With economic growth in the UK stalling and growing alarm about the state of the world economy, the Bank of England has announced a second round of quantitative easing (QE2). This will involve the Bank buying an extra £75 billion of government bonds (gilts) in the market over the following four months. This is over and above the nearly £200 billion of assets, mainly gilts, purchased in the first round of quantitative easing in 2009/10. The purchase will release extra (narrow) money into the economy. Hopefully, this will then allow more credit to be created and the money multiplier to come into play, thereby increasing broad money by a multiple of the £75 billion.
In his letter to the Chancellor of the Exchequer seeking permission for QE2, the Governor stated:
In the United Kingdom, the path of output has been affected by a number of temporary factors, but the available indicators suggest that the underlying rate of growth has also moderated. The squeeze on households’ real incomes and the fiscal consolidation are likely to continue to weigh on domestic spending, while the strains in bank funding markets may also inhibit the availability of credit to consumers and businesses. While the stimulatory monetary stance and the present level of sterling should help to support demand, the weaker outlook for, and the increased downside risks to, output growth mean that the margin of slack in the economy is likely to be greater and more persistent than previously expected.
… The deterioration in the outlook has made it more likely that inflation will undershoot the 2% target in the medium term. In the light of that shift in the balance of risks, and in order to keep inflation on track to meet the target over the medium term, the Committee judged that it was necessary to inject further monetary stimulus into the economy.
But will increasing the money supply lead to increased aggregate demand, or will the money simply sit in banks, thereby increasing their liquidity ratio, but not resulting in any significant increase in spending? In other words, in the equation MV = PY, will the rise in M simply result in a fall in V with little effect on PY? And even if it does lead to a rise in PY, will it be real national income (Y) that rises, or will the rise in MV simply be absorbed in higher prices (P)?
According to a recent article published in the Bank of England’s Quarterly Bulletin, The United Kingdom’s quantitative easing policy: design, operation and impact, the £200 billion of asset purchases under QE1 led to a rise in real GDP of about 2%. If QE2 has the same proportionate effect, real GDP could be expected to rise by about 0.75%. But some commentators argue that things are different this time and that the effect could be much smaller. The following articles examine what is likely to happen. They also look at one of the side-effects of the policy – the reduction in the value of pensions as the policy drives down long-term gilt yields and long-term interest rates generally.
Articles
Bank of England launches second round of QE Interactive Investor, Sarah Modlock (6/10/11)
Britain in grip of worst ever financial crisis, Bank of England governor fears Guardian, Larry Elliott and Katie Allen (6/10/11)
Interview with a Governor BBC News, Stephanie Flanders interviews Mervyn King (6/10/11)
The meaning of QE2 BBC News, Stephanie Flanders (6/10/11)
Bank of England’s MPC united over quantitative easing BBC News (19/10/11)
Bank of England’s QE2 may reach £500bn, economists warn The Telegraph, Philip Aldrick (6/10/11)
‘Shock and awe’ may be QE’s biggest asset The Telegraph, Philip Aldrick (6/10/11)
Quantitative easing by the Bank of England: printing more money won’t work this time The Telegraph, Andrew Lilico (6/10/11)
BOE launches QE2 with 75 billion pound boost Reuters, various commentators (6/10/11)
Shock and awe from Bank of England Financial Times, Chris Giles (6/10/11)
More QE: Full reaction Guardian, various commentators (6/10/11)
Quantitative easing warning over pension schemes Guardian, Jill Insley (6/10/11)
Pension schemes warn of QE2 Titanic disaster Mindful money (6/10/11)
Calm down Mervyn – this so-called global recession is really not that bad Independent, Hamish McRae (9/10/11)
Bank of England publications
Asset Purchase Facility: Gilt Purchases Bank of England Market Notice (6/10/11)
Governor’s ITN interview (6/10/11)
Bank of England Maintains Bank Rate at 0.5% and Increases Size of Asset Purchase Programme by £75 billion to £275 billion Bank of England News Release (6/10/11)
Quantitative Easing – How it Works
Governor’s letter to the Chancellor (6/10/11)
Chancellor’s reply to the Governor (6/10/11)
Minutes of the Monetary Policy Committee meeting, 5 and 6 October 2011 (19/10/11)
Inflation Report
Quarterly Bulletin (2011, Q3)
Questions
- Explain how quantitative easing works.
- What is likely to determine its effectiveness in stimulating the economy?
- Why does the Bank of England prefer to inject new money into the economy by purchasing gilts rather than by some other means that might directly help small business?
