The return to normality has begun. Interest rates remain at 0.5 per cent for the time being and that is totally abnormal. But the ending of quantitative easing is this first step along the road to the monetary conditions we know about. If "QE" was a leap in the dark, there are now signs of light ahead. Yes, the Bank of England has left open the possibility of resuming the programme, but while in theory that might be possible, in practice it isn't. Confidence in British economic policymakers is too fragile for that.
It is not only monetary policy that has to get back to normal; fiscal policy has to do so too. A start has to be made on that in the next few months too, for lack of discipline on the fiscal side could undermine efforts to boost demand on the monetary side. Indeed the interaction between fiscal and monetary policy will be one of the most fascinating – and dangerous – issues the country faces in the months ahead. Get it wrong and we could be in a lot of trouble.
The ending of QE first: there has unsurprisingly been a great deal of criticism of the policy, the central thrust of which has been that it has failed to boost bank lending to business. The charge is that the money has been printed but it has not gone to where it is needed. I find that unfair. It is true that it has not worked exactly as expected, and it is true that commercial lending has remained weak. But it has had other effects. It has reduced the cost of borrowing by the Government by perhaps half of one per cent, and it has enabled large companies to borrow more cheaply by issuing bonds. It has also helped the recovery in share prices and the housing market, though it is hard to quantify that effect. QE was always going to be uncertain because it was an untried policy, but in its fundamental aim, to inject demand into the economy, it has been reasonably successful.
Now, however, the patient has to be weaned off the drug. The scale of the Bank's purchases of gilts has been so great as to distort the gilt market. Yes, it is nice that the Government has been able to finance its huge deficit without a surge in long-term interest rates, but this is not sustainable. Have a look at the top graph, which comes from the new Institute for Fiscal Studies Green Budget report, out on Wednesday. As you can see, the Government has become increasingly dependent on two sources of funding: the gradual and steady increase in foreign holdings of gilts, which have quadrupled over the past decade, and the sudden surge in holdings by banks, in particular the Bank of England. That leap in the pink line shows the impact of QE.
The common sense response to this is twofold. First, who would have bought all those gilts if the Bank had not done so? And second, how do we persuade foreign holders not just to hang on to their gilts, but also carry on adding to the stock?
My own answer to both those questions is that we will inevitably have to have higher interest rates, maybe a lot higher. Some work by Michael Dicks at Barclays Wealth and Simon Hayes at Barclays Capital suggests that short-term rates could rise to 3.5 per cent by 2012 and 6.5 per cent by 2015. This would be especially troubling if the recovery is a sub-standard one.
In the IFS report, in which Barclays has collaborated, there are some new calculations for the loss of output as a result of the financial crisis. As you can see in the bar chart, the UK seems to have fared particularly badly by comparison with other major economies, so we have further ground to make up before we get back to the level of output we reached at the peak.
It gets worse. Not only have we more ground to make up, but we will recovery more slowly. One of the reasons why this is likely to be the case is the huge debts we have built up, both as individuals and as a country. British households have started to bite the bullet, as the savings ratio, which had dwindled to zero, is now back above 8 per cent of incomes, roughly its long-term level. But of course the Government hasn't begun.
That leads into a debate about how quickly the nation's finances should be corrected. It is an awkward one, as both major parties are jockeying for position in their efforts both to reassure voters that things will be put right but also they will not act precipitously in so doing. The new light shone on the matter by the IFS is that further tightening over and above that set out in the pre-Budget report is needed. But it also warned against moving too swiftly in getting things in order. You can see the mainstream proposals for both spending and tax revenues, together with the profile of a somewhat faster adjustment, in the bottom graph. The IFS concludes that even with the faster profile of correction, the country will not get its debt down to the pre-crisis level of 40 per cent of GDP until 2033!
What should we make of all this? The obvious danger is that this decision may not be in our hands. It will be in the hands of our creditors. There is a real risk, acknowledged in the IFS report, of a sterling crisis. The authors take the view that the country is likely to retain its AAA credit rating, but they acknowledge that gilt yields will have to rise. There are however two caveats to this relatively benign assessment. One is that the authorities need to be aware of financial market dynamics: the sudden loss of confidence that periodically hits countries. Both fiscal policy and monetary policy are on trial. So there has to be a credible medium-term plan to correct the fiscal deficit. And investors need to be persuaded that the country will not try to inflate away the real value of the debt, a fear increased by unconventional monetary operations. So sticking to the inflation target is vital.
From this it is clear that the emergency Budget after the election will be hugely important. There is an obvious danger that were there no clear majority after the election, the country's creditors may decide that the UK lacks the political will to tackle its problems. Actually I find that danger so obvious that maybe we should not worry too much about it. It is the dangers that you don't see coming that give you the worst bite. Besides other countries, including the US, have a pretty dire fiscal position and are finding it hard to generate the political will to tackle the situation. We are in a mess but we are in good company.
What we do have to be aware of – apart from the risk of sudden loss of confidence à la grecque – is that we must prepare for normal interest rates, rather than the artificial ones we have at the moment. My instinct is that the rise could be sharper than people currently seem to expect.Reuse content