The Pause in Quantitative Easing

Finally, the Bank of England has ended the policy of Quantitative Easing (QE), albeit that they are describing it as a pause:

The Committee will continue to monitor the appropriate scale of the asset purchase programme and further purchases would be made should the outlook warrant them.

The weasel worded technical name has never hidden the underlying reality of QE; that it is identical to the running of a physical printing press to print money. The vast majority of that money has gone into the purchase of government debt, and the cumulative purchases have been enough to have funded much of the unprecedented peacetime debt racked up by the government:

The amount spent by the Bank of England on its asset-buying program since March is almost 89 percent of the 225.1 billion pounds of bond sales planned by the Debt Management Office for the current fiscal year.

The fig leaf used to justify QE was the prospect of CPI deflation, and with CPI inflation moving higher, the initial justification for QE has disappeared. The bank must now leave the UK government to sell its debt to private investors and overseas central banks. The timing of the ending of QE has both positives and negatives.

On the positive side, there is a looming general election, and the possibility of a new government that might make real cuts to the size of the government deficit. The Conservative Party still looks the likely winner of the election, and have expressed greater concern about the deficit than the Labour Party, but still with no real concrete plans for tackling the monumental scale of the deficit. Despite this, some investors might suspect that, fearing electoral damage, the Conservatives are hiding the scale of the cuts that they will undertake. The success of the issuance of government debt may well hinge upon such a weak foundation for some time yet, but the fragility of such a foundation leaves a very real possibility of a failed debt auction. Then there is the point that the Bank of England has not ruled out restarting the printing presses, which analysts believe has weighed down on the £GB.

The concerns over sovereign debt extends further, with the ongoing saga of the PIGS (Portugal, Italy, Greece and Spain):

The Spanish and Portuguese markets led the declines as investors' fears focused on whether government plans to cut their deficits are tough enough. By late afternoon, Spain's main market, the IBEX, was down more than 5pc and Portugal's benchmark, the PSI-20, was off a similar amount.

The prospect of a sovereign debt crisis has been seen as one of the biggest risks facing the global economy this year as the downturn catches up with heavily indebted countries. Attention so far this year has been on embattled Greece, where the Government's debts have jumped to 12.7pc of gross domestic product, but appear to be switching to Spain and Portugal.

Then there is also increasing concern over the size of the US deficit, with many analysts and commentators worried about a sea of red ink stretching out to the horizon. Obama's freezing of sections of spending has done nothing to dent the fears that the US deficit is unsustainable, as the freeze covers such a small portion of total expenditure. Obama's expressions of concern over the deficit mean nothing if action does not follow the words. The result is the prospect of a downgrade of US debt:

The credit ratings agency cautioned that if the US were to grow at slower pace levels than expected, the largest economy in the world’s already-extended finances could be over-stretched, in turn damaging its AAA credit rating.

This might again be seen as a positive for the UK, but the position of the ratings agencies on the UK is equally as concerned, and preceded the worries about the US. Moreover, this is a comparison of a bad situation with a bad situation, and does not detract from the underlying reality that both countries are looking increasingly risky places to invest money. It is a bit like comparing a man with broken arms and a man with broken legs, and trying to decide who is in the worse situation.

Whether the US, the UK, or the PIGS, there is a concern that there is no solution to what is becoming apparent as structural long term deficits. It is not the deficit today that is the major problem (though that problem is large enough), but the lack of any route out of the deficit spending. In fact, ballooning entitlements from demographic changes present the prospect of enlargement of deficits, and further declines in the tax base.

The solution to the problem that is proposed by governments is that they must ensure that their economies return to growth. When they say growth, they actually mean debt based growth, meaning replicating the ersatz growth that took place before the economic crisis. There is much lofty talk of the resuscitation of growth through new technology, and innovation, but it all sounds like the much vaunted service economy, or post-industrial economy, touted before the crisis hit. Whilst talking of the innovative and growing economy, the governments are simply spending and consuming the future wealth of their countries. As I showed in my last post on the US and UK, the increasing deficits being generated by governments a just a return to pre-crisis levels of consuming more in relation to what is produced.

