Sunday, December 04, 2011
Shadow MPC votes 8-1 for policy hold
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent monthly e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one that Bank Rate should be held at ½% when the official rate setters make their announcement on Thursday 8th December.

The sole dissenting SMPC member wanted to raise Bank Rate to 1% immediately. The overwhelming reason why most SMPC members voted to hold in December remained their grave concern over the potential effects of the Euro-zone crisis for Britain’s exports and the UK banking sector.

Some ‘holds’ thought that Bank Rate was so far below the money market rates, which determined commercial bank lending costs, that it had little relevance to the wider economy. This meant that the main gain from holding Bank Rate was psychological. There was also a widespread concern that the supply side of the British economy was so arthritic that any fiscal or monetary stimulus would be largely dissipated in higher inflation rather than increased output.

The SMPC poll was carried out before the Chancellor’s 29th November Autumn Statement. However, committee members were given the opportunity to amend their contributions afterwards. A major concern, which was shared by many SMPC members, was the inconsistency between the official hard-line approach to financial regulation and the need to bolster the supplies of money and credit.

It was suggested that the main role of Quantitative Easing (QE) was to counter the adverse regulatory shocks that were being imposed on UK banks, both internationally and domestically, and that this represented a clear-cut policy inconsistency.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold Bank Rate.
Bias: Add another £75bn round of Quantitative Easing (QE).

The British economy is in a dire state. The signs are that domestic demand is pretty static if not falling a bit. Meanwhile, the position on the continent of Europe looks perilous. Nor is there any sign of anything on the horizon which could make things much better. About the best hope we have is that falling inflation will boost consumers’ real incomes – and, thereby, lead household consumption modestly higher – and that this factor will be intensified by a sharp fall of commodity prices.

The signs are now fairly clear that inflation has peaked, barring another upsurge of commodity prices. Inflation will probably fall sharply next year. Indeed, it will probably be below target by the end of 2012. There is a real prospect of deflation again becoming a realistic danger in 2013, if things do not improve markedly.

Accordingly, the Monetary Policy Committee (MPC) needs to relax policy considerably. It should complete its present bout of Quantitative Easing (QE) with all speed and then proceed to embark on another round of £75bn initially. However, and if the economy still looks as weak as currently, then the Bank should repeat the dose.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: Setting of interest rates and debt management policy (i.e. QE in present circumstances) to maintain low and stable growth of the quantity of money, broadly defined.

The effectiveness of QE – in other words, increases in the quantity of money, engineered deliberately by the state – has been called into question in recent newspaper articles, such as that in the Financial Times of 25th November by Professor Robert Skidelsky. The central proposition in the argument for QE during and since the Great Recession has been – or at any rate ought to have been – familiar from traditional monetary economics. This is that an increase in the quantity of money is associated with – and, indeed, usually causes – a proportionally similar increase in equilibrium national income and wealth. Nowadays, the quantity of money is dominated by bank deposits, which are more than thirty times larger than the note issue in the UK. The relationships between money, on the one hand, and national income and wealth, on the other, hold regardless of banks’ asset composition. Contrary to a widespread misunderstanding, the change in bank lending to the private sector is by itself neither here nor there. This is not to deny that new bank lending creates new bank deposits in the normal course of events. However, it is the deposits that matter to macroeconomic outcomes, not the loans.

The correctness of these remarks is confirmed by salient features of the Great Recession. Predominantly Keynesian economists might expect that the turmoil and confusion of the last few years would have destroyed the relationship between the supply of broad money and current-price national income. However, that is not so. In the five years to the third quarter of 2011, the increase in money Gross Domestic Product (GDP) measured at market prices was 13.8% (i.e., with a compound annual rate of increase of 2.6%), while the increase in the quantity of money (as measured by the M4ex measure) was 16.0% (i.e., with a compound annual rate of increase of 3.0%). The medium-term similarity of the rates of change of money and nominal expenditure has survived the Great Recession, just as it survived various bouts of macroeconomic instability in the 1970s and 1980s, and the happier Great Moderation in the fifteen years to 2007.

The point of emphasizing these facts is to assert that an acceleration in the rate of money growth – which can undoubtedly be delivered by sufficiently aggressive expansionary open market operations and/or by monetary financing of the budget deficit – can check emerging recessionary pressures. Inflation is going to fall in 2012, partly because of the easing in oil and gas prices since early 2011, partly because the effect of the early 2011 VAT increase will drop out of the annual comparison and party because of the high margin of slack in the UK economy. Given the widespread anxiety about the return of recession in 2012, the MPC’s decision to pursue another £75bn of QE should be endorsed. One would hope that it will lead to a burst of suitably positive money growth in the October 2011 to March 2012 period. The main caveat is that Britain’s banks remain under a regulatory cosh. Their shrinkage of risk assets may to a large extent offset the increase in their claims on the Bank of England and the government which is implied by QE.

The main criticism of official policy is one that has been stated many times and remains unchanged. The objective of QE is to increase the quantity of money and/or its growth rate, in order to counter the money stagnation/contraction attributable to the regulatory attack on the banks. The increase in the quantity of money is the variable that matters, not the location in terms of personalities and institutions, of the official decision to boost it. The simplest way of increasing money growth by far is for the government to stop selling long-dated gilts to non-banks, and to issue large quantities of Treasury bills and short-dated gilts with the intention that these will be acquired by the banks. The latter course would result in the creation of new money balances.

