Stephen King: Is the Treasury running out of ammo to save the economy?

Foreign investors are selling the pound, making British exports more competitive

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

Sport
Luis Suarez and Lionel Messi during Barcelona training in August
footballPete Jenson co-ghost wrote Suarez’s autobiography and reveals how desperate he's been to return
News
newsMcKamey Manor says 'there is no escape until the tour is completed'
Voices
Hunted: A stag lies dead on Jura, where David Cameron holidays and has himself stalked deer
voicesThe Scotland I know is becoming a playground for the rich
News
people
PROMOTED VIDEO
Arts and Entertainment
Architect Frank Gehry is regarded by many as the most important architect of the modern era
arts + entsGehry has declared that 98 per cent of modern architecture is "s**t"
Money
Welcome to tinsel town: retailers such as Selfridges will be Santa's little helpers this Christmas, working hard to persuade shoppers to stock up on gifts
news
Arts and Entertainment
Soul singer Sam Smith cleared up at the Mobo awards this week
newsSam Smith’s Mobo triumph is just the latest example of a trend
News
Laurence Easeman and Russell Brand
people
News
ebooksAn unforgettable anthology of contemporary reportage
Sport
Fans of Dulwich Hamlet FC at their ground Champion Hill
footballFans are rejecting the £2,000 season tickets, officious stewarding, and airline-stadium sponsorship
News
Shami Chakrabarti
people
Arts and Entertainment
Benedict Cumberbatch has refused to deny his involvement in the upcoming new Star Wars film
filmBenedict Cumberbatch reignites Star Wars 7 rumours
Sport
football
News
news
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Compensation and Benefits Manager - Brentwood - Circa £60,000

£60000 per annum: Ashdown Group: Compensation and Benefits Manager - Compensat...

Data Analyst/Planning and Performance – Surrey – Up to £35k

£30000 - £35000 Per Annum plus excellent benefits: Clearwater People Solutions...

IT Systems Business Analyst - Watford - £28k + bonus + benefits

£24000 - £28000 per annum + bonus & benefits: Ashdown Group: IT Business Syste...

Markit EDM (CADIS) Developer

£50000 - £90000 per annum + benefits: Ampersand Consulting LLP: Markit EDM (CA...

Day In a Page

Wilko Johnson, now the bad news: musician splits with manager after police investigate assault claims

Wilko Johnson, now the bad news

Former Dr Feelgood splits with manager after police investigate assault claims
Mark Udall: The Democrat Senator with a fight on his hands ahead of the US midterm elections

Mark Udall: The Democrat Senator with a fight on his hands

The Senator for Colorado is for gay rights, for abortion rights – and in the Republicans’ sights as they threaten to take control of the Senate next month
New discoveries show more contact between far-flung prehistoric humans than had been thought

New discoveries show more contact between far-flung prehistoric humans than had been thought

Evidence found of contact between Easter Islanders and South America
Cerys Matthews reveals how her uncle taped 150 interviews for a biography of Dylan Thomas

Cerys Matthews on Dylan Thomas

The singer reveals how her uncle taped 150 interviews for a biography of the famous Welsh poet
DIY is not fun and we've finally realised this as a nation

Homebase closures: 'DIY is not fun'

Homebase has announced the closure of one in four of its stores. Nick Harding, who never did know his awl from his elbow, is glad to see the back of DIY
The Battle of the Five Armies: Air New Zealand releases new Hobbit-inspired in-flight video

Air New Zealand's wizard in-flight video

The airline has released a new Hobbit-inspired clip dubbed "The most epic safety video ever made"
Pumpkin spice is the flavour of the month - but can you stomach the sweetness?

Pumpkin spice is the flavour of the month

The combination of cinnamon, clove, nutmeg (and no actual pumpkin), now flavours everything from lattes to cream cheese in the US
11 best sonic skincare brushes

11 best sonic skincare brushes

Forget the flannel - take skincare to the next level by using your favourite cleanser with a sonic facial brush
Paul Scholes column: I'm not worried about Manchester United's defence - Chelsea test can be the making of Phil Jones and Marcos Rojo

Paul Scholes column

I'm not worried about Manchester United's defence - Chelsea test can be the making of Jones and Rojo
Frank Warren: Boxing has its problems but in all my time I've never seen a crooked fight

Frank Warren: Boxing has its problems but in all my time I've never seen a crooked fight

While other sports are stalked by corruption, we are an easy target for the critics
Jamie Roberts exclusive interview: 'I'm a man of my word – I'll stay in Paris'

Jamie Roberts: 'I'm a man of my word – I'll stay in Paris'

Wales centre says he’s not coming home but is looking to establish himself at Racing Métro
How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?

A crime that reveals London's dark heart

How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?
Meet 'Porridge' and 'Vampire': Chinese state TV is offering advice for citizens picking a Western moniker

Lost in translation: Western monikers

Chinese state TV is offering advice for citizens picking a Western moniker. Simon Usborne, who met a 'Porridge' and a 'Vampire' while in China, can see the problem
Handy hacks that make life easier: New book reveals how to rid your inbox of spam, protect your passwords and amplify your iPhone

Handy hacks that make life easier

New book reveals how to rid your email inbox of spam, protect your passwords and amplify your iPhone with a loo-roll
KidZania lets children try their hands at being a firefighter, doctor or factory worker for the day

KidZania: It's a small world

The new 'educational entertainment experience' in London's Shepherd's Bush will allow children to try out the jobs that are usually undertaken by adults, including firefighter, doctor or factory worker