Policymakers traditionally stimulate a flagging economy by cutting interest rates. Those rate cuts affect the economy in many ways but in particular they encourage more borrowing (and less saving) and therefore more spending. While rates were high, that proved to be a successful way of managing the UK economy – and others. UK rates, however, are now at 2 per cent, having been cut rapidly from 5 per cent in September.
A sharp UK and global economic recession suggests that more rate cuts are likely – we expect rates to go below 1 per cent early next year. Once rates reach zero that approach to stimulating the economy is clearly exhausted. The question then becomes – what next?
At that stage central banks start to employ quantitative easing (QE). QE is a natural extension of monetary policy once interest rates reach zero. Rather than influencing borrowing levels by changing the price of credit, the central bank attempts to influence borrowing levels by increasing the commercial banks' reserves (on which the total economy-wide level of credit is primarily based) – hence the name "quantitative easing".
The central bank does this by increasing the size of both sides of its balance sheet – in particular by creating money. That money is used to increase the level of excess reserves held by the commercial banks at the central bank. Commercial banks can then draw upon those reserves and lend them on to the private sector, so increasing borrowing levels. Technically the central bank buys assets (typically government debt) from the commercial banks (or other agents) and credits the commercial banks' reserves at the central bank. This results in an increase in the monetary base (currency in circulation plus reserves at the central bank) which may lead to a rise in inflationary pressures.
QE isn't new. Some academics cite its use as one key reason why the US emerged from its Great Depression in the 1930s. More recently, Japan employed QE from 2001 through to 2006, expanding its central banks' balance sheet dramatically once interest rates had reached 0.25 per cent. Severe deflation was avoided and interest rates across the yield curve have been low ever since. But debt levels continued to contract and the economy has remained vulnerable to shocks.
So is it a good policy for the UK to pursue?
In many ways it's simply an extension of the current policy choice of UK policymakers. To date, that has been to throw everything at the current crisis. Rate cuts, fiscal stimulus, recapitalisation of the banking system, an attempt by the Government to maintain lending at 2007 levels, and measures aimed at stemming house price weakness have all been brought to bear.
But this crisis is different from all others in recent British history. It has come about because Britain, in aggregate, has borrowed too much. Debt per household under Labour has doubled. The Government has been running a budget deficit (borrowing to spend) since fiscal year 2002/03. That is set to worsen as the budget deficit rises to 8 per cent of GDP next fiscal year.
At the same time, one of the key drivers of economic growth has been the banking sector, whose balance sheet, in large part on the back of this lending boom, has increased fivefold in the past 10 years (from around £1 trillion to over £5 trillion today) such that it dwarfs the British economy by a factor of four.
QE would merely represent a further attempt to resuscitate demand by encouraging more borrowing. Given that borrowing is the root cause of this crisis it is unlikely to be the cure. The cure lies in policies that encourage savings and the productive use of capital. Over and above that the cure lies in allowing the recession to run its course and excess to be purged from the system so that the UK economy has a strong base from which to grow as it emerges from recession.
In that respect, therefore, QE, as with fiscal stimulus, aggressive rate cuts and attempts to force banks into more lending, will merely postpone Britain's day of reckoning, pushing today's problems into tomorrow and condemning Britain to its own Japanese style "lost decade".
The author is an economist at Longview EconomicsReuse content