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....?