Sunday, October 03, 2010
Britain's not Japan, so don't turn on the taps
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular Sunday Times piece is available to subscribers on the paper's website - this is an extract.

At present, you would want to be a fly on the MPC wall. On one side is Andrew Sentance, who wants to raise rates because the economy is recovering and inflation has been above target too long.

On the other is Adam Posen, the MPC’s American member, who dismisses inflation fears and is minded to vote for further quantitative easing to prevent a Japanese-style lost decade for Britain. He did not have to say it explicitly but clearly believes talk of a rise in interest rates is barking.
was done.

Posen is an accomplished economist and specialist on Japan and a veteran of the Washington policy circuit, though he was giving his speech at Hull City’s football ground.

The lessons of Japan, he says, are that economies can become locked unnecessarily into periods of weak economic growth and low inflation, even deflation, because of the timidity of policymakers.

“The risks I believe we face now are of sustained low growth turning into a self fulfilling prophecy, and/or inducing a political reaction that could undermine our long-run stability and prosperity,” he warned. “Inaction by central banks could ratify decisions both by businesses to lastingly shrink the economy’s productive capacity, and by investors to avoid risk and prefer cash. Those tendencies are already present, and insufficient monetary response is likely to worsen them.”

America in the 1930s and Japan in the 1990s stand as monuments to the kind of
errors that can be made, he argued. Not only would it be a mistake to tighten monetary policy prematurely by raising rates but it would be a mistake for the Bank not to respond with further easing. That might be simply a question of adding to the existing £200 billion of quantitative easing, by purchasing government bonds, gilts.

But there could also be a need for what Posen calls a “Plan B”, large-scale asset purchases, co-ordinated with the Treasury, what he calls “direct credit market intervention” and “fiscal measures supported by the Bank’s actions and implementation”. The Bank would pump taxpayers’ money into the economy, a much more explicit boost than anything attempted so far.

Posen has has been building up to this speech for some time. Is he right? The first thing is that, while many are worried about the recovery, there is no evidence Britain is following the Japanese path of the 1990s. For one thing it is far too early to say. For another, some indicators, not least a sharp rise in “money” GDP - growth plus inflation - are distinctly unJapanese.

Posen’s view is that the economy’s ability to grow has not been adversely affected by the crisis and that it would be a crime to hold it back. The Bank’s task is therefore to pump it up to full capacity.

But if the supply-side of the economy has been damaged, all that pumping will not drive it faster. The drivers of economic growth are fundamental. Pumping money into an economy in these circumstances could lead to sustained high inflation. Weak growth and high inflation can co-exist. Posen has provided an alternative view but it is also a stab in the dark. To use it to extend the Bank’e easing policy would be a mistake, possibly a dangerous one.

There is a respectable argument for extending quantitative easing which is distinct from Posen’s. Most members of the shadow MPC, which meets under the auspices of the Institute of Economic Affairs, favour more asset purchases by the Bank, with the consensus being around £50 billion on top of the existing £200 billion. Three also vote for an immediate rate hike to 1% which, as noted last month, would be an unusual policy combination.

The shadow MPC has a monetarist bias and its concern is the weakness of the money supply. It does not believe there can be a serious inflationary threat when the money supply (M4) has an annual growth rate of less than 2%.

Even monetarists are not singing from the same hymn-sheet. Simon Ward of Henderson notes underlying money supply growth has accelerated to a 4.5% annual rate in the past three months. The velocity of money is accelerating, as in the past when real rates were negative.

These are uncertain times. It is possible Britain is turning Japanese but I don’t think so. It is possible the money supply will be so weak it will need a further leg-up from the Bank but we are not there yet.

Many people - including many in business - are uneasy about what the Bank has done already. Some see it as Zimbabwe-style printing of money, with inevitable inflationary consequences. Others do not distinguish between a fiscal and a monetary stimulus and worry the Bank’s actions are adding to government debt.

Surely central banks are meant to try complex things that people do not understand? Yes, but one crisis lesson was that mistakes are made when institutions embark on things when they themselves cannot be sure of the consequences.

The Bank was right to embark on quantitative easing as part of its emergency actions to stabilise the economy 18 months ago. It would be wrong to go further to try to speed an economy likely to grow more slowly than in the past for good reason.

The recovery will be uneven. There will be times when it appears to be flagging. In the past, the Bank might have responded to such weakness by cutting rates. But, while quantitative easing is a natural extension of rate cuts, it is much harder to reverse. The gilts and other assets the Bank has bought as part of the programme will have to be sold back.

It is possible to envisage a scenario where the Bank is constrained by market conditions from selling back the gilts it has bought, thus necessitating a sharper rise in interest rates when the monetary brakes have to be applied.

MPC members are right to explore all avenues. A free debate is far better than a dull consensus. On the basis of what we know now, however, further unconventional measures are not warranted.