The enormous expansion of the Bank of England’s balance sheet since mid-2007 has led to administrative awkwardness and extensive misinterpretation. Liam Halligan has claimed in his Sunday Telegraph column, for example, that the increase in the monetary base – an increase which is clearly a by-product of QE – will result in rapid inflation and currency debauchery. The latest business surveys – which show a sharp loss of business confidence and clear declines in plans to raise prices – contradict these ‘forecasts’ although, to be fair, Halligan does not commit himself to a precise forecast of a particular inflation rate at any particular date. Ideally, an increase in the quantity of broad money can and should be organized without any significant effect on the monetary base.

The trouble is that the Bank of England – or at any rate its governor, Sir Mervyn King – believes that the Central Bank should have exclusive responsibility for monetary policy and, hence, for the specification of QE policy. It would be preferable if the Bank and HM Treasury – and also the Debt Management Office (DMO), to the extent that it has its own separate voice – worked together, with a view to achieving stable, moderate growth of the quantity of money. The management of the public debt undoubtedly has implications for the rate of money growth, or money contraction, and – willy-nilly – the central bank must always work with the finance ministry on the practicalities and tactics of debt issuance. An exaggerated sense of its own importance is one reason that the Bank of England has bungled so often in the last few disastrous years.

Thousands of words have already been written about the dysfunctionality of the Euro-zone, and there is no space here to rehash increasingly well-known analyses. Euro-zone sovereign debt and also, importantly, inter-bank claims between Euro-zone banks have become unsafe assets. There is little doubt that – if their assets were marked to market – virtually all the Euro-zone’s banks would now have deficiencies of capital. These deficiencies would take two forms, with equity capital either negative or far beneath the regulatory norms. Big Bang recapitalisation (i.e., a comprehensive and sudden imposed recapitalisation, compressed into a short period of time) would then be intensely deflationary and could plunge the Euro-zone economies into a second Great Recession, less than five years after the supposed end of the previous one. This would be a repetition of what happened to the East Asian economies in 1997, after Japan’s banks were told to recapitalise with undue haste, or to our own economy in 2009 after the bank-bashing of October 2008. Given that the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) both appear to favour a bank recapitalisation of the Big-Bang type, the risk of a second Great Recession is high.

However, a major recession in Europe can be easily avoided, if policy-makers use some common sense and do not insist on a Big-Bang recapitalisation. Frankly, the banks could not – in 2007 and earlier – have been expected to foresee either the Euro-zone’s disintegration or the traumatic effect on their solvency of that disintegration. Policy-makers must give the banks an extended period of time to recapitalise, with steady growth of the quantity of money as a key desideratum while that recapitalisation is taking place. In practice, early 2012 could be chaotic. We must envisage finance ministers in Euro-zone countries instructing the European Central Bank (ECB) governing council to expand its balance sheet rapidly in 2012, if a serious recession materializes. Unfortunately, a minor recession seems to be under way already. At this stage no one knows the eventual resolution of the huge row between Europe’s politicians and the ECB that seems imminent.

As long as the UK’s policy-makers keep the quantity of money growing at a reasonable rate (say, about 5% at an annual rate) in the next two or three quarters, the UK should be able to handle the side-effects of the Euro-zone recession without too much trouble. The British government’s efforts to curb the budget deficit are appropriate and desirable and – at last – there are signs that UK officialdom is rethinking its commitment to such expensive, growth-destroying follies as renewable energy and European Union (EU) social legislation.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: Additional QE; conditional on evolution of Euro-zone crisis.

At its October meeting, the MPC voted to extend its asset purchase programme by an additional £75bn. Gilts are to remain the asset of choice, with all purchases due to be completed by the end of February. The November Inflation Report suggests the Bank of England’s rate setters may soon vote to extend the programme beyond February. Given the downward revisions to the path of real GDP, and the Bank’s estimates of the effectiveness of QE, they seem to be shaping up for another £75bn to £100bn of QE, over and above the £275bn already announced. The MPC’s central forecast for inflation in the medium-term implied that there was a good chance that it would be below the 2% target. Three years from now, the MPC judged that there was a 40% chance that Consumer Price Index (CPI) inflation would be below 1%. These forecasts do not allow for the possibility of a disorderly default within the Euro-zone, since there is no realistic way in which MPC members could quantify the risk to the UK economy. However, there is little doubt that the MPC will take such a scenario into account in its policy choices. The magnitude of the risks may be unquantifiable. However, we do know that they are large and deflationary for the UK economy.

For the time being, the British economy is still growing, albeit at a rate noticeably below its underlying potential. The third quarter data point to sluggish growth once adjusted for the bounce-back from the weak second quarter caused by one-off events, such as the Royal Wedding. Indicators of activity in the final quarter of 2011 suggest softer foreign demand is hurting the manufacturing sector, although there still appears to be limited expansion in the service sector. The data does not yet point to a UK recession.

Over the next year, however, the UK economy is at risk, primarily because of events beyond its shores. The Euro-zone economy now appears to be in recession. Even if Continental leaders manage to cobble a plan together, economic conditions could get much worse in the next six months. Euro-zone growth risks are very much skewed to the downside. If anything, though, it is the risk of more significant disruption to bank funding markets that really threatens the British economy. Although UK lenders have so far suggested little impact on the supply of credit to domestic sectors, there are growing risks of a sharp tightening of monetary conditions. Broad money growth remains low. Were the £75bn of gilts to be purchased solely off UK non-bank investors, the direct effect would be to add around 5% to the stock of M4ex in three months. This represents a significant injection of money balances into the economy. Nevertheless, there could still be considerable downward pressure on the stocks of UK bank lending and broad money in the event of a worsening of the Euro-zone crisis. The MPC would be right to respond with further asset purchases.

