Wednesday, August 19, 2009

Monetization of Government Debt Continued in the UK

The Telegraph's economics editor's latest article headlines that 'Mervyn King Wanted to Buy Half of the UK Government Debt Market'. It is a headline that, of itself, is worth some contemplation. That the Governor of the Bank of England should propose such an extreme measure is quite astounding. Conway, as I pointed out in one of my early articles on quantitative easing, had been co-opted by the Bank of England, and was 'on board' with the program. However, even Conway appears to be having some reservations:
However, the argument will reignite questions over the ultimate purpose of QE. The Bank and the Government maintain that the idea is not in any way to monetise the deficit (in other words for the Bank to print money and buy government bonds in an effort to keep it from technical insolvency). I still believe them - though I know many of you are already sceptical. However, as the next years roll on and it becomes ever more difficult and painful for the Government to raise money in the capital markets, it will become ever more difficult to convince people of this argument – unless the world really does succumb to a deflationary trap of 1930s - or at the least Japanese - proportions. And that is a sentence no-one should ever relish.
The outcome of the policy decision is that Mervyn King failed to win the argument for the massive increase in quantitative easing that he wanted, but that the amount was still increased by £50 billion to a total of £175 billion.

For regular readers of Cynicus Economicus, quantitative easing (QE-printing money) will be a familiar subject, and my opposition to the policy has been consistent. In early articles (e.g. here), I identified that QE would be used once risk of failure to sell government debt loomed, and this is what has taken place. Just as government finance commenced a severe downward spiral, QE 'coincidentally' appeared as a new policy tool.

In a recent article, I identified that QE was supporting the UK gilt (bond) market, and that even a hint of ending the program saw bond yields start to soar. I also noted in another article that the Bank of England was introducing a new 'exit strategy' for QE, which was the issuance of short term Bank of Englan bills, rather than the sale of the gilts back into the market. If QE is not about the monetization of debt, why not simply resell the gilts? This is the most simple and direct reversal of QE policy...

Then there is the deflation scare that is used as the justification for the policy. In each Bank of England report, deflation is just around the corner, but never seems to materialise. As I discussed in one article, inflation has not yet even reached a level far enough from the 2% target to require a letter of explanation from the Bank of England. Despite this, a radical and highly unconventional policy has been implemented. Furthermore, there is no evidence that deflation is actually a 'bad thing', as I explained in a recent article, with no empirical evidence or justifiable explanation for the scare.

Finally, there is the convoluted justification for why the Bank of England is buying gilts, rather than other assets, as a means of expanding the money supply. Quite frankly, the Bank of England explanation makes no sense at all (discussed here). There is simply no justifiable explanation for the necessity to buy gilts over other assets.

The Bank of England has nevertheless reached a point at which it is expanding QE, and the Monetary Policy Committee (MPC) minutes make fascinating reading. I strongly recommend that you read them in full, as you will find frequent use of terms such as 'may have', 'could have', or 'possibly' in reference to the outcome of the policy to date. It is very clear that there is considerable uncertainty about the actual effects of the policy but, despite this, the policy is being continued.

Even more interesting than the MPC minutes is the most recent Bank of England inflation report, which is full of caveats and speculations. This section is typical of the general thrust:
The upward pressure from sterling’s depreciation depends on the extent to which companies need to adjust further to the higher import costs and on whether this adjustment comes through higher prices or lower wages. There may also be upwards pressure on inflation from rising global energy and commodity prices if world growth picks up by more than expected. There are risks in both directions that inflation expectations may become less firmly anchored, although the committee’s commitment to maintain inflation close to target should help to limit those risks.
At least the August inflation report shows the Bank of England has finally accepted that the weakening of the £GB will push up import prices and therefore impact upon inflation. In December 2008, I reviewed the prospects for inflation and concluded that 'In the case of the UK, the inflationary pressures have already commenced with the ever weakening £GB, but for the US, it will take a much firmer shove.' Even at that time, it was obvious that a falling £GB would have a counter effect to the deflationary impacts within the UK economy, and I 'guesstimated' that the impact would be broadly neutral overall.

In this latest inflation report, the Bank of England suggests that there will be volatility in inflation, and on this occasion I find myself in agreement. However, the prospects for volatility once again raises the question about why the policy of QE is being continued. From the outset, the Bank of England admitted that QE was an unconventional policy, and the MPC minutes show that the Bank of England is uncertain about the outcome of the policy in action. Even were it accepted that this policy was positive in principle, it seems that any justification must require a greater degree of certainty than the volatility and uncertainty discussed by the Bank of England.

