An Agenda for Gold?

For those familiar with this blog, they will know that I am not overly supportive of a gold standard currency, but that I think that it is better than the current fiat money system (see here for my alternative). As things stand, we can now see the dangers in the current fiat system, which is the ongoing debasement of many currencies through money printing (QE- Quantitative Easing).

It never does any harm to emphasise the point that so-called QE is absolutely no different from running a physical printing press, even though there are occasional commentators who try to suggest it is different. Creating money by electronically crediting a bank with previously non-existent money is no different from running a printing press and shipping the newly printed money into the bank's vault. In both cases, money is created and an asset is purchased. It is just that the former does so without the bothersome necessity of running a physical printing press. I suspect that, if the central banks were to be undertaking the old-fashioned printing press method, there would be greater outcry against the policy of QE. Trucks filled with newly printed money arriving at banks would focus minds and attention on what is taking place. As it is, the modern method of money printing is just abstract enough to obscure the reality of what is taking place.

However, it seems that commentators are now starting to see that there is something wrong with the new policy of printing our way out of troubles, and the gold standard is moving up the agenda. This from Forbes:

There is nowhere left to hide. America’s governing elites begin to internalize the magnitude of their failure to generate jobs. CBO now predicts worse than 8% unemployment until 2014. America begins to engage, seriously, with the implications of the faltering dollar and reconsider the appeal of the gold standard. From The New Yorker to The National Interest to The Washington Monthly to The Nixon Foundation, thoughts turn to gold.

The linkage between returning to a gold standard and the urge to print money is obviously related. Once again, there is talk of printing money in the US, or QE3:

As Wall Street parses the message the Federal Reserve chairman sent in his speech Friday from Jackson Hole, the narrative that has taken hold includes, on one level or another, more action to help boost the markets and the economy.

That was supported Monday with key endorsements from Fed presidents Charles Evans and Narayana Kocherlokota, who both said they either would support further monetary measures or a continuation of the ones already in place.

Whether future moves come in the form of traditional quantitative easing or something else is what Bernanke and other Fed officials must decide between now and the next Open Markets Committee meeting on Sept. 20. The expectation for easing was heightened when Bernanke said the meeting would be extended from one to two days, indicating that serious consideration would be given to additional monetary measures.

The UK is also flirting with another round of money printing, with this from the Guardian:

Hopes of a fresh round of quantitative easing in the UK increased on Thursday after Martin Weale, of the Bank of England's monetary policy committee (MPC), used a speech in Doncaster to say there is "undoubtedly scope" for the radical recession-busting policy to be extended.

Weale, who was one of two hawks advocating an increase in interest rates until he changed his vote at this month's meeting, said the Bank could restart quantitative easing if oil prices continue to fall and the sovereign debt crisis in the eurozone worsens.

Warning that events on the continent are a greater threat to the UK economy than the slowdown in America, Weale said: "There is undoubtedly scope for further asset purchases to trigger further reductions in yields on government debt should the need arise."

The European Central Bank (ECB) is more constrained, with an inbuilt philosophical opposition to printing money:

New York professor Nouriel Roubini called on the ECB to reverse monetary tightening immediately given the darkening global picture. "It should reduce rates to zero, and make big purchases of government bonds," he said.

Frankfurt is unlikely to heed the advice. The bank's president Jean-Claude Trichet, last week stuck to his anti-inflation script and said "we do not do QE".

The ECB began buying Spanish and Italian bonds for the first time yesterday, causing 10-year yields to plunge by 90 basis points. However, an ECB statement over the weekend came with too many strings to satisfy investors. The bank is likely to be tested over coming weeks.

David Marsh, co-chairman of OMFIF, said the statement was "half-hearted" and suggested that dissenting German hawks were imposing limits. "The ECB is clearly not going in with all guns blazing," he said.

Notwithstanding the growing discussion of a gold standard, one of the great curiosities about QE is how it has now entered into mainstream commentary as if it were a perfectly reasonable thing to do. There are all sorts of justifications given for the policy, but the lack of any remit for central banks to undertake the policy is quietly ignored or forgotten. The most obvious case of this is the Bank of England, which is supposed to use monetary policy to target inflation. Despite several years of overshooting the inflation target, as can be seen from the earlier quote, QE is back on the agenda in the UK. How is it that the Bank of England's remit is forgotten by so many commentators?

It seems that there is a growing divide in mainstream commentary on the policy of printing money, with some expressing fear about the consequence of the policy and moving back to the idea of a gold standard, and others supporting the policy as a magic bullet for the economic woes that are assailing so many economies. At the heart of the debate is the question of inflation, with those who are anti-QE arguing that it is inflationary, and those in favour suggesting that the lack of massive inflation following early QE demonstrates that the fears of inflation are exaggerated. A good explanation comes from Liam Halligan:

The reality is QE has already done an awful lot of damage. America has expanded its base money supply three-fold in two and a half years – from 6pc to 18pc of national income. But even this jaw-dropping measure hasn't led to much of an expansion in monetary measures, such as M2 that include bank lending, precisely because the banks, for all the propaganda to the contrary, are still determined not to lend. They can make more money simply channelling QE money into stocks and other investments.

Crucially, the banks also remain petrified of counter-party risk in the inter-bank market. Many of them, disgracefully, are still concealing vast sub-prime losses in off-balance-sheet vehicles. So they assume other banks are doing the same. Such mistrust between the banks – "we're lying, so they must be lying" – gums up the wheels of finance and starves even creditworthy firms of the funds needed to invest and create jobs.

That's why M2 has remained flat, despite a massive expansion of base money. The way to break the deadlock, though, isn't to do more QE, but to end inter-bank torpor by forcing "full disclosure" of bank losses. Such disclosure is barely happening, on either side of the Atlantic. The UK's monetary base has also tripled, while producing – for the same non-disclosure reasons as in the US – only minimal growth in M2.

Liam Halligan has captured one element of the reason for the lack of inflation, and another is the exporting of inflation through the 'carry trade', as the Wall Street Journal reports:

For much of the past two years global investors borrowed dollars and Japanese yen at the rock-bottom interest rates set by the U.S. Federal Reserve and the Bank of Japan and then poured that cheap money into currencies like the Australian dollar and Mexican peso to earn much higher interest rates.