- Explain how QE2 is likely to affect pensions.
- What will determine whether QE2 will be inflationary?
- Why is the perception of the likely effectiveness of QE2 one of the key determinants of its actual effectiveness?
The quarter 2 UK GDP growth figures were published at the end of July. They show that real GDP grew by a mere 0.2% over the quarter, or 0.7% over 12 months. These low growth figures follow 2010Q4 and 2011Q1 growth rates of –0.5 and 0.5 respectively, giving an approximately zero growth over those six months. The recovery that seemed to be gathering pace in early 2010, now seems to have petered out, or at best slowed right down. According to an average of 27 forecasts, collated by the Treasury, GDP is expected to grow by just 1.3% in 2011 – below the potential rate of economic growth and thus resulting in a widening of the output gap.
With such a slow pace of recovery, current forecasts suggest that it will be 2013 before the economy returns to the pre-recession level of output: just over five years after the start of the recession in 2008. This chart from the National Institute of Economic and Social Research compares the current recession with previous ones and shows how the recovery is likely to be the slowest of the five recessions since the 1930s.
The Confederation of British Industry (CBI) in its latest Economic Forecast says that the economic outlook has become more challenging.
The intensification of euro area sovereign debt pressures has added to the downside risks facing the UK economy – although the agreement reached at the recent summit appears to represent an initial step towards resolving the issues.
Meanwhile the global economy is going through a soft patch, partly as a result of the previous surge in commodity prices, which has put pressure on household budgets and raised costs for businesses.
Against this backdrop confidence appears to have wilted somewhat.
The opposition blames the slow pace of recovery on the austerity measures imposed by the government. The depressing of aggregate demand by cutting government expenditure and raising taxes has depressed output growth. The problem has been compounded by a lack of consumer spending as real household incomes have been squeezed by inflation and as consumers fear impending tax rises and cuts in benefits. And export growth, which was hoped to lead the country’s recovery, has been hit by weak demand in Europe and elsewhere.
With weak growth, the danger is that automatic fiscal stabilisers (i.e. more people claiming benefits and lack of growth in tax revenues) will mean that the government deficit is not cut. This may then force the Chancellor into further austerity, which would compound the problem of low demand. The opposition has thus been calling for a (temporary) cut in VAT to stimulate the economy.
The government argues that rebalancing the budget is absolutely crucial to maintaining international confidence and Britain’s AAA rating by the credit rating agencies, Moody’s, Fitch and Standard and Poor’s (S&P). Any sign that the government is slacking in its resolve, could undermine this confidence. According to George Osborne, while other countries (including the USA and many eurozone countries) are facing a lot of instability, “Britain is a safe haven. We have convinced the world that we can deal with our debts, bring our deficit down, and that’s meant that interest rates, for British families, for British businesses, are lower than they would otherwise be; it means that our country’s credit rating has been affirmed … and it means that we have that crucial ingredient of any recovery – economic stability.”
What is more, the government claims that the essence of the UK’s problem of low growth lies on the supply side. The focus of growth policy, it maintains, should be on cutting red tape, improving efficiency and, ultimately, in reducing taxes.
What we are witnessing is a debate that echoes the Keynesian/new classical debates of the 1980s and earlier: a debate between those who blame the current problem on lack of aggregate demand and those who blame it on supply-side weaknesses, including weaknesses of the banking sector.
So what should be done? Is it time for a (modest) fiscal expansion, or at least a reining in of the fiscal tightening? Should the Bank of England embark on another round of quantitative easing (QE2)? Or does the solution lie on the supply side? Or should policy combine elements of both?
