Uncharted Territory

January 8, 2009

On Deflation and Quantitative Easing

Filed under: Credit crisis, Economics — Tim Joslin @ 12:43 pm

The latest panic move by the UK authorities may well be to “print money”, much to the outrage of the Middle England tabs.  I’ve spent a good part of the last 24 hours trying to understand exactly what’s going on.  So here’s my take.

The government doesn’t want to just let events run their course, because what they’re worried about is the election… oh, sorry, I mean “deflation”, or falling prices.  Now, people like me, a heavy consumer of home electronics, have come to know and love the deflation phenomenon of consistent falls in the price of, for example, computing power and portability.  Not a problem.  Far from it.

The trouble is, deflation in other parts of the economy causes some quite nasty problems.  Property (domestic or commercial) is perhaps the main worry.  When property is worth less than the loan taken out to purchase it (negative equity), the owner is effectively trapped, as the value of the debt in effect increases.  Economic activity slows, as, even if insolvency or its consequences (bankruptcy etc) is avoided, it becomes more difficult to take advantage of new investment or spending opportunities, e.g. you can’t trade up from the starter home to the semi.  Prices continue to fall.

Then there is the process of falling prices.  It might not be so bad if the whole thing happened overnight.  Rents, in particular, are slow to fall – especially if the landlord has a debt to worry about! And it’s difficult for wages to fall generally – employees have debts and rent to worry about (since rent and mortgage payments may not fall proportionately, any salary reductions that are forced through will disproportionately affect discretionary spending, causing prices to fall further).  Instead, companies are likely to cut costs by laying workers off, again causing prices to fall further.

On the other hand there may be investment opportunities for those without a (growing) debt burden, especially as rates for new lending would be near zero – though another problem is that they can’t go negative.  New entrants in (say) retail or the housing market are suddenly at a distinct advantage compared to incumbents – the trouble is there are unlikely to be enough of them, and they are likely to hold off while prices are still falling.

This is a scenario the government (and economists) are especially keen to avoid.

The idea of “quantitative easing”, as I understand it, is to (in effect) print money. The idea is that, by issuing more cash, the value of money tends to fall, so prices tend to rise, counteracting the dreaded deflation.

Now, I’m a little worried by the way the process is explained by some of our leaders – Saint Vince Cable, for example.  Vince describes it this way:

“What happens is that the government borrows from the Bank of England, not from the markets.”

Fine, we’ve increased the national debt.  We have obtained some cash for public spending (or other uses such as tax rebates or reductions – some economists even think the government should just write cheques to everyone), but haven’t soaked up exactly the same amount of private cash to purchase the bonds.

But Vince says in the next sentence that we’ve managed to borrow without incurring a debt:

“It expands the money supply to keep the economy going and also to counter deflation without simultaneously increasing government debt.”  [my stress].

I wonder why the Japanese didn’t think of that?

Even more worrying, there may be some complacency about the cost of this cunning scheme.  Anatole Kaletsky writes (he’s talking simply about a big increase in public spending or tax cuts, rather than quantitative easing specifically):

“The beauty of such policies in a world of zero or near-zero interest rates is that they are effectively cost free.”

Interest rates for government borrowing are only low now, because investors see the alternative uses for their money as too risky.  I hate to criticise, because Kaletsky, like me, is sceptical about the virtues of saving. But…

Unfortunately, eventually you have to pay the piper.  When you come to roll over the debt, interest rates will be much higher (assuming the policy has worked).  I gather this happened in Japan, who in some ways were in a better situation, as at least people wanted their currency to buy their goods.

I mention this, because, as I understand it, the idea is not to keep the bonds issued for the debt in a tidy pile in the Bank of England’s safe (though even there they would have an effect on the market).  Rather, the cunning plan is for the Bank (as the Bank of England is simply referred to in the trade, interchangeable with the “Old Lady”, as in the “Old Lady of Threadneedle Street” – but I digress) to exchange the government debt for illiquid assets, e.g. the dreaded mortgage-backed securities. I gather the Fed is doing something like this in the States.

Since the plan involves a little more than the Chancellor giving an IOU to the Governor, Alistair “Blackadder” Darling would have to work closely with Mervyn “Baldrick” King.  Which, of course, the Old Lady doesn’t like as it undermines her independence.  And of course, the Bank is uneasy about the whole plan, since it complicates its job of controlling inflation.

Well, that’s my understanding of what’s going on anyway.  Watch this space…

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