When looking at sovereign debt, there are risks in every direction. Some analysts argue that Japan is looking high risk, others that the PIGS are ready to topple, and so forth. We can see the volatility and uncertainty in the currency markets, with endless shifting tides on each piece of data from each major economy and each policy response. It is now becoming a waiting game to see which economy will topple first, and set off a domino reaction around the world. In this context, is the UK at greater or lesser risk with the pause in the policy of QE?

There are many factors at play, which is the relative risk of UK debt in relation to other countries, as well as confidence in the overall economy. The UK does have a trump card in the forthcoming election, and the pause in QE may be seen as a positive. An alternative view is that the end of QE will now hasten a failed bond auction, and thus prompt the crisis. However, even if the UK does not lead a crisis, will a contagion from, for example the PIGS, just mean that the UK becomes a follower rather than just a leader? The UK is looking very vulnerable, and therefore is at great risk of contagion. This from Edmund Conway of the Telegraph:

Greece, in other words, is the fiscal Petri dish that reveals in gory detail what could happen in the UK if this Government – or the next – fails to maintain the confidence of investors. It is not merely that those interest rates are already inflicting an awful toll on borrowers in Athens and beyond. It is that they are sending the national government towards a full-blown debt spiral, in which the cost of its annual interest bill becomes so unmanageable that it can hardly afford to supply its citizens with basic services.

I take Edmund Conway's analysis with a very large pinch of salt but, in this case, his analysis is reasonable. Unsustainable borrowing will lead to problems, one way or another. The difference between the two countries is the UK can print its own money, but that of itself does not alter the need to eventually live within your means. It only serves to translate the nature and timing of the crisis (with potential for greater damage). However, will the Bank of England really end QE, or will the prospect of a failed bond auction see the Bank of England cave in, rather than see the crisis that follows such an event?

Perhaps the most curious aspect of the looming risk of sovereign debt crises is that, even as we read of them, we hear talk of economic recovery - albeit with many caveats. One of those caveats that is often mentioned is that governments can not sustain massive deficit spending forever. The problem is this; the 'economic recovery' is not a recovery but a rerun of debt induced growth, and the debt that is producing the growth is the driver of the potential sovereign debt crises.

If governments actually act to reduce their deficits, the so called 'economic growth' will disappear, and with it the confidence that the economies might service their existing debts. Their economies will contract rapidly, and with the contraction the debt to GDP ratios will soar and their currencies plunge. With the plunging of the currency, there will be the onset of rapid inflation, and loss of confidence by overseas creditors. For example, in a previous post, I estimated that, if just the overseas portion of US borrowing were to stop, the economy would contract by about 17%. That is just the impact of the end of overseas borrowing.

In this context, the US and UK policy of QE becomes clearer. Governments are on a debt treadmill - damned if they do, and damned if they do not. However, QE does not alter the underlying reality that an economy is consuming more than it produces, it simply alters the scope and nature of the crisis. It is a last gamble that something will turn up in the meantime to save the economies from the real underlying crisis. If all else fails, printing money to stave off a crisis in government funding looks more attractive to policy makers than the alternative being faced by Greece, on whom austerity measures are being enforced. The discontent within Greece has already started.

The reality is that Greece must now learn to live within its means. This is the reality that is being avoided with QE. Greece can not devalue, can not print money, and must actually accept that it is poorer than it would like to imagine. It literally means a lower standard of living than they have come to expect. In this context, I have to wonder just how permanent the pause in QE in the UK will actually be.

Note:

I read the interesting debate on the last post. I did however note some comments that were an attack on the person, rather than on their beliefs/views. I would prefer to see the issues debated, rather than the person, and generally think that the high standard of debate and thought (that contributes so much to the blog) would be better served by this approach. Many thanks, as ever for the links and contributions. I would like to respond to some of the points, but seem to have less and less time to do so, but will try to do so.