Mervyn King: this may be worse than the Great Depression
Bank of England to print an extra £75bn to combat downturn
The Bank of England caught financial markets by surprise yesterday by announcing that it will inject £75bn into the ailing British economy over the next four months.
The sharply slowing economy and intensifying threats to the health of Britain's banks posed by the eurozone crisis will lead the Bank to extend its £200bn quantitative easing (QE) programme – effectively printing money.
"This is the most serious financial crisis we've seen at least since the 1930s, if not ever," warned the Bank's Governor, Sir Mervyn King, in a stark reference to the Great Depression.
"We're having to deal with very unusual circumstances, and to act calmly and do the right thing. The right thing at present is to create some more money to inject into the economy."
The UK economy has flatlined over the past year, the Office for National Statistics confirmed earlier this week, downgrading its estimates for GDP growth in the second quarter of 2011 to just 0.1 per cent. Although City analysts had expected an extension of the QE policy – in which the Bank creates new money and uses the proceeds to buy up government bonds, with the aim of injecting money into the economy and prompting spending – they had not expected the Bank to push the button on a new stimulus until next month. The size of the injection of money also surprised investors. Most had been expecting another round of asset purchases of around £50bn. When the Bank's purchases are complete it will own around 24 per cent of the outstanding stock of British government debt.
The Bank, which left interest ratesat a historic low of 0.5 per cent yesterday, dismissed the argument that asset purchases will stoke inflation, which at the moment runs at more than double the Bank's official target.
On the contrary, the Bank's Monetary Policy Committee said, price pressures throughout the economy are receding as the economy weakens and QE is needed to help Britain avoid a deflationary slump. "The deterioration in outlook has made it more likely that inflation will undershoot the 2 per cent target in the medium term," it said. "In the light of that shift in the balance of risks... the Committee judged that it was necessary to inject further monetary stimulus into the economy."
However, the pensions expert Ros Altmann called the extension of QE a "titanic disaster", saying that it will depress the interest rates on the government bonds that provide many retirees with an income. "Falling bond yields make annuities more expensive, giving new retirees much less pension income for their money, leaving them permanently poorer," she said.
The Bank's primary concern, though, is the immediate health of the broader economy. And yesterday's statement also said that "the scale of the programme will be kept under review", implying that more asset purchases could be announced if the economic outlook deteriorates further.
The Chancellor, George Osborne, gave his approval to the decision and confirmed in a letter to Sir Mervyn that the Treasury is planning to implement its own monetary stimulus, which will involve the purchase of corporate bonds. The Chancellor wrote: "Given evidence of continued impairment in the flow of credit to some parts of the real economy, notably small and medium-sized businesses, the Treasury is exploring further policy options."
But the shadow Chancellor, Ed Balls, argued yesterday that the extension of QE will not be sufficient to rescue the faltering British recovery: "While another round of QE may help, I fear it will do little to create the jobs and growth we desperately need if we are to get the deficit down. What we really need is a change in fiscal policy."
Between March 2009 and January 2010, the Bank of England purchased £200bn of British government bonds, known as gilts. The Bank published research last month which suggested that the policy raised national output by as much as 2 per cent.
The announcement of a fresh round of QE is a victory for Adam Posen, the dove on the Bank's interest-rate setting committee. The US economist has been a lone voice on the MPC calling for an extension of asset purchases. Six months ago, the MPC was moving towards approving an interest-rate rise in order to dampen inflation expectations. And, right up until last month, Mr Posen was still the only member of the committee who voted for more QE. But this week the pendulum swung, decisively, towards his long-standing position.
Quantitative easing: A simple guide
The Bank of England wants to boost the economy by creating more money. But how precisely would this work? The primary purpose is to push down long-term lending rates, making it cheaper for companies to borrow and encouraging them to invest. A secondary effect is that those who sell bonds to the Bank, such as private banks and pension funds, spend the proceeds by lending or buying shares, and rising asset prices boost economic confidence. But does it work?
Adam Posen, the MPC member who has pushed for more quantitative easing, says that it does. And Bank of England research released last month purported to show that QE had had "economically significant effects". Yet others maintain that banks sit on gains from the Bank's bond-buying programme, failing to lend it out, and that pushing down borrowing rates does no good when businesses are not interested in investing, no matter how cheap credit is. The Bank's research did also say that its findings were "highly uncertain".
No one expects QE to have revolutionary effects so the Chancellor this week announced "credit easing", which would involve the Bank of England buying up the debt issued by small companies, rather than by the Government.
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