The elevated rate of inflation may seem like an impediment to additional monetary ease. It should not be. Headline inflation is set to fall sharply in 2012. By year-end, it should already be below the 2% target and heading south. Risks to inflation in the medium-term are on the downside, even if the multitude of possible endings to the Euro-zone crisis means it is difficult to quantify those risks. By the middle of 2013, Britain will have had five years of little to no growth in broad money. Notwithstanding the effect of very low interest rates on the demand to hold money balances, it is very hard to argue that UK monetary conditions warrant anything other than an easing bias.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Hold Bank Rate; expand QE further if M4ex broad money declines.

British economic growth continues to stumble along at a sub-par rate, tracing out a trajectory well below its unsustainable pre-crisis path. The earlier growth path of 2.5% to 3.0% per annum in real GDP between 2000 and 2008 had been fuelled by excessive borrowing and lending, and has resulted in serious damage to the balance sheets of households and financial institutions. The result, in terms of spending and production, was an overemphasis on domestic activities, such as housing and consumption, at the expense of investment and exports. The ‘new normal’ for real GDP growth is turning out to be close to 1% per annum. This is far below estimates derived from simple extrapolations of past rates of growth of productivity and the growth of the labour force.

The main contributor to lower real GDP growth in 2011 has been the higher than expected inflation rate – basically a shift in the terms of trade – which has eroded real income growth for consumers. However, the underlying reason for the step down in the growth rate – and the inability to resume the previous growth path – is the huge pressure on banks, other financial institutions and households to repair their balance sheets. This process requires cutting consumption, raising corporate and household savings rates and using part of those savings to repay debt. Shifting real GDP growth back to its pre-crisis trajectory is not going to be achieved by short-term manipulation of monetary or fiscal policy.

On the monetary side, the best the authorities can do is to prevent outright deflationary conditions developing by maintaining monetary growth at positive rates. To avoid any contraction in the broad money supply (M4 or M4ex), the Bank of England has recently expanded its asset purchases or QE by £75bn. Nobody can be sure that the latest programme of asset purchases will ultimately be sufficient since the economy-wide deleveraging process may well continue for several more quarters – or even years. Accordingly, that would require further episodes of asset purchases by the Bank until private sector balance sheets had achieved a new equilibrium.

On the fiscal side, public sector current expenditure continues to rise, increasing by £8.5bn (+2.4% year-on-year) in the financial year to October compared with the same period in 2010. Net investment has, however, started to come under control, falling by £24.1bn in the financial year to October compared with the same period in 2011. At the time of the budget in March 2011, the coalition announced no less than one hundred and thirty-seven new initiatives to boost growth. However, the net impact of these measures will be limited due to the necessary, and inevitable, retrenchment that is going on in the private sector. The public is learning the painful lesson that the aftermath of a credit bubble can be very protracted.

Overseas, the Euro-zone leaders’ summit of 26th October produced three main policy proposals: a ‘voluntary’ bond exchange involving a 50% debt write-off of Greek government debt held by private institutions in exchange for Euro30bn from the member states, a Euro106bn recapitalisation of the area’s banks, and a proposed expansion in the size and scope of the European Financial Stability Fund (EFSF) rescue resources. These policies have been perceived to be inadequate, causing sovereign debt yields to rise in the aftermath of the summit. Furthermore, the ‘voluntary’ write-down of 50% of Greek government debt held by private sector institutions has undermined the validity of credit default swaps as a hedging instrument, and therefore potentially lowered demand for the bonds of other indebted economies such as Italy or Spain. More fundamentally, the summit proposals do nothing to improve the near-term competitiveness of the ‘olive belt’ economies, or to restore growth. Meanwhile, the on-going financial stress is progressively tightening credit conditions in Euro-area inter-bank funding markets, and will exacerbate the Euro-zone recession that appears to have begun in the fourth quarter. Taken together with the downward revisions of US growth expectations for 2012 – for example, by the members of the Federal Open Markets Committee (FOMC) – the international environment is likely to have an adverse impact on the UK economy in 2012.

Against this grim backdrop the Bank should keep base rates at their current low levels and be prepared to extend again the programme of asset purchases to ensure monetary growth remains positive.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate; no more QE as yet.
Bias: To do no more QE, but instead consider direct/primary purchase of government debt in the event of disorderly Euro-zone collapse. If there is not a Euro-zone collapse, bias is to raise UK rates

The economic situation is difficult, and there are storm clouds in almost every direction. If there is disorderly collapse of the Euro-zone – a scenario to which a 30% to 40% probability should be attached – there could be a further 10% contraction in UK GDP, along with very serious further problems in the UK banking sector induced by multiple sovereign defaults and the collapse or nationalisation of much of the Euro-zone banking sector. If the UK economy drags along slowly for the next five years, but without Euro-zone collapse, UK households will default on their debts, bankrupting UK banks and dragging down the UK sovereign. If UK growth recovers and accelerates, there will be rapid rises in UK inflation, necessitating large rises in interest rates triggering a further recession in the UK. Almost all plausible scenarios from here onwards are bad.