The continuation of QE is once again built upon flimsy justifications. The simple truth is that the Bank of England is now on a treadmill in which it must continue the policy to prevent a collapse of the UK gilts markets. However, the further the Bank of England goes, the greater the build up of inflationary pressures, and the greater the danger when the policy finally unwinds. The Bank of England is supporting the fiscal irresponsibility of a bankrupt government, which is both bankrupt in terms of money and bankrupt in terms of ideas (the opposition are still not much better).

I had a brief moment of optimism that perhaps, just perhaps, the Bank of England was going to rebel, and withdraw support for the government's fiscal irresponsibility. I can now only conclude that the institutions of the UK are now all firmly intent on a path of that can only damage the UK economy. I have lost all confidence that there may finally be a stepping back from the brink. The UK economy is heading towards disaster. It is now just a question of when, and how the disaster will actually play out. After all, government deficits are still growing, the bond market is already fragile on the current issuance, and there is no prospect of a return to balanced budgets, let alone surplus. At what time could the Bank of England step off the treadmill? One years time, two years, or three....?


  1. Tiberius:

    Many thanks for the link on my last post.

  2. Cynicus,

    No problem - I figured you'd have been quick on this! ;)

    My own blog is on a temporary hiatus as I find myself in such utter disbelief at the situation this country finds itself in that I am unable to adequately express it. Glad to see you're fighting through though!

    You think the government is "bankrupt in terms of ideas"? How about this one:

    PLANS for mass graves have been drawn up to cope with a second wave of swine flu this Autumn.

    The chilling proposals are spelled out in a Home Office document discussed at a meeting of Whitehall officials and council leaders last month.

    Perhaps they've found their 'exit strategy' after all!


  3. PS. You may also like this - another fellow cynic!

  4. Tiberius:

    By coincidence, I took a look at your blog today after your first comment, and was surprised to see no new posting.

    I can quite understand your sense of disbelief. On a personal level, I kept hoping that someone, somewhere, somehow would reverse this course. As I mentioned in this post, I hoped for 'green shoots' of sanity in the Bank of England, but this latest news has crushed such illusions. I had thought that maybe, just maybe, the Bank would have enough sense to call time.....

    I have always been at the gloomy end of the commentators, but never imagined this scenario, that policy could be this catastrophic. It is moving in a direction so wrong-headed that the outcome is now beyond my imagination.

    Like you, I share a sense of disbelief....

  5. Good post, the official propaganda about the money printing is slowly being exposed to the light of truth. The fact that inflation has stood still despite being predicted to drop shows that something is wrong with their story.

    As Guido points out here

    The BOE may be talking up deflation, but has its pension fund in inflation protected securities.

    This really inspires confidence in their judgement.

    Lefty Feep

  6. Question: Why aren't wealthy people and institutions with £GB assets screaming about QE? QE is taking purchasing power away from existing holders of £GB, and pouring it into the Treasury and into rebuilding the banks' balance sheets, so those with big £GB assets should be objecting. Are they so scared of asset price deflation that they're prepared to accept a stealth tax on their assets as the lesser of two evils?

  7. Could this be part of an attempt to increase the real money supply by stealth?

    BBC Business: 'More £5 notes for cash machines'

  8. CE
    I posted the following comment in yesterdays Times. It seemed to cause a worried reaction. Reading this blog it seems you think we could actually end up down the Zambezi.

    steve potts wrote:
    Between 1979 and 1990 the Zimbabwe Government propagated a whole range of new economic policies, including a minimum wage.
    Between 1979 and 1990 total spending on healthcare trebled. Expenditure on public-sector employment rose by 60%, and on the civil service by 12% per annum. Central government expenditure increased its share from 32.5 percent of GDP in 1979 to 44.6% in 1989. Interest rates were artificially capped.
    This in turn generated a chronic budget deficit and a rapid increase in public debt. Private investment was crowded out by shortages of credit stemming from the fiscal deficit - all of which created a last resort - QE

    Fast forward 18years - things in Britain sound eerily familiar.

  9. CE

    I have been lurking for some time as I've been up to my ears in directing Shakespeare's Timon of Athens at a professional fringe venue in London.

