn has a bad case of ‘chasing the instruments’

Published on Friday 7 October 2011 00:57

Governor of the Bank of England’s decision to pump £75bn of invented money into the economy is too little, too late

AS A rule, I am not a fan of Sir Mervyn King, Governor of the Bank of England since 2003 and patron of Worcestershire County Cricket Club. An academic economist rather than a banker, Mervyn allowed himself to be browbeaten by Gordon Brown into ignoring the credit and housing boom till it went spectacularly bust in 2007.

Peeved and embarrassed, King got his own back during the 2010 general election, by publicly chastising Brown for his profligate public borrowing and spending. The Tories were delighted. In this year’s Birthday honours, King was appointed a Knight of the Grand Cross of the British Empire, with his banner displayed in St Paul’s Cathederal.

What is King’s professional weakness? It is a vice explained to all novice pilots. It is called “chasing the instruments”. I’ve done it myself at 5,000ft over Edinburgh. You strain your eyes to look at the instrument panel to tell you what speed you are going and whether you are upside down. Then you look up and move the controls. Unfortunately, you are too late. The wind, air pockets and clouds have all changed while you were digesting the information on the dials.

As in flying, so it is in running Britain’s monetary policy. Yesterday, Sir Mervyn and his Bank of England monetary committee pushed on the throttle to gain economic speed.

The Bank is to pump an extra £75 billion of invented money into the economy in order to swell liquidity and (hopefully) increase demand somewhere down the line. So-called quantitative easing (QE) is designed to offset the slowing of the UK economy over the summer and to fend off the gathering fiscal storm in euroland. Doubtless, there is a “thank you” note to Mervyn on its way to Threadneedle Street from Nos 10 and 11 Downing Street.

Alas, as happens when you chase your statistical instruments, this new round of QE is too little, too late.

Admittedly, two-thirds of City analysts thought that Mervyn would leave the announcement of the new monetary injection till November. But then they normally expect him to leave matters as long as possible while he consults his charts.

However, Chancellor Osborne gave the game away in his Tory conference speech on Monday when he said: “David Cameron and I have always said we would be fiscal conservatives and monetary activists … So as part of my determination to get the economy moving, I have set the Treasury to work on ways to inject money directly into parts of the economy that need it, such as small businesses … It’s another form of monetary activism.”

To be fair, more QE is a good idea. It involves the Bank of England using electronic cash to buy second-hand financial assets, eg government or company bonds. This pushes up the price of these assets because the Bank pays over the odds.

But it also lowers the yield on these assets because they pay a fixed-interest return relative to the higher market value. Thus long-term interest rates are lowered all round, which hopefully boosts private investment in the economy.

QE also gives financial institutions more cash than they need, so the theory is they will return this to the economy by lending and spending. The only downside is if the extra money created by QE creates inflation. But that can happen only if consumer demand outstrips supply – something that’s not likely to happen this side of Scotland winning the Rugby World Cup.

My beef is that QE wasn’t started sooner. The money supply in the UK economy – analogous to the lubricating oil that makes a machine operate properly – actually fell by 0.6 per cent over the past year, suggesting we are tiptoeing towards deflation and falling prices. Hence the desperate need for a Plan B.

(For anoraks, I know the Bank of England’s favoured M4ex measure shows money supply rose modestly in the year till August, but I have my doubts about the correctness of using this index as it deliberately excludes interbank lending – the weak spot in the financial system. Besides, M4ex is growing at far less than inflation, which still represents a squeeze.)

I am also unmoved by the scale of the monetary injection. The £75bn represents less than 5 per cent of current UK money supply. Assuming some gets lost in institutional accounts, it is not enough to turn the economy around. At best, it may stave off outright deflation, but give us ten years of stagnation, Japan-style.

In fact, I think that is Mervyn King’s preferred strategy. He sees QE not as a tool of expansion, but strictly as a way of avoiding undershooting his target of 2 per cent annual inflation.

At a recent press conference, King was asked what the Bank would do to help provide credit to small firms. He replied: “I think this is a problem of the structure of the banking system, and questions about the allocation of credit. And those are fiscal actions and they’re for government, not for a central bank.”

At the same press conference, King also admitted a major error. He reversed the Bank’s standard view that the recession had done little damage to Britain’s underlying productive capacity. Spare capacity means the economy can return to growth quickly when demand improves. But now King admits, having finally looked outside the cockpit, that factories and offices have shut capacity permanently, especially in England. Which explains why recovery could take a very long time.

My alternative is to use the £75bn to capitalise new regional investment banks, by buying their bonds. These banks would invest in infrastructure projects and lend to local companies, thereby restoring capacity and boosting productivity. They need not compete directly with existing high street banks. Instead, they could encourage private lending by underwriting syndicated bank loans for infrastructure projects, or by covering the tail risk in providing credit to SMEs.

But that would require flying the economic aeroplane with the panache of Biggles. Sadly, Mervyn King is no Biggles.

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