Now, those popular "carry trades," which profited from a difference in interest rates as high as 12 percentage points in Brazil's case, are starting to unwind as investors lose faith in the outlook for global growth and fret over financial turmoil. If it continues, it will bring an end to a rally in emerging market and commodity-based currencies that began shortly after the Fed slashed rates to near zero at the end of 2008 and it could drive up borrowing costs for banks, companies and even households in those countries.

That unwinding could be cut short if the Fed's announcement Tuesday that it would keep its target interest rates at "exceptionally low" levels "at least through mid-2013" makes carry trades attractive again. But the problem with the strategy is that it is only profitable if currencies are either stable or if the funding currency is falling against the investing currency. And if the past week's bout of global financial turmoil persists and puts emerging market and commodity currencies under more pressure, many investors will be forced to throw in the towel and buy back dollars.

The problems of the carry trade for the recipients has led to reactions to try to prevent the inflows of 'cheap' money, such as Brazil establishing capital controls:

Brazil has been vocal on one of the themes put on the table by France as G-20 chair: how to better police capital flows globally. Several emerging countries, including Brazil, have been faced with buoyant capital flows in search of higher yields, which have put upward pressure on their currencies and hurt their exports.

Countries have reacted by imposing capital controls or intervening on their currency in a unilateral way. This has prompted the G-20 to try and coordinate capital controls better, so as to avoid adverse impact on growth from disorderly moves.

This is what I had to say in TFR magazine in December 2009:

But there is also another factor, there is increasing talk of a US dollar ‘carry trade’, as a result of dramatically increased liquidity combined with near zero interest rates.

The idea is simply that a good return on investment can be made by borrowing at a low interest rate in one country, and investing in another that has a higher interest rate. In doing so, the inflationary effects of printing money are exported to the country that is the destination for the carry trade.

This was what happened when Japan resorted to quantitative easing, with the printed money going west in the yen carry trade, acting as one of the sources of excess liquidity for the credit bubbles that burst in 2007 and 2008. There is less talk of a sterling carry trade, but it’s fair to assume that, with monetary circumstances similar to the US, something similar may be taking place there (albeit on a much smaller scale).

The interesting point here is that, as a result of the carry trade, Japan itself did not experience the inflationary effects of printing money. The case of Japan is cited as the reason why inflation will not take place in the UK and US. However, there is a fundamental difference between the UK, the US and Japan.

During the period of the carry trade, Japan was generating a large current account surplus, so the flood of yen onto the market did not result in significant currency weakness. By contrast, both the UK and US have been (and continue) to run large current account deficits. In both cases the currency is already sitting on weak foundations and, therefore, export of the dollar and sterling into the carry trade will simply put more pressure on the value of those currencies. They are flooding the market with currencies for which there is already a potential over-supply.

What we can see is a problem looming on the horizon. Output in both the UK and US has fallen (and is still falling in the UK), which means that some of the effects of the reduction in credit are already ‘eaten up’.

Furthermore, the governments of both countries are stepping in to fill the void of private credit contraction with government borrowing. If the money sitting in central banks were to enter into the economy, there would be a real increase in the money supply and this would cause rapid inflation. On the other hand, if the money exits the economy via the carry trade, it will severely weaken both nations’ currencies and re-enter the economy through the back door of import-price inflation.

At the moment, the increase in money has not entered into the real economy, but it will do at some point. I suspect that it will be through the back door of the carry trade.

What we can see in Liam Halligan's analysis and my own explanation is the reason why it is that we do not currently see massive (or hyper) inflation in the money printing economies. However, what we can also see is the potential for inflation to start a rapid upwards climb in the QE economies. The only way that the money supply might be reduced is to reverse the QE, which would mean selling the government bonds that have already been purchased and destroying the proceeds of the sale. Could markets absorb such a sale when government debt is already flooding the markets? It seems improbable.

For the proponents of QE, the lack of massive inflation is used as a justification for continuation of the policy. For those who are arguing for a return to gold, they can see that somehow, at some point in time, the massive expansion of the monetary base in QE countries must eventually see a rise in inflation. For the latter, they are not always clear in their understanding/explanation of why massive inflation has not taken place. However, their instinct that QE must eventually have a price is correct. Furthermore, the price is already being paid around the world as easy money has flooded into other economies. That in turn is creating distortions in markets, and those distortions will ripple back towards the countries that caused the problem in the first place. Again in TFR, this is what I had to say about 'extreme policy' in the context of the 'carry trade':

From enactment to (unpredictable) result, there is a period during which the effects of the policy build and interact with the results of other policies and the markets, both domestic and international.

It can therefore often take a long time before the full effects become apparent. As they do become apparent, the other actors respond with their own policy provision, and the effects of that policy will again take time to impact.

Among all of the major economies, the responses to the economic crisis have been extreme policy making. We are only now seeing the full impacts of those policies, and the reactions to those policies are building. The underlying problem is that, the more extreme the policy of one actor, the more likely that the response of another actor will be extreme. The world economy is a dynamic system, and the actions of each policy will, in the end, lead to a response from other actors in the world economy.

As such, when actor ‘A’ pulls on policy lever ‘X’, they really cannot see the outcome of their own actions. The larger the actor, and the more extreme the policy, the greater the chance that the reaction of other actors will also be extreme. The greater the reaction of these actors, the greater the reaction that will be forthcoming in response.

And so it continues, creating an ever more unstable system; the more the levers are pulled, and the harder that they pull on them, the greater the potential for the policy intentions to be confounded, and the greater the general instability.

We can see this instability taking place. We see, for example, the Swiss taking ever more radical measures to try to lower the value of their currency in the face of the 'safe haven' purchases of their currency. We can see the instability in the surge in the gold price. We can see the instability in the on-off panics in markets. Every day we see more examples of the instability.

One way or another, the effects of extreme policies such as QE ripple out into the global economy, only to eventually wash back in unpredictable forms. The great conceit of the policymakers is that they think that they know what they are doing. In the end, the call for a return to a gold standard is really a call for the policymakers to take their hands off the levers of monetary policy, as they do not really understand what happens when they pull on the levers.

