Keep the change
The British economy is walking a tightrope. On the one hand it has deficits the size of Greece; on the other it has interest rates as low as Germany.
The coalition puts this remarkable, and unsustainable, state of affairs down to its much trumpeted austerity. Investors are said to be rewarding Britain with low interest rates for acting early and decisively to curb its ruinous borrowing. The borrowing costs of Greece, Portugal, or Italy are cited as examples of the merciless knee-capping Britain could have expected without it.
With the British public and government up to their necks in debt almost all points on the political map agree that higher interest rates are an evil to be avoided at all costs. So opponents of the ‘austerity’ program have to argue that continued borrowing won’t cause interest rates to rocket. They say that we won’t incur the borrowing costs of the PIIGS because we have our own central bank and can print our own currency.
They are arguing, in other words, that we don’t need to worry about turning into Greece because we always have the option of turning ourselves into Zimbabwe instead.
It might seem eccentric to worry about inflation right now. The Bank of England has forecast that inflation will fall throughout 2012, a prediction borne out by the most recent figures. Indeed, the M4 measure of broad money has been flat.
But this isn’t because the Bank of England hasn’t done everything necessary to generate inflation. Behind these figures lies incredibly aggressive monetary ‘stimulus’. Bank of England base rates have been held at 0.5 percent for nearly three years. Quantitative easing has seen £275 billion spent since the program was launched in March 2009 with another £50 billion announced recently. The Bank of England has seen its balance sheet balloon from 5 percent of GDP to around 20 percent, an increase of 300 percent, exactly the same as its growth in the highly inflationary 1970s.
We have been saved from higher inflation so far because banks aren’t lending the money out but using it to repair balance sheets ravaged by the collapse in mortgage backed asset prices. As demonstrated by banks’ failure to meet their Project Merlin lending targets the money the Bank of England has pumped out in these various manoeuvres has been parked up on banks balance sheets.
So far so ineffective. But banks aren’t in the business of sitting atop ever higher piles of reserves and policy makers at the Treasury and Threadneedle Street speak constantly about the aim of returning to more ‘normal’ lending conditions. If banks do begin to lend and this vast pile of newly printed cash finds its way out into broader money measures then we will see inflation.
We are told that this won’t happen because when this turning point is reached the Bank of England will step in to unwind its positions. It will sell the various financial assets it has bought under QE and remove from existence the money banks use to pay for them. The inflationary money will vanish.
This obviously relies on a bit of split second timing from the Bank. It will rely on the Bank of England retiring its holdings at exactly the rate the market can absorb; hold onto them too long and inflation will result, liquidate them too quickly and interest rates will spike. Anyone who has witnessed its lead footed lumberings of recent years might wonder if it’s capable.
But could the economy withstand it anyway? When the Bank sells the assets it has bought their prices will drop and, inversely, yields and interest rates will rise; the very same interest rates which, we are told, are an evil to be avoided at all costs in a highly indebted economy such as ours. It might, in fact, be the case that the British economy is now so hooked on debt that any rise in interest rates will generate a politically intolerable level of economic pain. If this is the case then vast monetary easing will remain with us until the inevitable point at which it brings collapse.
Of course, the Bank of England might just pull it off. Even so the British economy will have another tightrope to walk.
This article originally appeared at The Commentator