Like a sword blunted by hammering for too long on tough armour, the Bank of England's conventional monetary measures for stimulating our foundering economy are no longer cutting it. Interest rates cannot usefully go any lower. In the view of the Bank's Monetary Policy Committee, the time has come for unconventional measures: a direct increase in the money supply.
This is a grave moment in the history of the Bank, and indeed the country. Increasing the money supply to stamp out deflation – or quantitative easing, to give it its technical name – has never been attempted before in Britain and is a deeply contentious subject among professional economists. It is also a large step into the unknown. No economist, even those who strongly believe it is necessary, would dare to predict with any precision how much of this medicine it will take to eradicate deflation, nor when the process will need to be thrown into reverse (as it inevitably will) to stop rampant inflation taking hold.
There is no road map for this journey. And yet to refuse to embark on it would be just as dangerous. Asset prices are collapsing, unemployment is spiralling and confidence is evaporating. Moreover, the inflationary pressures that have bedevilled our economy for so long are nowhere to be seen. These are the classic conditions that preceed a deflationary slump.
And our national overhang of private debt, accrued irresponsibly during the boom years, makes the prospect of falling prices doubly ominous. In a deflationary environment, the real burden of debts gets bigger, further sapping confidence. The danger of Britain entering a Japanese-style period of negligible growth and stagnant living standards is a very real one. Our fiscal and monetary authorities would be failing in their responsibilities if they did not attempt to head off that threat.
However, we should not assume that the action announced by the Bank of England yesterday will be enough, in itself, to restore health to our economy. The theory of quantitative easing is that a central bank, by buying up government bonds in the private credit markets, increases the overall amount of cash in the economy. And, because people generally store their cash in banks, the reserves of retail banks will then increase, giving them an incentive to lend more money to other customers. This process should get money circulating through the economy at a quicker rate, resurrecting confidence and boosting prices.
Yet the balance sheets of several of our large retail banks are in such a bad state that it is possible that they could simply hoard the new cash that flows to them as a result of the Bank of England's intervention, rather than lend to the UK businesses that so urgently need it.
The Bank of England and the Treasury must supervise this process extremely closely. If there is evidence of cash hoarding, full public control of the guilty banks must be swiftly imposed. And if credit still does not reach those businesses that need it, direct lending from the Bank of England might be necessary.
Just as importantly, the public needs to be kept fully informed by the Bank of what action is being taken to support the money supply. These decisions will directly affect the savings and livelihoods of us all, perhaps even those of future generations. If we must enter this perilous new world, we should at least do it with our eyes open and our wits about us.