A sterling sidestep

Published in Business Spectator (Melbourne), 13 October 2011

For once Britain can be happy that there is the euro. As without all the discussions about Europe’s ailing currency, we would now be talking about the next sterling crisis.

As eurozone countries were once again engaged in a new round of emergency negotiations over Greece, bank recapitalisations and an extension to the EFSF rescue fund, the latest round of quantitative easing in the UK went almost unnoticed outside Britain.

The lack of international attention is despite the fact that a further £75 billion (approximately $A117 billion) have now increased the total amount of Britain’s virtual money printing exercise to £275 billion. What’s more, it is possible (if not likely) that the Bank of England will continue this policy to much higher levels. At least that is what remarks by the bank’s governor, Sir Mervyn King, suggest.

In an interview with ITN television, Sir Mervyn explained that it was concerns about a downturn in global economic activity that led the bank to resume its quantitative easing activities as a pre-emptive measure. If mere fears about future downturn are enough to trigger a new round of asset buying, an actual economic contraction would almost certainly mean even more money printing. At a bank rate of just 0.5 per cent the UK’s central bank does not have any other ammunition left in its monetary arsenal.

After fourteen years of formal independence, the Bank of England now appears more politically biased than ever before. When then Chancellor Gordon Brown delegated monetary policy to the Bank’s Monetary Policy Committee in 1997, the two core purposes of the bank were monetary and financial stability. Indeed, both objectives are still listed on its website as the top priorities. Supporting economic growth, on the other hand, had never been the BoE’s primary goal and yet it now seems to dominate everything else.

If it were otherwise, a resumption of quantitative easing would have been off the cards. Inflation as measured by the consumer price index currently stands at 4.5 per cent, and the Bank of England has already indicated it expects a rise above the 5 per cent mark in the coming months. The last time the index was below the 2 per cent level, which the bank defines as price stability, was in mid-2009. In its latest inflation report, published in August, the bank had predicted a return to this level by 2013. However, that was of course before the extension of the asset purchasing program.

Though Sir Mervyn claims that it was previous quantitative easing that had prevented a more severe economic downturn in the past years, the UK’s dismal economic performance makes such claims sound hollow. Of course it is possible that the UK could have fared even worse. On the other hand, not even he would seriously believe that asset buying was a miracle cure. In his rare TV interview, he was careful not to create great expectations about the bank’s latest intervention.

Although it is less than certain that quantitative easing will have a substantial effect on economic activity, the side effects for Britain are all too visible. UK savers and pensioners are now in the worst situation for decades. High street banks are currently offering interest rates on easy access accounts of 2.25 per cent at most. This means that UK savers are currently incurring substantive losses on their investment, especially after tax. Effectively, savings in Britain (not just the interest earned) are taxed – and every year savers are losing a proportion of their capital.

The Institute for Fiscal Studies, a widely respected public policy think tank, has just published a report on the social consequences of high inflation combined with low wages growth. It estimates that a typical family with two children on a moderate income would see their earning falls by about 7 per cent in real terms from 2010 to 2013. This is mainly due to the fact that wage increases – currently averaging 2.2 per cent – do not keep up with inflation.

The effect of ultra-loose monetary policy on ordinary Britons is painful. However, the primary victim of its policies is the Bank of England itself. After its asset buying activities, it finds itself in an unenviable position. Its credibility as an independent central bank is badly damaged, and its accounts are in a state that would drive any commercial bank to the brink of default.

Even before its latest asset purchases, the bank’s equity buffer was down to about 2 per cent of its balance sheet. Though the scheme is arranged in a way that ultimately makes the UK Treasury the final guarantor of any losses resulting from quantitative easing, this relationship between the British government and the Bank of England calls the latter’s independence even more into question.

In any case, the longer the bank’s bond buying activities continue, the harder it will be to understand who really backs whom. The bank has become a substantial holder of UK gilts, while the UK Treasury backs this gilt buying program. The result is a circle in which the government in effect guarantees paper which it had just purchased from itself with freshly printed money.

What is most frightening about the British situation is that there is no positive solution in sight. Previous efforts to get the economy back on track have produced meagre growth results while creating dangerous levels of inflation. There are no short-term growth effects to be expected from a contractionary fiscal policy, either. However, at a budget deficit of £163 billion, there is little real choice but to cut spending.

This leaves the bank’s virtual money presses as the only source of potential stimulus. And though this operation may buy Britain some time (as it indeed has over the past two years), the end result could well be a compromised and wrecked Bank of England, persistent high inflation and a severe fall in British living standards.

Under more normal circumstances, we would now be discussing the coming sterling crisis. That we are not doing so does not mean that it will not happen.

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