The decision to re-start QE in the UK was at the same time too late, premature and inadequate. Too late, in that it should have been done from mid-2010 to early 2011, addressing the domestic slowdown of the period from September 2010 to June 2011. However, that boat has sailed. More QE now cannot undo the past. Premature, in that QE was actually re-introduced in response to the Euro-zone crisis and potential problems in the UK banking sector – which have not happened yet. However, further QE cannot prevent the Euro-zone crisis; neither can it stop the Euro-zone crisis, if it turns into a full-blown banking crisis, from sucking in the UK banks.

If the Euro does indeed collapse in a disorderly manner, QE – by which is meant purchases of government bonds in secondary markets – will no longer be the best mechanism of direct monetary injection. Instead, at that stage, the Bank of England should step up the scale by purchasing UK government bonds directly from the government. This would provide a more powerful monetary stimulus, and could potentially be combined with measures such as money-printing-funded income tax rebates sent directly to households. Such measures are obviously desperate. We would be in desperate times.

If the Euro does not collapse (and, arguably, even if it does), it would be desirable to escape from current zero interest rates. Setting interest rates at zero is obviously an emergency measure. More generally, setting interest rates below the Wicksellian natural rate should always be conceived of as a temporary measure. It is not good policy to hold interest rates systematically below the Wicksellian natural rate on a long-term basis. Doing so does not merely create inflation risks. Even if there is no inflation, real interest rates that are too low mean that there will be investment projects undertaken that are value-destroying, and will subsequently be exposed as ‘mal-investment’.

We are now approaching the third anniversary of zero interest rates in the UK. Such extended ‘emergency’ rates cannot indefinitely be regarded as temporary. At some stage, we must seek to normalise – otherwise the long-term growth of the economy will be damaged by excessively low rates, just as it would be by excessively high rates. Since it is more rapid long-term growth that the UK economy desperately needs, rather than a short-term boost, it would be desirable for the long-term health of the economy to seek to raise rates.

There is little to be gained, however, in raising rates when Euro-zone collapse might be only weeks away. For now, therefore, it is appropriate to vote to hold. Nevertheless, we should be seeking to raise rates at the earliest opportunity. The UK economy has got beyond the point at which policy accommodation on the interest rates side remains healthy. Monetary policy’s last role, here, is to maintain government liquidity if there is total meltdown in international sovereign bond markets. That is subject to the proviso that it can be done on a small scale, and temporarily, and is not used by the government as an excuse for not cutting spending enough in response.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again; QE should not be resumed.

The crisis in the Euro-zone worsens almost daily, with Greece, Portugal, Italy and now Spain facing interest rates that make their finances unsustainable. An attempt was made some weeks back to create a ‘big bazooka’ – i.e. a large amount in the EFSF – that would underwrite these countries’ financial difficulties. However, this attempt has collapsed with the problems now requiring far greater funds than Germany was willing to provide. Currently, the EFSF stands at Euro440bn but about half of this has already been used up on Greece. Banks that have lent to Greece have ‘voluntarily’ had their claims written down through a ‘haircut’ of 50%. The maturity of the EFSF loans to Greece has been lengthened to fifteen years, extendable to thirty, from the original seven-and-a-half years. The interest rate charged has been reduced to around 3.5%. However, the exact rate depends on the cost of funds to the EFSF, so this rate represents an agreed reduction in the EFSF spread to virtually zero. These terms have also been extended to Portugal and Ireland, the other countries currently receiving EFSF bail-out money. However, Greece looks unlikely to be able or willing to repay, even with all these adjustments. Italy, Spain and Portugal too look overwhelmed by the current situation. The austerity packages theoretically needed will almost certainly be rejected by voters. Meanwhile, the German electorate are also unlikely to countenance any further transfer of money from Germany to the rest of the Euro-zone.

This crisis situation looks set to rumble on for weeks, months and even years. Greece seems likely to leave the Euro first, perhaps early in the New Year. Efforts will then be redoubled to keep others inside. However, by the end of 2012 another victim – Portugal, probably – will have been claimed. It may not be until 2013 that Italy and Spain will leave the Euro. At this point, France too will look vulnerable and Germany may decide to restore the Deutschmark.

Accompanying this rumbling will be a huge German effort to beef up controls on every Euro-zone country’s economic policy. The Germans will not tolerate being caught like this again – did they not write a ‘no bail-out’ clause into the Maastricht Treaty and where did it get them? No teeth. Now, there will be teeth in abundance. How well will this new German economic empire go down with the satellites? Will being in the Euro seem worth it? All these developments seem to add up to the end of the Euro, rejected by the voters of all these countries because of its dreadful economic consequences. It would be really astonishing if democratic wishes were flouted on such a scale as to permit the sort of cross-country interference currently being proposed by Germany, France and the Commission.

Then there is the UK. It does seem that the Euro-zone ‘governance’ proposals will include tax proposals, such as the notorious financial transactions tax, which would put the City out of business overnight. Now these are supposed to be for the Euro-zone; but they will argue that, because of ‘competition’ from other tax jurisdictions in the EU, they must be ‘general’. They will argue that the Single Market mandates this and, under the Single Market agreement, the UK can be outvoted routinely by qualified majority voting. Such is the UK’s problem. Just like the ridiculous EU working time limits, we will be subjected via the Single Market to more highly damaging interference with our economy – this time taxation which will hit like an ‘Exocet’ missile into the heart of our economy. No wonder that our EU relations are climbing the UK political agenda fast. Even Liberal Democrats will not like these things ‘up ‘em’.