The Use of the Expression 'Sterling Crisis' Increases Day by Day

It seems to be that jury is still out on the prospects for the UK economy; there are still a few analysts that believe that the UK might suddenly motor ahead. However, increasingly the commentators, analysts, and even some politicians, are coming to the view that the UK is in deep, deep trouble. For regular readers of this blog, this will come as no surprise, as they will know that the brewing crisis in the UK was apparent many years ago, and that the government's action has only served to increase the scope of any coming crisis.

One particular commentary in the Telegraph sums up many of the concerns for the UK economy, as follows:

Is it remotely possible that Mr Brown has succeeded not just in delaying the pain, but suspending it entirely? Here's why not. The key questions are these. Given the amount of policy action that has already been thrown at the problem, how come there is still so little sign of recovery? And by extension, will continuing to provide life support eventually produce the sustained recovery the Prime Minister promises, or will it only bankrupt the country before we get there?

When I first started this blog, I suggested that the UK was already bankrupt, and that it was just a question of time before this was accepted. I proposed that it would be necessary for either the UK to print money or default on debt and, lo and behold, the money printing solution appeared from nowhere with the Bank of England inventing justifications for the policy. When quantitative easing (QE- the euphemism for printing money) was finally introduced, I argued that it was nothing more than a method to pay for government profligacy, but nevertheless the vast majority of commentators and analysts bought into the Bank of England's justifications. It seems that they are increasingly rumbling the game:

Ian Stannard, currency strategist at BNP Paribas, said markets are fretting over how the UK will cover its deficit following the pause in quantitative easing by the Bank of England. The Bank has absorbed £200bn of debt, more than total Treasury issuance over the last year.

"The UK may have difficulty in attracting extra investors to fill the gap. We think they will have to do more QE as recovery falters," he said.

It has taken a long while, but it is starting to look like the game is up for QE. The Bank of England has described the current ending of QE as a 'pause', but that they may restart if they deem that the economic situation warrants it. The problem that the Bank of England faces is this; they originally justified QE through spreading fear of Consumer Price Index (CPI) deflation, even though no such deflation had yet occurred. They also, as I pointed out at the time, sought to mix in the use of the RPI measures, even though this was beyond their remit. As things stand, the UK inflation rate is high at the moment, and climbing:

It might be noted that RPI went into deflation, but RPI includes housing costs, which are determined by the Bank of England interest rates. At the time QE started, I predicted inflation being imported through currency devaluation. The same situation applies now, with the £GB continuing to sink:

LONDON, March 10 (Reuters) - The Bank of England's trade-weighted sterling index fell to a fresh 11-month low on Wednesday in the wake of data showing an unexpected fall in British manufacturing output in January.

The much hoped for improvement of the balance of trade has also not taken place. In fact, the opposite has taken place. The increase in imports, alongside a devaluing currency, does not bode well for inflation.

The current account situation is also seeing no improvement. As I have suggested before, the importation of inflation through currency devaluation takes time to fully impact, as many contracts and goods in transit take time to adjust to the new situation. As such, we can expect ongoing inflationary pressures lagging the devaluations.

In this circumstance, with inflation climbing, and realistic prospects of even more inflation, how might the Bank of England explain any further QE? When the Bank of England last started QE, they justified the policy with projections of CPI deflation, but the deflation never took place. It might be argued that this was because of QE, but even before the policy might have had an effect, there was no deflation (also, the idea that deflation is an inherently bad thing is something I have contested in previous posts). I doubt the Bank of England will get away with QE so easily this time around, as too many analysts are becoming cynical.

What we are now seeing in the UK is the brewing of a perfect storm. The underlying size of the UK economy, the size of the economy without borrowing, is very much smaller than many imagine. It simply can not support the level of borrowing that has been undertaken by the government. This was true even before the borrowing binge following the onset of the economic crisis, but the difference is now that the borrowing is concentrated in the government rather than consumers. The real size of the economy in relation to borrowing is the underlying problem, but other factors are adding to this fundamental problem.

One of these, which is commonly reported as a reason for weakness in the £GB and gilts (UK government bonds), is the political instability, and the prospect of an ineffective government after the coming election. This from the Wall Street Journal:

NEW YORK (Dow Jones)--The U.K. pound tumbled against the dollar and the euro Monday as investors worried that the upcoming national election could result in political gridlock, hampering the country's ability to deal with its growing debt levels.

Such sentiments are not rare, but there are other concerns, and in particular the relative health of the UK economy in relation to other economies. As governments issue record levels of debt, the competition for who is funded is intensifying. Again, it is an argument that I made long ago, and it is now an argument that is gaining a broader airing. Whilst other economies may look very bad, the credit will flow to the countries that look least bad and the UK is not well placed in such a competition. The result is that yields on gilts are climbing, meaning that funding the government is already becoming more expensive:

Yields on 10-year gilts have already crept up to 4.14pc, compared to 3.94pc for Italian bonds, 3.48pc for French bonds, and 3.19pc for German Bunds, though part of this reflects worries about higher inflation in Britain.

I undertook a search for 'sterling crisis', and the results speak for themselves. Some examples of the articles including the term can be found here and here. It is the increasing frequency of the discussion that is of real concern. As the £GB falls, as the doubts about fiscal policy gather more weight, as the prospects of a return to QE are discussed, the attractiveness of funding UK government debt diminishes. As concerns grow, the £GB weakens further, and as the £GB weakens the doubts are reinforced. However, underneath it all, the core problem is doubt about the solvency of the UK.

Just as in Greece, it appears that the electorate in the UK are taking their creditors for granted, and have not accepted (yet) that it is possible for the credit taps to switched off. The Labour Party and the Conservative Party are running scared of the polls, and are afraid to propose the cuts necessary to restore the UK's fiscal situation. The Conservatives talk of concern for the credit rating of the UK, but are not offering the policy proposals that might reassure creditors. Meanwhile, the Labour government is suggesting that the coming pre-election budget will be 'business as usual', even whilst a currency and funding crisis is brewing. At some point, the UK electorate needs to wake up and accept reality, but the prospects for this are dim.

