Jeremy Warner: Bank Governor's reverse ferret may be wrong

Wednesday 18 March 2009 01:00

Outlook Mervyn King, Governor of the Bank of England, is like the sinner who repents. Having been far too cautious in the early stages of the credit crunch when he was more concerned with the principles of moral hazard than saving the banking system, he now implicitly criticises our European neighbours for an insufficiently robust macro-economic response to the crisis. Looking at the latest shock forecasts from the International Monetary Fund, it is perhaps easy to see why Mr King has taken so wholeheartedly to throwing everything he has, including the kitchen sink, at the problem. The IMF is predicting a 3.8 per cent contraction in the UK economy this year, plus a bit more the year after. This would make us worse than any other advanced economic region other than Japan.

Yet just as the Bank of England was slow to recognise the seriousness of the economic crisis, is it not now in danger of going the other way and over-reacting. Regular readers will know my reservations about Quantitative Easing, a potentially toxic way of dealing with the deflationary threat by creating money.

The manner in which it is being applied, through the purchase, initially at least, of UK Government bonds, is very helpful to the Government, which is thereby able to underfund the burgeoning budget deficit, but its other supposed benefits are debatable and unproven. One unanticipated consequence is that by driving down gilt yields, QE has massively increased the already swollen pension fund deficits of a large number of defined benefit schemes, including most of the leading banks.

Pension liabilities are benchmarked against government bonds, with the effect that any sustained fall in yields greatly increases the costs of servicing the pension promise. Sponsoring com-panies are under growing pressure from trustees and the pension regul-ator to address these shortfalls. Paradoxically, then, QE may worsen the problem it is trying to address, that of business and credit contraction. If all the company's cash is being swall-owed by the pension fund and by artificially inflated gilts, there's going to be nothing left for business investment.

Mr King seems to take the view that anything is worth a try. Jean-Claude Trichet, president of the Euro-pean Central Bank, is understandably more cautious. A third of the £150bn sanctioned for QE in Britain is earmarked for commercial loans. This looks a potentially more rewarding approach to QE, for it would encour-age corporate debt markets to re-open and help end the credit famine for business. When everyone else is buying gilts and eschewing all other forms of debt, it seems perverse for the Bank to be doing the same thing. Or perhaps the purpose is simply that of funding the public sector deficit with newly printed money.

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