Stephen King: Is the Treasury running out of ammo to save the economy?
Foreign investors are selling the pound, making British exports more competitive
Monday 26 October 2009
Half-a-dozen quarters on, the UK is still in recession. The 0.4 per cent drop in Gross Domestic Product in the third quarter of this year left economists dumbfounded. Where were the green shoots? Why was recovery yet to materialise? Why had the efforts of policymakers – interest rate cuts, quantitative easing, big budget deficits, a drop in sterling – not paid off?
Friday's release left so many people in a state of shock because other pieces of the economic jigsaw puzzle had pointed to a modest recovery. For example, the Purchasing Managers' Surveys (which calibrate health in manufacturing and services) had picked up over the last few months. More often than not, they have provided a useful advance guide to developments in the broader economy. On this occasion, however, their optimistic tone was not reflected in the data.
The real problem, however, is that the initial estimates of quarterly GDP made by the Office for National Statistics are often not much more than garbage. In a December 2006 article, ("Revisions to quarterly GDP growth and its production (output), expenditure and income components"), David Obuwa and Heather Robinson, both at the ONS, showed that revisions between the initial and much later estimates of quarterly GDP growth ranged from minus 0.5 per cent to 0.7 per cent.
These sizeable errors in no way imply that the third quarter numbers will be revised upwards, as many economists are now suggesting, but they certainly suggest that these first estimates should be treated with a large pinch of salt. As the authors note, first estimates of GDP are based on only 44 per cent of the data which will eventually become available, thereby offering the precision of a blindfolded man taking part in a darts tournament.
Nevertheless, these numbers present a dilemma for policymakers. If the economy continues to shrink, or fails to recover, what are the necessary "next steps"? What is left in the policymakers' arsenal?
As things stand, the answer is "not much". Interest rates are already remarkably low. Both Labour and the Conservatives accept that the budget deficit cannot continue to grow. That, then, leaves so-called quantitative easing, whereby the Bank of England buys gilts (government IOUs) in the market. These purchases drive gilt prices higher, persuading other investors to sell their gilts for newly-created cash which, in turn, is then invested in riskier assets: in recent months, the stock market, the corporate bond market and the housing market have all been beneficiaries of this process directly or otherwise.
Quantitative easing is very imprecise. Knowing whether or not it is proving successful is tricky: its effectiveness depends on faith as much as pure economic reason. Earlier in the year, for example, it was widely thought that QE's success would be reflected in faster money supply growth. Yet there has been little evidence of any acceleration. If it is working, another explanation has to be found.
For me, there are three possibilities. First, QE works merely by boosting people's expectations. Given that interest rates are more or less at zero, it is important for the Bank to demonstrate that all is not lost on the monetary front: QE seems to fit the bill even if no one understands how it works (central bankers, like God, work in mysterious ways). Its introduction may have helped to lift asset prices, consistent with a new wave of economic optimism.
Second, it works by allowing companies to replace bank debt (which, in the aftermath of the credit crunch, has proved expensive to service) with debt raised on the capital markets via, for example, the issuance of corporate bonds. In other words, QE enables borrowers to bypass the banking system entirely. This bypass leaves money supply rather weak even if the economy as a whole is benefiting from the extra liquidity created via the QE programme.
Third, and most obviously, it works because foreign investors are losing faith in the UK economy, can hear the hum of the printing press in the background and choose, in their droves, to sell the pound, thereby making British exports more competitive in the process.
Friday's events are certainly consistent with these explanations. As the weaker-than-expected GDP figures were released, the exchange rate fell and gilts rallied: both reactions stemmed from the idea that the Bank of England would be forced to extend its QE programme in November. Faced with a still-weak economy, it is the only option left on the Monetary Policy Committee's table.
Yet, even if QE is extended or the third quarter GDP data are eventually revised upwards, there is still a sense of uncertainty and foreboding about the UK economy. Over the last six quarters, the loss of output has been huge, down by a staggering 6 per cent from the peak at the end of 2007. The loss is bigger still when compared to policymakers' expectations before the crisis began. In the 2007 Budget, for example, the Treasury suggested GDP would continue to expand in a 2.5 to 3 per cent range in 2008 and 2009. Compared with those projections, GDP is over 9 per cent lower.
The debate regarding the quality of the third quarter numbers is, thus, small fry compared with the scale of the economic upheaval we've been living through. Yes, it would have been nice to have seen official confirmation that recovery was coming through but, given the massive shocks seen since 2007, that confirmation would have said little on its own about Britain's economic future.
For me, there are two big uncertainties, one institutional and the other structural. The Bank of England enjoys its independence. If QE continues, however, that independence may slowly be undermined. What are investors to make of a central bank which claims to be independent but is persistently filling its coffers with government paper? The obvious danger is a further uncontrollable fall in sterling. In a bid to restore credibility, the Bank might then choose to end QE, thereby tightening monetary conditions.
How would that square, however, with an incoming Conservative administration promising to reduce the budget deficit aggressively? Might the combination of tighter monetary and fiscal policy then send the UK economy into free-fall again? Put another way, to what extent should the Bank of England take into account the fiscal plans of an incoming government?
The second uncertainty relates to the UK economy's underlying economic potential. One of the more puzzling aspects of the huge loss of activity over the last couple of years has been the persistent stickiness of inflation. Might it be that the underlying economy can offer nothing like the growth rates that, earlier in the decade, were mostly taken for granted? If so, efforts to push asset prices up through the QE programme will ultimately amount to nothing.
The growth which follows will be weaker than before and the asset price gains seen in recent months will simply go into reverse. And, as we wean ourselves off our earlier debt-dependency, we'll slowly realise that no combination of monetary and fiscal policies will return the UK to "business as usual". Rather than sustained recovery, we'll be put on a diet of stagnation and austerity.
Stephen King is managing director of economics at HSBC
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