Today’s announcement of quantitative easing  – lowering UK’s interest rates to 0.5% accompanied by the decision to print more money – is widely acknowledged to be a total untried gamble and an admission of failure of all previously announced rescue-the-economy measures by the present UK government. It appears it’s the first time this is being tried in the UK, so we don’t know whether this will be successful or a total disaster.

Failures to date: OK, so nothing groundbreaking in the above statement. We’ve known that the late 2008 VAT reduction to 15% was a gimmick – now even the government acknowledges it’s had no impact. And we’ve known that all efforts to date to get banks to restart lending was a bit akin to ordering water to flow upstream. Gordon Brown might have been “disappointed” with banks’ reluctance to lend, but without transparency of information about the extent of toxicity on banks’ balance sheets we don’t stand a chance. 

Whether another government could have done something better or done it quicker, is a purely theoretical question. As this blog has said on past occasions, what is missing in Britain is true leadership, and what we have plenty of is political posturing on both parties’s sides. So we’ll leave this question aside for now as it is getting plenty of attention elsewhere.

Money talk: It’s far more interesting to look at the true intent of increasing the money supply, and here I will look at some bare basics. I am sure the economists amongst you will be able to add to this and please feel free to comment.

In a nutshell, the Bank of England controls money supply not just through printing notes in circulation, but also through its decisions to issue or buy back government securities and thus redeem money (tighten the money supply) or spend its money (ease the money supply). In our scenario now, BOE plans to buy £75 billion ($105 billion) of various assets and securities paying for these with its own money. This is akin to directly crediting accounts of commercial banks from whom these assets are purchased.

The intention is that once commercial banks will have more cash released from the sale of these securities, they will feel more inclined to increase their lending to the private sector and boost the economy. Demand is stimulated, and we’ll start getting out of this recession. Of course it’s not that simple, but you get the jist.

Another aspect of inflation: If inflation is on the rise, the real value of debt on everyone’s hands actually erodes. Which is to say, as the nominal value of the debt stays the same, as long as everything else – prices, salaries – move in line with increasing inflation, debt becomes a smaller portion of one’s income. It can thus be argued that one of the ways of dealing with an unbearable burden of debt is to introduce price inflation; one of its effects will be to reduce the debt burden on the debt holder and make it easier to pay it back all things being equal.

Impact of deflation: The Bank of England is actually very worried about the dangers of deflation. As the the Economist writes today, 

In a debt-laden economy such as Britain’s, deflation is the last thing anyone would want, as it increases the real weight of the burden.

It’s an opposite effect of inflation eroding the value of debt. So I think it is really not surprising that we are seeing the Bank of England turn to quantitative easing today. As long as they can keep it under contol, of course, which is what they are also worried about.

The timing of an untested strategy: I am wondering if it’s wise to launch this strategy and introduce monetary distortion (aka inflation) into the economy before the economy has stabilised following the deflation of the recent asset bubble. Don’t we have enough uncertainty to deal with without messing with key economic parameters again?

One key aspect still not addressed: And we are still not addressing the issue of the lack of transparency about exposure to toxic assets on banks’ balance sheets. Why isn’t something being done about by our government and regulators? Surely until we quantify the nasties out there banks will hang on to their newly obtained BOE cash, won’t want to lend, and the quantitative easing will have very little effect – another failed measure in the making?

So we’d still be asking water to flow upstream…

 

Copyright 2009 by CuriouslyInspired

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