Articles
UK economy grows by 0.2% BBC News (26/7/11)
Economic growth stalls – and slump will carry on until 2013 Independent, Sean O’Grady (27/7/11)
GDP figures mean Britain will miss its economic growth targets Guardian, Julia Kollewe (26/7/11)
UK GDP figures show slower growth of 0.2% BBC News (26/7/11)
UK growth forecast looks unrealistic after GDP fall Independent, Sean O’Grady (27/7/11)
UK set for low growth as the mood ‘darkens’ Independent, Sean O’Grady (1/8/11)
No sign of a U-turn – but there may be a minor course change Scotsman, John McLaren (27/7/11)
George Osborne vows to stick with ‘plan A’ despite UK GDP growth slowdown The Telegraph, John McLaren (27/7/11)
Weak growth may force Chancellor into further austerity The Telegraph, Jeremy Warner (26/7/11)
UK households squeezed harder than US or Europe The Telegraph, Philip Aldrick, and Emma Rowley (30/7/11)
UK Government will have to act if growth remains weak, warns CBI The Telegraph, Philip Aldrick (1/8/11)
UK economy GDP figures: what the experts say Guardian, Claire French (26/7/11)
My plan B for the economy Guardian, Ed Balls, Ruth Lea, Jonathan Portes, Digby Jones and Stephanie Blankenburg (27/7/11)
Not much of a squeeze The Economist, Buttonwood’s notebook (26/7/11)
Some safe haven The Economist (30/7/11)
UK growth – anything to be done? BBC News, Stephanie Flanders (26/7/11)
IMF report on UK: main points The Telegraph, Sarah Rainey (2/8/11)
Families to be £1,500 a year worse off, IMF warns The Telegraph, Philip Aldrick (2/8/11)
IMF casts doubt on UK deficit plan, Financial Times, Chris Giles (1/8/11)
Data and reports
GDP Growth (reliminary estimate) ONS
Gross domestic product preliminary estimate: 2nd Quarter 2011 ONS (26/7/11)
World Economic Outlook Update IMF
OECD Economic Outlook No. 89 Annex Tables OECD (see Table 1)
United Kingdom: IMF Country Report No. 11/220 IMF (2/8/11)
Prospects for the UK economy National Institute of Economic and Social Research (3/8/11)
Questions
- What special ‘one-off’ factors help to explain why the underlying growth in 2011Q2 may have been higher than 0.2%?
- Why is the output gap rising? How may supply-side changes affect the size of the output gap?
- Why is the recovery from recession in the UK slower than in most other countries? Why is it slower than the recovery from previous recessions?
- How may automatic fiscal stabilisers affect (a) economic growth and (b) the size of the public-sector deficit if the output gap widens?
- Distinguish between demand-side and supply-side causes of the slow rate of economic growth in the UK.
- Compare the likely effectiveness of demand-side and supply-side policy measures to stimulate economic growth, referring to both magnitude and timing.
The government is sticking to its deficit reduction plan. But with worries about a lack of economic recovery, or even a double dip recession, some economists are calling for a Plan B. They back up their arguments by referring to the lack of consumer confidence, falling real incomes and rising commodity prices. Without a slowing down in cuts and tax rises, the lack of aggregate demand, they claim, will prevent a recovery.
The government maintains that sticking to the cuts and tax rises helps maintain international confidence and thereby helps to keep interest rates low. Also, it argues, if the economy does slow down, then automatic stabilisers will come into play. Finally, even though fiscal policy is tight, monetary policy is relatively loose, with historically low interest rates.
But will there be enough confidence to sustain a recovery? Economists are clearly divided. But at least the IMF seems to think so. In its latest assessment of the UK economy, although it has cut the growth forecast for 2011 from 2% to 1.5%, that is still a positive figure and thus represents a recovery, albeit a rather fragile one.
Articles
Coalition’s spending plans simply don’t add up Observer letters, 52 economists (5/6/11)
Is George Osborne losing his grip on Britain’s economic recovery? Guardian, Heather Stewart and Daniel Boffey (4/6/11)
George Osborne plan isn’t working, say top UK economists Guardian, Heather Stewart and Daniel Boffey (4/6/11)
How are the Coalition fixing the economy? The Telegraph, Tim Montgomerie (28/5/11)
Cameron’s new cuts narrative The Spectator, Fraser Nelson (27/5/11)
The changing narrative of Chancellor George Orborne Channel 4 News, Faisal Islam (17/5/11)
The UK could be leading with a new economic approach, instead we follow Guardian, Will Hutton (4/6/11)
The coalition’s strategy is courting disaster Observer, (5/6/11)
Government faces fresh calls for a Plan B BBC News (5/6/11)
‘Serious debate’ needed on economy BBC Today Programme, Stephanie Flanders (6/6/11)
IMF cuts UK growth forecast for 2011 BBC News, John Lipsky (Deputy Director of the IMF) (6/6/11)
IMF says hope for best, plan for worst BBC News, Stephanie Flanders (6/6/11)
IMF set out a ‘Plan B’ for George Osborne BBC News, Paul Mason (6/6/11)
How to rebalance our economy Independent, Sean O’Grady (6/6/11)
IMF maps out a Plan B for the UK economy The Telegraph, Jeremy Warner (6/6/11)
A long and hard road lies ahead for the British economy Financial Times, Martin Wolf (6/6/11)
IMF Report
United Kingdom – 2011 Article IV Consultation Concluding Statement of the Mission (6/6/11)
Forecasts
OECD Economic Outlook 89 Annex Tables (June 2011): see especially Annex Table 1
Output, prices and jobs The Economist
Questions
- Explain what is likely to happen to each of the components of aggregate demand.