    Timon centres aroud the life of a man very similar to your 18th century aristocrat who lavishes spending on his friends only to find it's all built on a sea of debt he has ignored. When those same friends deny him any help he leaves Athens and turns misanthrope using gold he then finds to sow destruction in Athens.

    As you'll have gathered it's brilliantly relevant...!

    Reason for the post was to request your permission to use one of your blog posts in the programme.

    No worries if for any reason you'd rather not but would be great if you could.

    The play is on at the Barons Court Theatre, London. Sep 1st - 12th.

    Keep up to good work!



  10. Matt:

    Of course, no problem. I am flattered that you might consider this. Use the material as you wish!


  11. Reasons for the Commodity Price Spike in Food of 2008

    Here is an in-depth analysis of the commodity price spike in food of 2008:

    It offers a better explanation for the food price spike than Cynicus' theory about the doubling of labour "combined with capital, technology and access to the world market."

  12. Lord Keynes

    I didn't know that CE had explicitly blamed global food shortages on the doubling of the global labour force, but the article you refer to does stress that "depeasantization" is a factor. It includes the following sentence:

    People are pushed off the land at an accelerating pace as farmers and the general population become more integrated into world markets...

    The way I read CE's argument is that any artificial distortion of free market mechanisms will ultimately result in a reduction in the efficiency of all aspects of the economy, including food production. Many of the factors cited in the article could be as a result of a sudden increase in the global workforce (which happened because of 'artificial' political policies).

  13. I remain depressed by the inability of the people around me to see just how grim everything is getting. Frequently people say: "See, you've been worried all this time and yet the recession is over!"

    My brother said: "There isn't a recession. It's fake. Everybody has loads of work. Your worried about nothing." I despair, really.

    Even now, even with some commentators finally coming around to the true state of things, people presume all is well.

    Recovery has "apparently" begun. We'll be "back to normal" by the end of the year. This "short" recession was a mountain being made out of a molehill. That's what people keep telling me ... so it MUST be true then.

  14. Hi Cynicus,

    Death to Bubble Addicts here. I've been busy trading the bull market so haven't had time to follow your outstanding blog. I hope you are well!!

    Looks the double-dip is being set up to hit in 2010. The debt-junkies are being kept afloat on cheap money but the piper has to be paid.

    The Bears are coming out on Sterling and reckon it will really plunge once the Tories win, say four weeks after vistory. "Buy the rumour sell the fact". It is probably the expectation of a Tory victory that is giving confidence to traders. I have little confidence in the Tories. Cameron and Osborne come across as lightweights. They are always behind the curve and scared to voice a strong opinion. I think they lack intellectual confidence.

    Take care


  15. Mark

    You're going to have to re-think your entire idea of how the economy works. From a headline article in today's Guardian entitled

    "Surge in business confidence means UK recession 'at an end'"

    A record surge in confidence among business professionals indicates Britain's recession is at an end, according to research...

    Coupled with euphoria after England captured the Ashes last night, the news fuelled gains on the London stockmarket this morning...

    On no occasion over the last two years of reading your blog have I ever seen you refer to national sporting results as being a critical factor in the economy. I really think you need to pull your socks up on this one.

  16. Lemming:

    Well, if we have won the ashes, then we know that it is all going to turn out ok....looks like I need to revise my view on the UK economy...

    All we need now is a rugby world cup win, and we will be back on the economic leader board..

  17. Apparently the British Dental Association is predicting a recovery as the number of Veneers is almost at 1994 levels. We're saved!


    No real surprises in there, but here's a study on how we maintain our beliefs in the face of contrary evidence.

    Study demonstrates how we support our false beliefs

    ..."Our data shows substantial support for a cognitive theory known as 'motivated reasoning,' which suggests that rather than search rationally for information that either confirms or disconfirms a particular belief, people actually seek out information that confirms what they already believe.

    "In fact," he says, "for the most part people completely ignore contrary information.

    "The study demonstrates voters' ability to develop elaborate rationalizations based on faulty information," he explains...

    ...We form emotional attachments that get wrapped up in our personal identity and sense of morality, irrespective of the facts of the matter...

    ...So voters' ability to develop elaborate rationalizations based on faulty information, whether we think that is good or bad for democratic practice, does at least demonstrate an impressive form of creativity."


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