In a recent article in the Economist (last week's print edition), they discussed the coming battle between the interests of the older generation and the younger, and the private and public sector. Of note is that, with an increasingly large share of the UK economy in the hands of government, the government us building a client state - where any serious cuts to government expenditure threatens the livelihoods of ever more individuals. The more the government spends, the more people are dependent on government expenditure, and the harder it becomes to develop the political will to cut expenditure. My guess (and it is no more than a guess) is that underlying the uncertain outcome of the coming election is the imbalance between a growing client state, and those in the private sector.

The Economist, which seems to be returning to better analysis, suggests that, in the end, it will finally be necessary for countries like the UK to have reform imposed upon them from outside. In other words, the politicians will need a crisis for them to tackle the structural problems within their economy. It is rather a depressing indictment of the politicians that are supposed to lead us, that they need such a crisis to do what should in any case be done. Within all of this is the concern that the UK is supposed to be a 'mature' democracy, in which the electorate should know better. It seems though, that they lack the maturity to face up to the severity of the economic situation.

The truth is this; if the UK continues on the current course, there will be wider and deeper damage when resolution is imposed from outside, and the wider and deeper the damage the more people who will lose their livelihoods, including the current clients of the government. In other words, nobody will win from carrying on with the current situation. Those who live as clients of the government need to recognise that their interests are inextricably bound up with the private sector. It is in not in the interest of anybody to risk a funding and sterling crisis. In the end, everybody will bear a share of the pain. Somehow, I doubt that this will be learnt before the coming election, but we can but hope....perhaps then the politicians will have the courage to do what must be done?

Note 1: Thanks for the many comments on the last post.

Lemming asks how we might determine sustainable economic growth. I am not sure that there is an easy answer to this in the current system. In particular, the manipulations of the money supply by central banks, in conjunction with fiscal tinkering, serve to bury what the real state of economies might be. A particular problem is that the policy of government 'x' can have unexpected impacts on country 'y', such as the way that QE and zero interest rates encouraged asset price inflation in countries like the US. How is it possible to untangle such effects? I long ago provided (what I believe to be) a solution to these problems, but doubt the solution would ever be adopted.

A commentator called 'D' noted that there is a situation in which government is in bed with select businesses, and suggests that this means not all blame should be placed with the government. I would argue that this is still a problem of government, as government should not put itself in this position. The more honey in the government pot, the greater the number of bees buzzing around the pot. The solution is less honey in the pot, and some fierce constitutional constraints. Sorry, a short answer, but all I have time for.

An anonymous poster corrected me that, in the event of default, somebody still pays; in this case the creditor. You are quite right, but I hope that this was implicit in the rest of the post.

'Rural Idiocy' added an interesting quote as follows:

"The Bank for International Settlements says Britain needs a primary surplus of 5.8pc of GDP for a decade to stabilise debt at pre-crisis levels, given the ageing crunch as well. The figure is 6.4pc for Japan, 4.3pc for the US and France."

Certainly food for thought.

As ever, Lord Keynes also posted several comments which challenge the views of this blog. It is always good to see the alternative views presented. As for the other comments, I have read them with interest, but do not have time to respond to them all. However, they reflect the high standards of commentary on this blog, and I feel privileged to have such a thoughtful readership.

Note 2: As with many posts, there is much else that I could say, and many subjects that might demand more attention. For example, I could talk more about the other indicators for the UK economy, but will leave that for this time. If time allows, I may try a full review of the UK in the future.

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.

The Masters of the Universe

I have not posted for a while, but have two three quarter finished posts which I can not quite manage to finalise. The reason for the procrastination is that there are so many elements in the world economy that are flashing warning lights. Each element, of itself, might not be a major concern, but collectively they add up to some major concerns. The problem is how to convey concerns about such wide swathes of the global economy. I will do my best, but will apologise in advance for a lightly referenced and perhaps rather rambling post.

The other problem is the sheer volume of views and opinions on what is taking place. As Ambrose Evans-Pritchard of the Telegraphs says, it is time to rip up the textbooks. He is talking about the ongoing and partially hidden crash in US housing, and the underlying unemployment rate of just over 17%, and makes comparisons with the Great Depression. In my case, I long ago ripped up the economics textbooks, as they never made any sense, but it is interesting how many mainstream commentators are now taking this view.

What we saw in 2009 was the final and last gasps of the enactment of the textbook economic theory that has dominated policy over the last few years. The economists and policymakers have now shot most of their monetary and fiscal bolts. In other words, the politicians, the economists, and the central bankers have continued pulling and pushing on the levers of the economy in the hope that reality might be forced back into its box. We have seen fiscal stimuli, and a flood of printed money into the world, and this has been used to finance record government deficits. We have seen bailouts, guarantees of toxic assets, the concentration of the banking systems into ever fewer too big to fail players.

However, in 2009, whilst everything appeared to change, very little has really changed. Whilst many of the 'rich world' countries have fallen into deep recession (if not depression), there has been no change in the underlying reality of the world economy. On the surface, we can see all of the activity of governments to 'save' their economies, but the changes are restricted to appearances, not to the actual way in which their economies are really structured.

What do I mean by this?

It is very simple. Whilst governments intervene in ever greater swathes of the economy, nothing has changed in the underlying competitive position of the 'rich world' economies that are in such deep troubles. Except for the devaluation of currencies.

It is the lever of last resort. If you can not compete, do whatever you can to devalue the currency, and then your workforce will be cheaper relative to the work force of your competition. It is a strategy that directly reduces the standard of living of every person paid in that currency. It punishes the savers, punishes the investors, but if it is taken far enough, eventually the economy will once again be 'competitive'. It is an economic policy of impoverishment, however it may be dressed up.

However, even with such devaluations, all is still not as it should be. The imbalance at the heart of the world economy has not gone away. Even as the $US falls, the RMB falls with it, making the Chinese economy ever more competitive, and ensuring that Chinese goods and serviced continue to win on the back of mercantilism policy. Nothing has changed, as no country yet has the resolve to face down Chinese mercantilism, even as the policy of China slowly but surely destroys swathes of industry around the world. Even in the depths of recession, the pre-crisis current account deficits persist in many countries.

In the latest mercantilist move, China is now talking of restricting the export of rare earth metals, over which they have a virtual monopoly. These metals are vital commodities in the manufacture of a huge number of goods:

Worldwide, the industries reliant on REEs [rare earth metals], which produce anything from fibre-optic cables to missile guidance systems, are estimated to be worth £3 trillion, or 5 per cent of global GDP.

