Jeremy Warner: Bank resorts to extreme solutions. Possibly lethal too
Thursday 19 February 2009
Outlook Quantitative easing (QE) here we come. QE is the fancy term for increasing the money supply, or turning on the presses and printing money. Nothing exactly like it has been tried before on these shores, but something similar has, and on virtually all occasions it has proved disastrous.
Debasing of the coinage under Henry VIII and Edward VI contributed greatly to the inflation of that period, and whereas their successor, Elizabeth I, did much to restore the integrity of money, she too managed to reign over a period of heightened inflation caused partly by increases in the money supply. In her case, it was simply a case of influxes of Spanish silver and minting more coins.
More recent attempts to deal with economic problems by expanding the money supply have proved equally problematic. Just look back to what happened in the 1970s. The inflation of that period wasn't wholly the fault of the oil-price shocks. There was much underfunding of the budget deficit too. So why is the Bank of England even remotely considering this potentially toxic policy approach?
Minutes to the last meeting of the Monetary Policy Committee, published yesterday, which confirm QE has moved way beyond the point of consideration to imminent implementation, provide a half-way decent explanation. With interest rates at 1 per cent, the Bank of England has run out of road on conventional monetary easing. It is not just that interest rates can’t physically fall much further, but rather that to attempt to cut them more might actually prove counter-productive.
This is because banks and building societies maintain a spread between deposit and lending rates so as to cover the costs of banking and make a profit. Deposit rates are already at or close to zero, so any further decrease in bank rate would squeeze the spread. Profitability would therefore be reduced for those banks that pass on any further decreases in rates, which might cause them to restrict their lending even more than they are already.
Since the main thrust of the policy approach right now is to try and get the banks lending again, cutting rates further may therefore not be the sensible thing to do. Restoring the banking system to health cannot involve making the banks less profitable.
Cognescenti will accuse me of muddling up two different things. The purpose of past debasing of the coinage was to raise money for the government. That’s not what’s intended this time, though QE may have that side effect. Rather, the purpose is to expand demand, get the inflation rate back to target, and persuade the banks to lend properly again.
By buying government and corporate bonds with created money, the Bank of England achieves the double purpose of injecting cash into the banking system for alternative lending, and by reducing yields on these securities, persuading the banks to lend to higher interest-paying borrowers. That’s the theory, anyway.
Will it work? It’s anyone’s guess, but it is certainly easy to see how it might run out of control and end up creating an even bigger mess than the one we are in. Mervyn King, Governor of the Bank of England, insisted at his quarterly press conference last week that QE should not be called “unconventional policy”, as it has long been an accepted part of the armoury of monetary authorities.
Perhaps so, but QE has also very rarely been used in the manner now proposed, if ever. The dangers of it blowing up in everyone’s faces, with perhaps a severe loss of international confidence in the currency, seem quite high. We’ll see how it goes.
In the meantime, one of the other main planks in the Government’s attempt to get the banks lending again – the asset protection scheme – seems to be running into some of the same difficulties which have bedevilled the US “bad bank” proposal, Tarp. Do try to keep up. This is important stuff, even if it does fair make the head spin.
The Government hopes that the protection scheme will help further unlock lending by providing banks with a degree of certainty about what their capital position really is. Once they know that capital isn’t going to be further eroded by the downward spiral of asset prices, they might stop hoarding it and start lending again.
As with the Tarp in the US, the problem is deciding which assets are going to be insured, in what quantity, and at what price and cost. If the assets are insured at an inflated price, that’s a straight subsidy from the taxpayer to the banking system. Yet if the cost of the insurance is too high, then it will further undermine the capital position of the bank and end up being counter-productive.
The guinea pig for this negotiation has been Royal Bank of Scotland, which is hoping to announce the terms of the deal hammered out with the Government at the same time as its full-year results next Thursday.
It’s possible the Government will outline details of the scheme, which will be open to all banks on the same terms, at an earlier stage. In any case, there isn’t a whole lot of point in the Government charging too much or the scheme won’t work.
All too tortuous for words? It’s certainly a point of view. Even Alan Greenspan, former chairman of the US Federal Reserve, now seems to accept it may be necessary to nationalise some banks to get the supply of credit flowing again. Nationalisation would provide a swift and orderly approach to restructuring, he has been quoted as saying, allowing the government to transfer toxic assets to a bad bank without the problem of how to price them. Mr Greenspan was referring to the US banking system, but he might equally well have been talking about Britain. I’ll suspend judgement until details of the asset protection scheme are published. But there is a real danger of the scheme being too complicated, messy and expensive to do the trick of underpinning confidence in bank balance sheets.
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