The grim reality of this poorly constructed EU economic edifice and the rumbling crisis will continue to have consequences for the world economy. The UK will probably detach itself to a large extent from it all over the next decade. People worry about ‘trade with the EU’; initially, attempts will be made for us to stay within the EU ‘customs union’ for this reason. However, as our economy moves more and more into services, where the EU has made no attempt to create a single market, the trade issue will become less and less relevant. Basically, the EU protects manufacturing with preferential prices, over world prices. But any of our manufacturing that needs such protection is not really worth having; we are better off moving into areas where we have ‘comparative advantage’ – i.e. those that are ‘competitive’ at world prices.

The Euro-zone crisis will have a dampening effect on growth, clearly, both via the reduction in our exports to a slowing area (for every 1% reduction of Euro-zone growth, UK growth could be reduced about 0.2%) and via the problems of the banking system, where the inter-bank market is once again frozen. However, the most important overseas factor for us is in the overall world economy. After all, our exporters can sell outside Europe, if there is growth elsewhere. Actually, the world is still growing fairly strongly (perhaps by 4% this year) and has endemic inflation. This inflation should now fall back as a result of the strenuous attempts to cool their economies being made by such leading emerging markets as China, India and Brazil. Commodity prices have fallen back, which is a good start. This should pave the way for better growth in 2012, with these countries able to resume a neutral monetary policy. The problems of the developed economies are related to the slow productivity growth that occurs when raw materials are in short supply and also to their banking-industry difficulties, which have been exacerbated by over-regulation. These adverse factors will not change soon. So the outlook is for continuing slow growth and difficult labour market conditions. However, the Euro-zone crisis is only a small part of these difficulties.

Furthermore, a determined effort by the coalition government to address the UK’s supply-side problems would pay off. Unfortunately, these ideas are mostly opposed by the Liberal-Democrat part of the coalition. But they would include abolition of the 50 pence tax rate, deregulation of hiring and firing, reductions in public sector union powers, road and airport infrastructure and most important of all in the present banking impasse a much lighter touch on banks during the slow growth period.

The most likely outlook for UK inflation is for a moderate fall to the 3% to 4% range, given that commodity prices are easing. Nevertheless, the Bank of England is still taking unacceptable risks with the control of inflation. It is highly vulnerable ‘on the up side’. Possible developments that could embed inflation further are: 1) a renewed commodity price spiral fuelled by new QE by the US Federal Reserve; 2) a breakdown of credibility in the UK inflation target regime, possibly as a result of political ‘loose talk’, and 3) a tightening of parts of the UK labour market leading to rising wage awards. At present, none of these look too threatening. Nevertheless, they are material risks. Why take them when monetary looseness is capable of achieving so little improvement in growth? Interest rates are at the zero bound; any QE goes straight into bank reserves; the UK’s growth rate is being determined by supply-side factors, including the effects of high raw material prices on capacity and productivity, mismatch in capital and labour market, and terms of trade effects on living standards from high raw material prices.

Everything we know about money and the economy suggests that efforts to use money to stimulate growth apart from in response to surprises (such as the banking crisis) are fully discounted by households and firms, and so have minimal effects on growth. As for the Euro-zone crisis, it merely means that there is just one more factor slowing UK growth over which we have no control. Our exporters need to divert their efforts away from the European Continent but this will take time. In terms of banking problems, we have already stuffed our banks full of reserves and if necessary we could give them yet more. However, that would be a specific response to a particular banking problem and need not be pre-empted by general monetary looseness.

For all these reasons, the Euro-zone crisis notwithstanding, it is time for the Bank to retreat from its highly exposed position on inflation risk. It needs to signal that it is doing so. Bank Rate should rise 0.5% (market rates are already around this level in fact); not much tightening would result but it would be a good signal. QE should not be extended unless it is needed to resolve bank reserve problems from the crisis. The bias would be for further, slower upward moves in rates and no further QE.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate, until the Euro-zone situation clarifies; keep QE on standby for lender of last resort purposes.

The British monetary and fiscal authorities appear to have found themselves in the position of shipwrecked mariners clinging to an overcrowded life raft. Any false move could lead to an immediate disaster but staying motionless will not provide long-term salvation. Meanwhile, an unpleasant-looking wall of water is heading for the raft from off Continental Europe, while the vital location-finding instruments have been destroyed through the incompetence of the official statisticians. This is not a hopeful prospect. The first priority has to be to prevent any individual member of the party from doing anything so stupid that it de-stabilises the situation. It is also too late to worry about whether the ship was sunk as a result of the gross incompetence of the previous ship’s captain, Gordon Brown, and whether a bolder initial response by midshipmen Cameron, Osborne and Clegg could have averted the peril. The situation is what it is and the only issue is how to get out of this mess.

There are at least four possible scenarios in which all could be easily lost. The first is if the government’s fiscal credibility gets destroyed as a result of the persistent overshoot of the official borrowing targets. The 29th November Pre-Budget Report and the accompanying forecasts from the Office for Budget Responsibility (OBR) indicate just how far the government’s fiscal retrenchment plans are already off course. In particular, the stock of public sector net debt, which encapsulates the totality of the upwards revisions to public sector borrowing is now expected to be £112bn (8.2%) higher in 2015-16 than was forecast at the time of the March 2011 Budget (see: OBR Economic and Fiscal Outlook, November 2011, Table 4.31, page 165). There is a real risk that the sovereign debt crisis that would probably have hit Britain in mid-2010, if the election outcome had been different, may have been postponed – but not averted – by the Coalition’s measures.