If you want to manufacture using these materials, best you have a base of supply and manufacture in China. Even the possibility of a freeze on exports will result in industries moving to China. And the response to this latest mercantilism policy? Nothing. No threats of trade sanctions, no action whatsoever. As before, China just continues its economic power grab, and the reaction is nothing of any substance. As I have said, nothing has really changed. Wealth creation will continue its inexorable shift to the East.

Then there is the structure of trade that is associated with the shift of wealth. Nothing has changed there either. Just as before, much of the 'rich world' continues to consume more than it produces. Sure, consumers are no longer the primary drivers of the debt binge economy, with the government seeking to fill the holes created by the retraction of consumer borrowing, but the essential reality of consuming more than is created continues. Nothing has really changed though because, in the end, government borrowing is consumer borrowing, as consumers will eventually pick up the bill.

There is one change that results from the debt binge of governments. The belief in the wealth of the 'rich world' is eroding, and the ability for the rich world to raise finance is eroding with this belief. It brings us full circle to the problem of printing money to pay the government's bills. If ever there were an exemplar of the underlying reality that this is a means to finance government profligacy, the Bank of England should metaphorically step forward. Tasked with maintenance of steady CPI inflation, the Bank of England claimed that the policy of printing money was to stave off deflation. Even as CPI inflation threatens to climb upwards, the original purpose of the policy is de-emphasised, and the policy continues.

For a while, the massive government borrowing of countries like the US and UK appeared to be possible. It seemed that the world accepted that all would be well, that the rich countries would continue to be rich, and were good for their debt. It seemed that countries could even 'get away with' printing money to finance government spending. I for one, never believed that such a situation could be possible, and was certain that it would all rapidly end in tears. However, throughout 2009 governments 'got away with it'.

As we enter into 2010, this looks unsustainable. More and more cracks are appearing in the edifice. Whilst each crack appears to be meaningless of itself, cumulatively they are destroying the integrity of the structure. There are the bilateral deals by China to trade outside of $US, the emergence of a petro-currency, the withdrawal of PIMCO from US and UK bonds, the shift of money into commodities, the carry trade of the $US and so many other small cracks....

The big question is this. Who is going to continue to finance the debt binge of the deficit countries in the coming year?

The cracks in the edifice of belief in the inevitability of the 'rich world' being rich mean that the supply of endless credit may well be coming to an end. In many countries, and I think of the US and UK in particular, though there are many others, there is the belief that the current structure of their economies might, somehow, be maintained. There is a lack of understanding that, in the end, that structure is built upon the credit provided by other countries, and without that credit, the structure can not be sustained. Even as the structure is crumbling before our eyes, there are many commentators, analysts and politicians claiming that this is a temporary aberration, and that all will one day return to normal. There are even claims that the economic crisis is coming to an end.

The analysts and commentators point to their indices, and say that, 'yes, things are looking up'. GDP is growing, or house prices rising once more, or industrial output has ticked up. The indicators are trotted out to suggest that all will be fine once again. The magic of governments and central banks pulling on their levers has worked. That the only explanation for such upticks is due to the largess of government, and that the largess of government is built upon overseas credit, is ignored. Strip out that overseas credit, and the situation looks very, very different.

Then there is the stability of the financial system. The banks appear to be making hay again, with business as normal having resumed. Meanwhile, in the background, do we really know what is going on? How much of that business as normal is resultant from the support of government and central banks? How much of this has been the socialisation of losses, the manipulation of accounting rules, the propping up of the house market through guarantees, and all of the other levers being pulled in the background. How much of the financial system sits upon the implicit guarantees of government, and how much risk is being transferred to the state?

What happens if the implicit guarantees of the state can no longer guarantee the financial system, because the states themselves are no longer seen as a guarantee? This is circular, as the more guarantees provided by the state, the greater the liabilities of the state, and the less the guarantee of the state might be seen as a guarantee.

I am not sure that anyone can actually pull apart the increasingly tangled knots between the financial system and the state. They appear to be mutually dependent, with the state providing guarantees, and the financial system funding the state with financial support through bond purchases to shore up their capital ratios, and so forth. How convenient that bank capital adequacy encourages the holding of government debt. Going back to Renaissance Italy, bankers were granted licenses and monopolies if they were willing to lend to the state on preferential terms. Nothing has changed.

But that supposedly rock solid capital that the banks are accumulating in the form of government bonds might, itself, be less solid than it is supposed to be. The same framework on capital adequacy that says that such bonds are safe is the same framework that said that lending to an OECD bank was safe - even though this proved not to be the case. Except....except, the lending to other OECD banks did prove to be safe, as governments and central banks stepped in and socialised the losses. The difference this time is that, if government debt goes sour, who might step in and socialise the losses?

Ambrose Evans-Pritchard is right when he suggests that we should rip up the economics textbooks. What we are seeing is a grand experiment, in which economists and policymakers are attempting to structure wealth in economies by fiat. As each lever is pulled, as each policy is enacted, there are ripples through the world economy. Flooding $US into the markets whilst holding interest rates low sees the export of $US popping up and creating bubbles elsewhere. Backstopping the mortgage market sees foreclosures reduced, but at the risk of calling into question (contributing to doubts about) the financial viability of the state. Holding the value of the RMB down leads to greater trade imbalances. Each policy has a consequence, and each policy interacts with the policy pursued by every other government.

In other words, as each lever is pulled, the consequences defeat the intention of the lever puller. For example, if the trade imbalances destroy the economic stability of the destination of Chinese exports, where will this leave the Chinese economy? The more each state pulls on the levers, the greater the turbulence between each of the economies. The world economy is a dynamic system, such that policy in one country impacts on the economy of another country, which then reacts with its own policy provisions, which then impact upon other countries. It is an endless cycle of reactivity, with each reaction driving further reaction, and developing an increasingly unstable system as each country enacts ever more dramatic policy to counter or ameliorate the effects of the policies of other countries.

