Synopsis
Mervyn King, the Governor of the Bank of England was in Cardiff last night, a speech to the South Wales Chamber of Commerce delivered at the Millennium Centre. Old anthems rang out through the valleys as the Governor spoke of the need to rebalance the economy and outlined the merits of quantitative easing.

“The need to rebalance the economy remains one of the main challenges to economic policy. We need to rebalance the economy away from domestic spending, towards exports and investment.” Puzzling then the exact opposite seems to be the case, the paradox of policy, his preferred term.

But is this such a paradox of policy or more a confrontation with economic reality? There is no paradox of policy, it is a perversion of policy that is to blame. Old Anthems in the Valley must ring true through the hills. Perhaps there is no paradox of policy just the inevitable clash as economic theory confronts reality of life. We should be realistic and honest about policy and QE along the way.

Main Article
Mervyn King, the Governor of the Bank of England was in Cardiff last night, a speech to the South Wales Chamber of Commerce delivered at the Millennium Centre. Old anthems rang out through the valleys as the Governor spoke of the need to rebalance the economy and outlined the merits of quantitative easing.
Dark clouds over Europe and new clouds as yet of undefined definition have drifted over China, India and Brazil. Yes, growth in China has slowed to 7.5%, the implications for Cardiff beyond significance as the Governor offered consolation, “Your economy is suffering too”.

This “sceptered isle, this precious stone in a silver sea is like some storm tossed vessel”, the Governor explained, the audience turning green no doubt as mal de mer swept around the millennium hall

“The need to rebalance the economy remains one of the main challenges to economic policy. We need to rebalance the economy away from domestic spending, towards exports and investment.” Puzzling then the exact opposite seems to be the case, the paradox of policy, his preferred term.

But is this such a paradox of policy or more a confrontation with economic reality? The Governor believes the world behaves as the economic models predict. The Governor lives in a DSGE model, Dynamic, (subject to change), Stochastic (subject to shock) General (covers a lot of things) Equilibrium (adds up down and across), and overall in the long run returns to balance.

Unfortunately certain “imbalances” do not return to equilibrium except perhaps in the very long term. The US – China trade imbalance, the German trade surplus, the inherent structural UK trade deficit, consumer spending in the West, imbalances persistent and protracted.

Recovery led by the march of the makers rebuilding the workshop of the world has not taken place. It was never likely to happen. A surge in investment stimulated by low interest rates was never likely to happen either as long as domestic demand remained constrained. Depreciation of Sterling would not lead to a recovery in net trade since much export led growth is dependent upon imported raw materials, basic commodities and semi manufactures.

Depreciation of sterling, is more likely to lead to an increase in domestic price levels, given the rise in dollar denominated energy and food costs, the resultant pressure on household real incomes providing a further constraint to recovery and growth.

There is no paradox of policy, it is a perversion of policy that is to blame. The Governor promised a serious explanation of what the bank can do. But in doing so demonstrated the disconnect between theory and reality.

Consider for example the impact of monetary policy on households. “Monetary policy supports demand and output by encouraging households to switch demand from tomorrow to today” but when tomorrow becomes today, more stimulus is required until tomorrow becomes not just today but yesterday”.

OK I paraphrased a little but the impact of interest rates on households does not impact on spending intentions. Mortgage related payments (or returns on savings) have a direct impact on incomes in the same way fiscal direct taxes impact on real wages.

Consumption models geared to life cycle or permanent income hypotheses offer little explanation to take home pay hit by energy and food bills exacerbated by imported inflation, mitigated by lower mortgage payments over the short term.

Easier monetary policy does not encourage households to switch demand from one period to the next, it just makes it easier for households to get by on a day to day basis.

The Governor also explained the mechanics of Quantitative Easing. Buying gilts pushes up prices and lowers yields, higher asset prices increases wealth and (our models tell us) leads to an increase in expenditure.

QE pushes up gilt prices and lowers yields, this is clear, the precise impact of wealth on spending is obscure and the empirical research is clouded in assumption.

But this is not the real complaint about the Governor’s proposition. The Governor claims the Bank is purchasing gilts from the non bank sector, yet concedes, the quantity of gilts in private hands is higher now than when the Bank began the asset purchase programme.

In fact the increase in total gilt stocks has increased by over £500 billion since QE began, of which the Bank of England has bought over 70%. So if the quantity of gilts in private hands has increased, from whom has the Bank of England acquired the gilts?

The answer directly or indirectly is the Bank of England has been gilts from the Debt Management Office, a form of debt monetization. This may or may not be a good thing, it reduces the cost of Treasury funding and avoids “crowding out” of government spending . If we accept this, we can better understand the process, and can better understand the impact on the economy and the methodology of the unwind.

QE is not of itself inflationary but neither is it good or bad money. It is a form of debt monetization. So how do we unwind? The Bank is unlikely to “cancel” the debt owed by Government and will find resale of the Gilts challenging. The debt will not be cancelled but extinguished by holding to redemption.

The Bank has been reactive and accommodating in an attempt to avoid another Great Depression or Lost Decade. This is a good thing. But policy must avoid outdated theory and dogma and reflect reality.

Old Anthems in the Valley must ring true through the hills. Perhaps there is no paradox of policy just the inevitable clash as economic theory confronts reality of life. We should be realistic and honest about policy and QE along the way. JKA