The second risk is that the government takes the political line of least resistance and tries to tax its way out of the fiscal mess, as it did earlier with its misguided decisions to increase VAT to 20%, raise National Insurance Contributions and implement Labour’s 50% higher income tax rate. Mr Osborne’s attempt to raise the tax burden in a recession, in order to fund government spending levels that could not reasonably be supported by the economy’s private sector, merits a Herbert Hoover award for supreme economic incompetence. However, it may be all that one should expect from a government of ‘wealth conservators’, who believe ‘nice’ people inherit money and look down on vulgar ‘wealth creators’ who wish to enrich themselves and society in general through their own efforts.

The third potential catastrophe scenario stems from the risks that misguided financial regulations will lead to a renewed downturn in the supplies of money and credit, either at a synchronised international level via the latest Basle accords, or domestically as a result of the UK financial regulators gold-plating international agreements and trying to introduce additional regulatory requirements of their own. The time for stepped up regulatory requirements was during the pre-2007 credit boom, as some of us were arguing at the time. To do so now, is simply perverse. Even phasing in the proposals over a long period, does not obviate the likelihood that commercial bankers will endeavour to contract their balance sheets in advance of new capital and liquidity requirements so that they are in the right place ‘when the whistle blows’. Public-choice theory suggests that government bureaucracies always try to over-regulate to a point well beyond the social optimum for two reasons. One is that it allows the expansion of well-paid bureaucratic empires, paid for by a covert tax on bank shareholders and customers. The second is that over-regulation reduces the risks of political embarrassment to the officials concerned, even if it has the pernicious hidden costs of reduced innovation and slower economic growth. It is simply dumb to indulge in round after round of QE to offset the effects of excessive and inappropriately timed pro-cyclical financial regulations. Traditional banking and finance economists understood many decades ago that the purpose of reserve asset requirements was to act as a safety net, which could be run down to zero if need be when the crisis hit. The same applies, mutatis mutandis, to capital requirements.

The fourth potential catastrophe is that developments in the Euro-zone become so adverse that they pose a major threat to the British economy, either because of the loss of export demand or contagion affecting British banks. The latter risk should be manageable if the Bank of England acts as efficiently as the Bank of Canada did when the neighbouring US banking system went into meltdown in September 2008. It must be hoped that recent institutional changes, including the establishment of the Bank of England’s Financial Policy Committee (FPC), will allow an appropriately rapid and effective response if UK banks are threatened by Continental defaults. The problem of exports is probably more intractable. However, British manufacturers should be shifting their efforts from slow-growing Continental markets to the faster growing rapidly industrialising nations, in any case.

While it is tempting to concentrate on the high-frequency gyrations in the financial markets where the crisis in the Euro-zone is concerned, the common currency area has been fundamentally blown apart by a low-frequency phenomenon. That is the difference between the relative fiscal conservatism with which the German public finances have been managed since 2000 and the large spending increases elsewhere in the Euro-zone. An important paper from the ECB dealing with this issue is ‘Towards Expenditure Rules and Fiscal Sanity in the Euro Area’ by Sebastian Hauptmeier, Jesus Sanchez Fuentes and Ludger Schuknecht (ECB Working Paper Series, No, 1266/November 2010). This argues that the tension between the tight government spending restraint in Germany, and the big spending policies of many peripheral Euro-zone members before the global financial crisis, was a major cause of the sovereign debt crisis. However, none of the countries concerned indulged in a public spending ‘bender’ of anything like the scale of the UK’s between 2000 and 2010. This is why the Coalition’s timorous attempts at improved spending discipline have simply been inadequate to the task in hand. Since May 2010, the government have erroneously behaved as if they were a new management acquiring a viable business, when they needed to act with the ruthlessness and despatch of receivers taking over a massively-indebted and near-bankrupt concern.

Finally, and in order to not needlessly rock the life raft, Bank Rate should be held in December and probably for the next few months. This is largely for psychological reasons, since banking lending costs are driven off money-market rates which have become detached from Bank Rate. QE remains a valid tool, which should be used without inhibition if the UK authorities have to act as a lender of last resort because of financial contagion from the Continent. However, it is not a cure all; it is grossly unfair to savers, especially those forced to buy annuities, and it lets the Chancellor too easily off the hook that he has got caught on because of the Coalition’s failure to exercise greater spending rigour. Meanwhile, Western governments have become so hooked on cheap credit that they have taken it for granted that they are entitled to borrow at ludicrously low nominal and real rates of interest. In the case of Italy, for example, a 7% bond yield does not look at all unreasonable for a country with 3.4% inflation even within the Euro-zone, and a huge funding task ahead of it. In normal times, one might expect a ten year government bond yield to equal inflation, plus a real rate of, say, 2½%, plus an extra 0.1 to 0.2 percentage points for each 1% of GDP accounted for by official debt sales. The financial markets are not being unreasonable in asking for higher bond yields from profligate governments. The politicians are being unreasonable – or delusional – to expect anything else. One very last comment, from a technical macroeconomic modelling and forecasting perspective, is that the UK Office for National Statistics (ONS) has made such a complete mess of the national accounts and its data bank that it is hard to see how the reliability of the latest Inflation Report and OBR forecasts can be anything other than seriously degraded as a consequence.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; no extension of QE; reinstate Special Liquidity Scheme. Bias: Raise Bank Rate once constraints on bank lending have been alleviated.