A simple example is the relatively recent Japanese policy of printing money to stave off deflation. With rock bottom interest rates, the newly printed money was simply exported into other countries in the so called 'carry trade'. Within Japan, deflation persisted, whilst the newly printed Japanese money appeared in other countries, contributing to the process of asset price inflation in the countries that were the destination of the carry trade. The policy levers were pulled, but the consequences were far from those that were intended.

What textbook might be able to predict the outcome of such a dynamic system? Despite this, we see the policymakers pulling on their levers, and offering confidence that they know what they are doing. Apparently, the masters of the universe are in control.

I simply do not believe it.

As I said, nothing has really changed. The policymakers continue pulling their levers, continue to react, continue to seek to 'control' their respective economies. The only thing that has changed is the scale and scope and intensity of the policy. As they pull harder on ever more levers, the imbalances grow, the risks grow, and the consequences become ever less predictable. I was worried in 2009, but somehow governments succeeded in shoving reality back into its box. Can the masters of the universe continue to do so in 2010?

I am not convinced. Welcome to 2010.

Note: Thanks to Lemming who posted the link to the rare earth metals story, and thanks in general for the many interesting comments.

Bank of England Bills and Printing Money

Regular readers may remember that, some time ago, I sent some questions to the Bank of England regarding quantitative easing (QE - printing money), following an offer by the deputy governor to answer QE questions. I sent an email on July 16th, and now have a response. Before looking at the reply, these were my questions:

1. Reuters has reported on the 9th July that, following no announcement of an extension of the policy of QE by the Bank of England, bond yields rose sharply. Bearing in mind that just the possibility of an end to the policy caused this reaction, does this not suggest to you that QE is propping up the Bond Market?

2. The CPI has finally dipped below the 2% target that the Bank of England uses in setting monetary policy, but is still not far enough off target to require a letter of explanation. I believe that the Governor of the Bank of England has identified QE as an untried unconventional policy with uncertain outcomes. Bearing in mind that during all but the last week, CPI has not fallen below target, how can such an untested policy be justified? In particular, with monetary stability as a key aim, how can such an unconventional policy be justified?

3. With regards to exit strategies for QE, the Bank of England Quarterly Bulletin for 2009 Q2 states that 'Alternatively, the supply of reserves could be reduced without asset sales, through the issuance of short-term Bank of England bills.' Is this policy? If so, can you confirm exactly when and under what circumstances you will finally sell the gilts that have been purchased?

4. A secondary question as a follow on to question 3. If the purpose of QE is not to monetize government debt, then why would you not sell gilts at the end of QE policy? Do you have concerns that the existing expansion of gilt issuance would preclude the sale as the sale might destabilise the gilt market? Is this not a recognition that the gilt market can not support the level of issuance?

The BoE took the trouble to write to me with some answers in an email but, they also referred me to other general answer to questions on their website, pointing me to answers 1, 6, 11 and 13 in particular. I will use the answers from the email and some of the general answers in this post, but you may wish to see the originals general answers in full.

The first point to note is that there was no direct answer to my question (1) in any of the answers that were provided. It appears that the Bank of England does not want to comment on whether they might be propping up the bond market. It might be argued that, in purchasing bonds, the intention is to hold down yields, but I think the implication of a spike in yields on a mere sniff of an end to QE goes beyond this. The question is, of course, an indirect way of asking whether the BoE is monetising government debt. This they have answered, and this is from the email they sent:

Quantitative easing has not been carried out to help the government meet its financing needs, and asset purchases by the Bank have not been made to keep gilt yields at a particular level. Other things being equal, yields can be expected to fall in response to the Bank’s gilt purchases.

In the general answers, they add that monetization of government debt would infringe upon article 101 of the Maastricht treaty, and that they are not being forced to make up a shortfall between government debt and expenditure:

The key point is that the Bank is not being forced to create money in order to cover the gap between the government’s tax income and its spending commitments. If it were carried out to finance the budget deficit, it would be a violation of Article 101 of the Maastricht Treaty (which the United Kingdom must abide by, even though it is not a member of the euro zone). [...]

Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money markets and such operations are not deemed to amount to monetary financing under the Maastricht Treaty.

The interesting word in this answer is forced, as it is not apparent where this word has come from. This is the original article 101:

1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions.

The interesting point in this article is that the direct purchase of government debt is actually prohibited, but there is nothing to prevent indirect purchases (as they point out). At the same time, it is not apparent where this idea of 'forced' has appeared from. The implication of this is that, if the BoE were to monetize debt without being forced, this would all be right and proper. It is a most puzzling answer...

With regards to the question about why the policy is being enacted whilst CPI has barely moved below target, this is the answer in the email:

The objective of the MPC remains to hit the Chancellor’s 2% CPI inflation target. Therefore the MPC continues to focus on the medium term prospects for inflation when setting monetary policy. The MPC judged in March that in the absence of a further monetary policy stimulus, the growing margin of spare capacity created by the recession would push inflation significantly below the target in the medium term. With Bank Rate already almost as low as it could go, the MPC decided that a substantial stimulus through quantitative easing was warranted. That was the reason for embarking on unconventional monetary policy. Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money markets. What distinguishes quantitative easing from normal operations is their scale and the length of time for which the assets are likely to be held.

There is nothing new in this answer. The BoE been wrong in their inflation forecasts up to now, such that the expected fall in the CPI has not taken place ....it is not clear therefore why QE is still being enacted, as it is freely admitted that it is 'unconventional' and therefore carries with it risks that are unknown? Under their own considerations, it will take at least 6 months for the impact of the policy to be felt, so it is not the policy that has prevented deflation. Deflation has simply not happened.

Questions (3) and (4) generated some interesting answers, with this from the general answers:

When it comes to tightening policy, the MPC will have two instruments available: raising Bank Rate; and selling back assets. Removing money from circulation can be achieved by selling the assets back to the private sector. The MPC will be likely to use a combination of raising Bank Rate and selling back assets, although the precise sequencing and the relative importance of the two instruments will be considered month by month at each MPC meeting. The Bank will seek to sell the assets it owns in an orderly fashion in order not to disrupt the market for government debt.