- Is monetary policy loose enough? How could it be made looser, given that Bank rate is at the historically low level of 0.5% and could barely go any lower?
- What are automatic fiscal stablisers and how are they likely to affect aggregate demand if growth falters? What impact would this have on the public-sector deficit?
- What is meant by the ‘inventory cycle’? How did this impact on growth in 2010 and the first part of 2011?
- What is likely to happen to inflation in the coming months and why? How is this likely to impact on economic growth?
- Referring to the economists’ letter (the first link above), what do you think they mean by “a green new deal and a focus on targeted industrial policy” and how would this affect economic growth?
The debate about how much and how fast to cut the deficit has often been presented as a replaying of the debates of the 1920s and 30s between Keynes and the Treasury.
The justification for fiscal expansion to tackle the recession in 2008/9 was portrayed as classic Keynesianism. The problem was seen as a short-term one of a lack of spending. The solution was seen as one of expansionary fiscal and monetary policies. There was relatively little resistance to such stimulus packages at the time, although some warned against the inevitable growth in public-sector debt.
But now that the world economy is in recovery mode – albeit a highly faltering one in many countries – and given the huge overhang of government deficits and debts, what would Keynes advocate now? Here there is considerable disagreement.
Vince Cable, the UK Business Secretary, argues that Keynes would have supported the deficit reduction plans of the Coalition government. He would still have stressed the importance of aggregate demand, but would have argued that investor and consumer confidence, which are vital preconditions for maintaining private-sector demand, are best maintained by a credible plan to reduce the deficit. What is more, inflows of capital are again best encouraged by fiscal rectitude. As he argued in the New Statesman article below
One plausible explanation, from Olivier Blanchard of the IMF, is that the Keynesian model of fiscal policy works well enough in most conditions, but not when there is a fiscal crisis. In those circumstances, households and businesses react to increased deficits by saving more, because they expect spending cuts and tax increases in the future. At a time like this, fiscal multipliers decline and turn negative. Conversely, firm action to reduce deficits provides reassurance to spend and invest. Such arguments are sometimes described as “Ricardian equivalence” – that deficits cannot stimulate demand because of expected future tax increases.
Those on the other side are not arguing against a long-term reduction in government deficits, but rather that the speed and magnitude of cuts should depend on the state of the economy. Too much cutting and too fast would cause a reduction in aggregate demand and a consequent reduction in output. This would undermine confidence, not strengthen it. Critics of the Coalition government’s policy point to the fragile nature of the recovery and the historically low levels of consumer confidence
The following articles provide some of the more recent contributions to the debate.
Keynes would be on our side New Statesman, Vince Cable (12/1/11)
Cable’s attempt to claim Keynes is well argued — but unconvincing New Statesman, David Blanchflower and Robert Skidelsky (27/1/11)
Growth or cuts? Keynes would not back the coalition – especially over jobs Guardian, Larry Elliott (17/1/11)
People do not understand how bad the economy is Guardian, Vince Cable (20/5/11)
The Budget Battle: WWHD? (What Would Hayek Do?) AK? (And Keynes?) PBS Newshour, Paul Solman (29/4/11)
Keynes vs. Hayek, the Rematch: Keynes Responds PBS Newshour, Paul Solman (2/5/11)
On Not Reading Keynes New York Times, Paul Krugman (1/5/11)
Would a More Expansionary Fiscal Policy Be Effective Right Now? Yes: On the Invisible Bond Market and Inflation Vigilantes Once Again Blog: Grasping Reality with a Prehensile Tail, Brad DeLong (12/5/11)
Keynes, Crisis and Monopoly Capitalism The Real News, Robert Skidelsky and Paul Jay (29/4/11)
Questions
- What factors in the current economic environment affect the level of consumer confidence?
- What are the most important factors that will determine whether or not a policy of fiscal consolidation will drive the economy back into recession?
- How expansionary is monetary policy at the moment? Is it enough simply to answer this question by reference to central bank repo rates?
- What degree of crowding out would be likely to result from an expansionary fiscal policy in the current economic environment? If confidence is adversely affected by expansionary fiscal policy, would this represent a form of crowding out?