The Bank of England, far from being the saviour of the UK economy, is becoming its greatest liability. Warming to its expanded role in the wake of the global financial crisis, the Bank’s recent actions run the risk of condemning the country to a permanent state of crisis and emergency. Compounding its reluctance to respond to a persistently adverse inflationary trend, the Bank has followed a wayward US Federal Reserve in seeking to suppress interest rates across the yield curve for government bonds. However, the appropriate response to the threat of contraction in the market for wholesale funds prompted by the Euro area banking crisis is the provision of significant additional liquid funds (Treasury bills) to the UK banking system by the Bank of England, not the extension of the Asset Purchase Scheme for government debt.

Despite the repetition of the very same threat that plunged Northern Rock into darkness four years ago, the Bank remains adamant that it will close down its Special Liquidity Scheme (SLS) by January 2012 and is on course to do so. UK banks have been preparing for this withdrawal for the past two years. As a consequence, they have held back from net new customer lending and have reined back their unused credit facilities by 11.5% or £31.7bn in the past year. This enforced abstinence has robbed low interest rates of their expansionary vigour and denied to the UK economy even the temporary phase of rapid economic recovery that normally occurs following a slump.

Essentially, the Bank has adopted the position that the liquidity support for the banks should be temporary while the compression of interest rates, extending across the yield for government debt, should continue for a considerable period. This combination is wrong-headed and counterproductive. As Professor Ronald McKinnon of Stanford University has recently pointed out in the US context, the continuation of near-zero short-term interest rates poses a credit constraint on the banking system. Low interest rates only stimulate faster credit growth when inter-bank rates are comfortably above zero. Banks with good opportunities for lending to individuals and small and medium-sized enterprises (SMEs) typically do so through the extension of credit facilities. These credit lines, like an overdraft facility, can be drawn down when the borrower requires them. For the bank, this creates uncertainty in knowing what its cash positions will be. An illiquid bank would soon be in trouble if its customers decided to use up their credit lines in a synchronised fashion, as often happens during a temporary decline in economic activity.

If banks had ready access to wholesale funds through the inter-bank market then their fears of illiquidity would be allayed. They could cover unexpected liquidity shortfalls by borrowing from banks with excess reserves without needing to offer collateral. However, with an inter-bank rate close to zero, as now, strong banks with surplus reserves are unwilling to part with them for a derisory yield. Weaker banks, including those in which the government has a stake, cannot readily bid for funds at an interest rate significantly above the inter-bank rate without signalling that they might be in trouble.

The solution is to reverse the Bank’s position: to reinstate the SLS for an extended period, and to begin to raise Bank Rate from its unhelpful and unrealistic low level of 0.5%. The market-determined three-month interbank rate was 1.02% in October, while the average interest rate on bank and building society accounts with notice periods was 1.19%. The logical response to the Euro-area threat to UK wholesale market funding is to strengthen the offer of substitute liquidity facilities to UK banks, not to compress interest rates. Once Bank Rate has been raised to around 2%, the volume of commercial inter-bank lending will recover and the Bank’s special liquidity facilities can then be withdrawn safely. Until then, the UK banking system is hamstrung in its capacity to lend to creditworthy unencumbered individuals and businesses by the ongoing and sudden threat of a contraction in wholesale funding in the context of a moribund inter-bank market. The UK banking system’s vulnerability to shrinkage of wholesale funding is every bit as great as when the crisis first struck in 2007. This is a plumbing problem that the Bank of England could and should have solved without recourse to an expanded balance sheet or the indefinite extension of crisis-level interest rates. In keeping interest rates at emergency low levels, the Bank is perpetuating the emergency.

As discussed in last month’s minutes, the psychological impact of increasing Bank Rate in the prevailing economic climate would be clearly damaging. However, it is imperative that the Bank of England relaxes the liquidity constraint on the UK banking system to head off a further tightening of credit conditions. When bank lending growth has recovered from this arbitrary clampdown, Bank Rate should be raised to the region of 2% as part of the normalisation of UK money markets.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold Bank Rate and maintain QE.
Bias: To hold Bank Rate and be prepared to raise QE total to £400bn by end 2012.

Despite a recovery of 0.5% in UK GDP growth in 2011 Q3, the economy has steadily worsened. In fact, the slowdown started around this summer, when the US Federal Government’s credit rating was downgraded by the Standard and Poor’s agency from AAA to AA+, and the European debt crises went viral. Without increased stock building and a rise in government spending, the British economy would have contracted in the third quarter. As it was, national output was just 0.5% higher than in the same period of the year before.

The latest indication from our December ‘Business Barometer’, which has survey data for November, shows that the economic prospects index fell to its weakest level since January 2009. Although companies’ own trading prospects in the Barometer have remained more resilient, the overall data imply that quarterly growth will be flat in 2011 Q4 and the provisional projection is for a 0.3% contraction in 2012 Q1. Interestingly, the new OECD projections published on the same day predicted a marginal fall in quarterly growth in the fourth quarter of this year and a 0.15% contraction in Q1 2012 – meaning a technical recession. Using Lloyds Bank Corporate Market survey data to predict the probability of recession in the next two quarters suggest a recession risk of 50% - up from 30% last month.

With this backdrop, rates can only sensibly be left on hold. QE is putting money into the economy via the banking sector and so ends up providing some of the liquidity that is required to help stave off the threat from any spill-over effects of the debt crisis in Europe. Nevertheless, with the economic slowdown in Europe likely to get worse before it gets better, it would be sensible to plan for a worst case scenario whereby a Continental recession tips the UK into a deeper downturn. In that case, the UK authorities will have to be prepared to inject up a total of £400bn into the economy, a further £125bn more than announced so far.