And this is the answer sent in the email:

The market for UK government debt is one of the deepest and most liquid financial markets in the world. Nevertheless, buying and selling large quantities of assets quickly is likely to influence prices.If the MPC decides that it wants to reduce the quantity of reserve balances held by the banks, it could issue Bank of England bills in exchange for the reserves, rather than selling the Bank’s holdings of government debt back to the non-bank private sector. The assets could then be sold back in an orderly fashion over a longer time period. Whether the Bank issues extra bills in exchange for the reserves or not will ultimately be a technical decision that will be taken with a view to market conditions at the time [emphasis added].

It is notable that they do not mention the sale of Bank of England bills in the general answers, but instead simply say they will sell 'assets'. It is apparent that I was correct in thinking that the BoE is not planning to sell the government debt back into the market for a long time, but is rather planning on tightening monetary policy through issuance of Bank of England bills. This is still not public knowledge, and I am uncertain that the distinction would be understood.

The BoE are right to assert that any quick sale of the bonds would influence prices, but this bumps up against a fundamental concern. How might the BoE sell the bonds into the market at any time during which there is already such massive issuance of new debt? How long will the BoE have to hang onto the government debt, and what market conditions might be considered opportune for selling the bonds?

The bottom line is that the BoE will not be reversing the QE policy in what might be seen as a conventional way (e.g. selling the original assets back). It might be argued that there is no conventional way in an unconventional policy, but I do not believe that open market operations, the nearest equivalent, would allow for assets to be purchased and held in this way. With such a radical policy, it would be expected that the BoE would have clear criteria for a return of the bonds to the market in an orderly way, and under what circumstances they might sell them.

The logic of QE is that, should an upturn in the money supply or inflation become apparent, they will need to reverse the policy. However, this would not mean an immediate tightening of the money supply, but would likely be a progressive tightening. Just as interest rates are not normally altered by large increments, or the policy of QE undertaken in one large 'dollop', there is no reason why the end of QE should be undertaken as a 'dollop'.

There is no discussion of any detail, because the Bank of England will certainly know that, with government issuance of debt flooding the market, there is absolutely no time in the foreseeable future at which they might offload the bonds without causing a crisis. The BoE's holding of government debt is simply too large...The only reason that any other method might be used for monetary tightening is that the amount of debt being issued by the government can simply not be digested by the markets. There is more debt being issued than demand. The BoE is simply filling the hole in demand.

As another concern, this is a quote from the general answers, on reselling of BoE holdings of bonds:

It is possible that gilt prices will fall, thus raising the corresponding interest rates, when the Bank starts to sell its holdings. Subject to achieving the 2% inflation target in the medium term, any sales will be co-ordinated with the Debt Management Office so as to limit any adverse impact on the functioning of the gilt market.

This should be a matter of some concern. The BoE will be co-ordinating the sale with the DMO, which is the arm of government that raises finance. There should be no direct linkage between the activity of monetary policy and the issuance of government debt. The BoE has no business in ensuring that the government might be able to finance their debts or at what rate, and is now admitting that their operations are now (at least partly) being controlled by the central government through the DMO.

This is the basic problem; if the government were not issuing too much debt, then there would be no need for the co-ordination, as a steady offloading of the debt would not unduly interfere with the market. Also, if a private institutions were to co-ordinate with the DMO there would be outrage. The BoE and the DMO acting together is, quite literally, rigging the market.

What we have is a situation where the BoE is preparing to find reasons to hang on to government debt, and to not return the debt to the market (where it belongs) without the permission of (sorry, co-ordination with) the DMO. All the while, they continue to purchase more debt, despite the fact that CPI is still at a level at which there is no need even for a letter of explanation.

Over and above the answers to my questions, there were some interesting points in the general answers. For example, they go to some lengths to distance themselves from the idea that what they are doing is a variant of the Zimbabwe problem. This is the disingenuous explanation:

In the Weimar Republic and Zimbabwe, the central bank printed money to finance government expenditure. This vastly increased the money supply, and hence prices rose rapidly. This is not happening in the United Kingdom. Here, the Bank is buying assets from the private sector to stimulate the wider economy, because otherwise we risk undershooting, rather than overshooting, the inflation target. Quantitative easing is not carried out to help the government meet its financing needs. When the economy recovers, most of the purchased assets will be sold back to investors, reducing the money supply.

Note the misdirection in suggesting that they are buying 'assets' from the public sector. Whether directly or indirectly, they are buying government debt, and therefore they are supporting the purchase of government debt. Note also, that they are talking of when the economy recovers, and also implying that they will sell the government debt back. However, the prospect of sales of Bank of England bills in place of reselling the bonds directly contradicts this.

The last quote is one which is not of great importance in the big picture, but is indicative of the way in which the BoE is trying to bury the simple fact that they are printing money.

What is the difference between reserve balances and printing money?

Reserve balances are, in effect, electronic money held only by commercial banks and can only be used to settle transactions between them and with the Bank of England. The Bank issues paper currency in response to the demand for banknotes from the public. But reserves and notes both represent claims on the Bank of England (‘central bank money’) and the banks can exchange the reserves for notes, although as they receive Bank Rate on their reserves they will only do this if the notes are needed to meet, for instance, withdrawals of deposits. When the Bank buys assets under its quantitative easing programme, the bank account of the seller goes up by the value of the sale and their bank simultaneously acquires an equal quantity of reserves.

How this might differ from running money off a physical printing press and depositing the money in the vault of the recipient bank completely eludes me. In both cases, the recipient bank has the money available to them to do with as they wish, including converting reserve balances into bank notes. The implication here is that a reserve balance is not printing money, and whilst technically correct (there is no physical printing press) the outcome is identical.

In amongst such obfuscation, I would just like to highlight the one useful new piece of information that has emerged. It is apparent that the BoE holding of government debt is not going to be returned to the market for a long, long time. Whilst they have not said this directly, I believe that their direction is pretty clear. Their explanation for why they might not sell back the bonds in a rush is plausible, but there is nothing that would stop them from steadily selling - if the market were not already flooded.

This is the key point. The BoE have been stepping in to support issuance of government debt which would otherwise almost certainly not find sufficient buyers. The issuance of debt from the government is ongoing, and there is therefore no opportunity to sell the bonds in the foreseeable future. The Bank of England is therefore engaging on a policy of purchasing government debt which it will hold over a long period, and it is doing it with printed money.