- Why may fiscal multipliers have ‘turned negative’?
- For what reasons might a tight fiscal policy lead to an increase in aggregate demand?
- Your turn: what would Keynes have done in the current macroeconomic environment?
According to a report just published by accountancy firm Deloitte, UK household real disposable incomes are set to fall for the fourth year in a row. What is to blame for this? According to Deloitte’s chief economic adviser, Roger Bootle, there are three main factors.
The first is the combination of tax rises and government expenditure cuts, which are now beginning to have a large impact. Part of this is the direct effect on consumer disposable incomes of higher taxes and reduced benefits. Part is the indirect effect on employment and wages of reduced public expenditure – both for public-sector employees and for those working for companies that supply the public sector.
The second is the rise in food, fuel and raw material prices, which have driven up the rate of inflation, thereby eroding real incomes. For most people, “pay growth is unlikely to catch up with inflation any time soon. Inflation is heading towards – and possibly above – 5%. Real earnings are therefore all but certain to fall for the fourth successive year in a row – the first time that this has occurred since the 1870s.”
The third is that demand in the private sector is unlikely to compensate for the fall in demand in the public sector. “I still doubt that the private sector can compensate for the cuts in public sector employment – which is already falling by 100,000 a year.
The upshot is that I expect households’ disposable incomes to fall by about 2% this year in real terms – equivalent to about £780 per household. And it will take until 2015 or so for incomes to get back to their 2009 peak.
… In terms of the year-on-year change in circumstances, although not the absolute level, that would make 2011 the worst year for households since 1977 (the depths of the recent recession aside). Were interest rates to rise too, conditions would arguably be the worst for households since 1952.”
Well, that’s a pretty gloomy forecast! The following articles examine the arguments and consider the likelihood of the forecasts coming true. They also look at the implications for monetary and fiscal policy.
Since I wrote the above, two more gloomy forecasts have been published: the first by the Institute for Fiscal Studies and the second by Ernst & Young’s Item Club. Both reports are linked to below.
Articles
Squeeze on incomes expected to rule out rate rise Guardian, Phillip Inman (3/5/11)
No rate rise until 2013, says Bootle MoneyMarketing, Steve Tolley (3/5/11)
UK households ‘face £780 drop in disposable incomes’ BBC News (3/5/11)
Why our purchasing power is set to suffer the biggest squeeze since 1870 The Telegraph, Ian Cowie (3/5/11)
2012 ‘worst year’ for household finances says Deloitte BBC News, Ian Stuart, Chief Economist with Deloitte (3/5/11)
Retailers expect sales gloom to continue Guardian, Graeme Wearden (3/5/11)
What makes consumers confident? BBC News, Shanaz Musafer (4/5/11)
Household incomes in UK ‘may return to 2004 levels’ BBC News (13/5/11)
Biggest squeeze on incomes since 1980s TotallyMoney, Michael Lloyd (13/5/11)
High street to endure decade of gloom, says Ernst & Young Item Club Guardian, Julia Kollewe (16/5/11)
Outlook for spending ‘bleak’ and road to recovery is long, Ernst & Young ITEM Club warns The Telegraph, James Hall (16/5/11)
Reports
Feeling the pinch: Overview Deloitte (3/5/11)
Feeling the pinch: Full Report Deloitte (3/5/11)
Long-term effects of recession on living standards yet to be felt IFS Press Release (13/5/11)
ITEM Club Spring 2011 forecast Ernst & Young
UK high street faces difficult decade as consumer squeeze intensifies and households focus on paying down debt, says ITEM Club Ernst & Young (16/5/11)
Data
Forecasts for Output, Prices and Jobs The Economist
Forecasts for the UK economy: a comparison of independent forecasts HM Treasury
Commodity Prices Index Mundi
Consumer Confidence Index Nationwide Building Society (Feb 2011)
Confidence indicators for EU countries Economic and Financial Affairs DG
Questions
- For what reasons may real household incomes fall by (a) more than and (b) less than the 2% forecast by Deloitte?
- What is likely to happen to commodity prices over the coming 24 months and why?
- With CPI inflation currently running at an annual rate of 4% (double the Bank of England’s target rate of 2%), consider whether it is now time for the Monetary Policy Committee to raise interest rates.
- For what reasons might households respond to falling real incomes by (a) running down savings; (b) building up savings?
- What are the implications of the report for tax revenues in the current financial year?
- What makes consumers confident?