Reversing this monetary easing will be a challenge when the time comes for it to be done. Clearly, the risks are of higher inflation if this policy injection is not managed carefully. But not doing anything in the near term runs the risk of pushing the economy into as deep a downturn as in 2009. Strong growth in the rest of the world will help the economy only when the UK can orient exports away from Europe to faster growth markets elsewhere.

In the meantime, the UK is trapped in the reality that 50% of its exports still go to an economic area that is undergoing a period of extreme volatility and financial and economic challenge. It is true that the UK economy would have faced a crisis despite the problems in the euro zone - and one should not blame the UK's slow growth on Europe. Blame should go to a lack of the right skills, productive capability and export industries that have reduced the ability to switch from reliance on domestic demand and debt to export-led growth. Not even a weak currency has reversed the adverse effects of these structural weaknesses, although it may have helped ameliorate them. When combined with Europe’s challenge, the UK economy is very vulnerable in the short term.

Over time, the authorities will have to continue to reduce long-term government debt levels, to free up capital for the private sector to meet the challenge of focusing on the supply side of the economy. Help with Research and Development (R&D) tax credits, reform of regulations, long-term infrastructure spending and more incentives for skills training and apprentices will help the economy. However, these are all for the long term. In the short term, the direction of the economy has already been determined.

Appendix: ‘E-mail from America’

Editorial Note: The SMPC member Anthony J Evans is currently on an academic sabbatical as the Fulbright Scholar in Residence at San Jose State University, California. He has not been contributing to the SMPC UK Bank Rate polls while he was away. However, it was thought that his close-up view of the US economic scene would be of general interest. This section has been named ‘E-mail from America’ with acknowledgements to the late BBC correspondent Alistair Cook’s ‘Letter from America’. Anthony J Evans will shortly be returning to Britain and this will be his final US e-mail.

It seems increasingly likely than one of the intellectual legacies of the US’s continued economic woes will be the rise of Nominal Gross Domestic Product (NGDP) targeting. Inflation targeting has come under immense scrutiny and the main argument in its favour – the Great Moderation – has now turned into the Great Recession. As ever, economic performance tends to determine the fate of economic theory. NGDP targeting is nothing new. It has a rich lineage in the history of economic thought, perhaps championed most famously by Bennett McCallum. However, one can also find strong hints of it in the works of FA Hayek. The issue I want to draw attention to is not the idea itself – which it is assumed readers will be familiar with – but the way that it is spreading within American discourse.

The resurrection of NGDP targeting can be accredited to Scott Sumner, the Bentley University economist, who blogs at Throughout the current crisis, he has made repeated and persuasive claims that the US Federal Reserve’s policy response in mid-2008 was contractionary and that a credible commitment to a level target for NGDP futures would be the best cure. It is possible to have reservations about his views. However, it is fascinating how they have gained traction. Sumner’s blog soon got the attention of prominent macroeconomists, across several different schools of thought. These schools included monetarists (e.g. Bill Woolsey), Keynesians (Paul Krugman and Brad De Long) and quasi-Austrians (Tyler Cowen). Several other bloggers, including Nick Rowe, David Beckworth, David Glasner and Lars Christenson (who has written an academic paper on the spread of this movement) have formed an epistemic community that has gained the label ‘market monetarism’. In contrast to the Public Choice attention to ‘interest groups’ an epistemic community is a knowledge-based group, typically international, formed around an intellectual commitment to certain policy ideas.

And they are becoming increasingly influential. Christina Romer recently endorsed NGDP targeting in a New York Times article and the Federal Reserve Open Market Committee have held an “interesting conversation” on the idea. Thinking in terms of NGDP targeting is instructive not only in terms of the implied policy responses, but also as an interpretation of history. The Bank of England has de facto abandoned its commitment to 2% inflation, so observers are wondering what is guiding their decisions. There’s a plausible argument that NGDP growth sheds some light. Not only did cash GDP grow at 5% in the decade prior to the credit crunch – indeed, it rarely changed by more than 0.5 percentage points either side – but the official forecasts of cash GDP project that this will continue through 2016.

When interest rates are low, and the quantity of base money is high, economists and policymakers have a habit of getting confused about the monetary stance. Expectations in the path of NGDP provide a solution, and suggest that keeping inflation expectations anchored to 2% is a bad idea. Ironically, the good news is that the British MPC seem incapable of delivering this, so it may not stay this way for long. An alternative way to infer the monetary stance is to look at Federal Reserve holdings of US Treasuries (as a share of the total market). Given that monetary policy takes place through open market operations, the degree to which the Federal Reserve is ‘moving’ that market can be taken as a sign of their monetary intentions. In a new working paper, Justin D. Rietz of San Jose State University uses ‘Freedom of Information Act’ requests to attempt to uncover this information. He found that from 2002 to 2007 the Fed’s holdings fell from 19.6% to 15.9%, and that the Federal Funds rate hit its lowest point a full eighteen months after the Fed’s market share began to fall. He uses this evidence to conclude that other holdings – namely foreign governments – were driving US short term interests rates, providing empirical support for the global savings glut hypothesis.

In the ongoing discussion about a new policy framework, defining the monetary stance may form a crucial part of the debate.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other members of the Committee include: Roger Bootle (Deloitte and Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.