It is, quite literally, monetization of government debt and, even if it was started as inflation policy (unlikely), it is now the only thing that is preventing government bankruptcy. That the BoE must hold on to the debt is an indictment of the government, and their fiscal incontinence. I have long argued that this is a policy of debt monetization, and the use of BoE bills to reverse QE is just further confirmation.

Note 1: Despite my cynical view of the BoE policy, I am always impressed with their polite approach in their answers. As a strong critic of the BoE, this is to their credit.

Note 2: Please accept my apologies for the lack of replies to many comments. My 'real life' is very busy at the moment, such that I am very pressed for time. I have even been forced to rush this post, even though it is one of the subjects of particular interest to me, and would have preferred a better researched post (finding article 101 in EU documentation exacerbated the problem, as it was not very easy to find). I hope that the rush does not show.

When will the Money Printing Stop?

Having already posted today, this is more of a note than a full post. I have noted recently that the UK inflation figures yet again defied Bank of England expectations of deflation. Whilst their recent inflation report was full of caveats on inflation vs. deflation, the original justification for quantitative easing (QE-Money Printing) was a deflation scare. As I have pointed out in many posts, the target inflation rate has barely been missed throughout the entire period of QE, and the predictions of deflation have never come to pass. The requirement for the Bank of England to write a letter of explanation to the chancellor is if the Bank of England misses the inflation target by 1%.

Yet again, inflation is still sitting stubbornly close to the target, such that no letter is required. This from the Telegraph:

The Consumer Prices Index (CPI), which is the Government's preferred measure of inflation, dropped to 1.6pc from 1.8pc in July - the lowest level since January 2005 according to data from the Office for National Statistics (ONS). It was the third month in a row that CPI was below the 2pc target.

As it is, the main cause of the fall in the rate of inflation is lower gas and electricity prices, which have fallen by considerable amounts. If we turn our minds back, it is apparent that the high prices with which these price falls are compared were extremely high prices resultant from the spike in prices of oil, which I predicted would fall back.

It is also noteworthy that the reason for continuing inflation is the higher prices of imports, which was my suggested reason for continued inflation when considering inflation versus deflation. The weakness of the £GB was always going to have a counterveiling impact to the shrinking of the economy. This point is of particular note for the US, now that the $US is sliding. In the case of the UK, I pointed out that currency weakness would take a while to show up in import inflation, as prices and contracts will take a while to adjust (e.g. when a contract is signed, it takes often takes a long while before the contracted goods are actually delivered at the pre-inflation price). The same will apply for the US, with time lags in inflationary pressures.

Returning to QE, it is interesting to see that the media have been distracted from the original purpose of QE, now that the predicted deflation has not taken place. This is from the FT:

Although six months is a comparatively short time to judge QE, Mr King can already point to some signs of success, but these are balanced against other more negative indicators.

On the positive side, government and corporate bond yields have fallen, boosting company borrowing in the capital markets. Indeed, sterling corporate bond issuance has surged to an annual record, with three months still remaining of the year.

Ten-year gilt yields are only 3 basis points lower, at 3.61 per cent, than the day before QE - but Charles Bean, the Bank's deputy governor, insists that they would have been 50bp higher without QE.

Investment grade sterling bond yields are 2 percentage points lower, at 6 per cent, than in early March, although euro-denominated corporate bond yields have fallen just as sharply with the help of the European Central Bank's injections of liquidity into the money markets.

QE has also boosted the equity markets, although it is difficult to quantify how much money investors have switched into shares from their gilt sales. The FTSE 100 has risen 38 per cent since the launch of QE, but a lot of the gains were due to an improving world economy and resilient corporate profits.

Like so many commentators, the deflation scare that was the justification for QE is quietly being forgotten. It is not clear why the memory of so many journalists and commentators are so short. With the notable exception of Liam Halligan in the Telegraph, it seems that the origins of QE are of no importance.

Throughout the policy of QE the Bank of England has sought to generate confusion over the role of deflation and inflation as their justification for QE. This is an excerpt from a previous post, where I highlight the kind of methods being used:

If we remember, the bank targets CPI, not RPI. However, in the Bank of England inflation report from February, it might be noted that the RPI is discussed in the report, even though the CPI is the target for inflation. You will note how the measures are blurred in this passage.

Deflation is sometimes used to describe any fall in the general level of prices (as measured in the United Kingdom by the CPI, RPI or the GDP deflator), however short-lived. A more economically significant phenomenon, however, would be a sustained period of negative inflation.

The RPI is likely to fall temporarily over the coming months (Section 4.1). This period of negative retail price inflation would be unusual (Chart A) and predominantly reflects the much lower contribution from mortgage interest payments, following the recent large falls in Bank Rate. The MPC’s central projection is for its target measure, annual CPI inflation, to remain above zero throughout the forecast horizon. (p33)

Whilst there is no direct statement of targeting of RPI, the way in which the whole passage is put is somewhat grey. The same section of the report then goes on to warn of the dangers of deflation......it appears that the Bank of England is subtly conflating the two measures, and they even use a chart which is designated as the 'ONS composite index'. (p33) One of the interesting points is that an argument for printing money directly follows this discussion of RPI and deflation:

Periods of low inflation, associated with weak demand, may limit a central bank’s ability to use conventional monetary policy to stabilise the economy. But if reductions in official interest rates do not prove sufficient to meet the inflation target, policymakers still have other options available to them to stimulate the economy, if necessary (see the box on pages 44–45 in this Report). (p33)

In a previous post, I have explained exactly why there is no element of QE that might justify the policy. This is beyond either a summary or quote, so I would recommend those that have not already read the post, to read it now.

Yet again, despite no indication of serious deflation, there is no indications of any halt to quantitative easing. Why is this? More to the point, why is it that so many in the media are sitting back and watching the monetization of government debt continue with so little concern? At this point, the press should be filled with outrage. Instead, they appear to accept this policy as if it were perfectly normal. Have they not noticed that the policy justification has failed to materialise?

Exactly how or when QE might stop, and under what circumstances, continues to be opaque. It seems that nobody seems willing to give the answers, and the press does not appear to be concerned. In the interim, the government continues to spend money still wet from the printing press.....to say that this is a bad situation is an understatement.....