The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (39 page)

And so, on 5 March 2009, quantitative easing was launched in Britain, accompanied by a cut in the base rate from 1 per cent to an unprecedented 0.5 per cent. Mervyn King announced £75 billion of asset purchases, with Alistair Darling authorising the same amount again, if required. (A year later, the full £150 billion had been used, plus another £50 billion authorised that year, with a further round launched in 2011.) The Treasury encouraged a break with convention and pressed King to appear in front of the television cameras. At lunchtime, with about an hour’s notice, the major broadcasters, including myself for
Channel 4 News
, were invited to the Bank to interview the governor. This was somewhat unexpected, given the fact that King – unlike his counterparts at the US Federal Reserve and the European Central Bank – had declined all TV interviews for the entire duration of the financial crisis. But, once in front of the cameras, Mervyn King proved the epitome of calm authority. The essential message: keep calm and carry on, while we try this new thing out, which should work – eventually.

Senior Bank officials did their best to explain the new world to journalists used to a world in which interest rates changed only 0.25 per cent at a time. One official said there was no theoretical limit to how far the policy could be pushed, other than wryly pointing out that it would have to end if the Bank ‘bought every asset in Britain’. The bank fended off a series of questions about whether this was a backdoor way of Britain funding its deficit, not through raising taxes or cutting spending but through printing money, the so-called ‘monetisation of debt,’ with all the inflationary dangers that that entails. King tried to reassure his audience that the actions were ‘a standard central bank procedure’.

But what counts as ‘success’? I suggested to King that he could not know that this policy was going to work. ‘I believe these measures will work,’ he tried to reassure me, ‘though I cannot tell you exactly when or indeed the scale of purchases we may need to carry out in order to reach our objective. But our objective is clear: to see an increase in the supply of money in the economy, so we can see a level of spending return and a beginning to economic recovery.’ I pressed the governor on the idea that the financial system would simply hoard the cash on their own balance sheets. He replied: ‘We are putting money directly into the wider economy. It doesn’t have to go through the banks.’ My question was more important than I realised at the time.

By the beginning of 2010 (relative to the size of Britain’s economy), this policy had been pushed further and faster than ever before, and further and faster than in any other major economy. That world record still stands. Britain is, for now, the undisputed QE world champion. So ‘Is QE working?’ has become the £375 billion question.

Passing judgement on QE is a bit like divining the impact of water fluoridation on the state of Britain’s dental health. The sparklier teeth in Britain’s credit markets are evident, but is that attributable to the Bank’s experiment? And what about the wider stimulation of the economy that was intended?

Between April and June 2010, about a year after QE was launched, the economy raced out of slump to post an incredible growth rate of 1 per cent, the fastest growth in nearly a decade. Unemployment and repossessions were far lower than in previous, milder recessions. But the direct effect of QE appears to have been negligible. The broad money supply was not going up, and that had been one of the main aims outlined by King. The bank’s magic money was finding its way into corporate credit markets, but it wasn’t being passed on by commercial banks. After four years, the growth impact had faded, as Britain bounced between contraction and sluggish growth.

One effect of QE is not controversial. At a time of record issuance of British public debt (mainly in the form of government bonds or gilts, with a fixed annual interest payment attached), the interest paid on that debt was driven down thanks to the Bank becoming a large new customer.

The mechanism by which the Bank bought government debt was convoluted, for operational and legal reasons. On any given morning the Debt Management Office (DMO), an arm of the Treasury, sold billions of pounds of British gilts to the world. Then in the afternoon, barely 400 metres away, the Bank of England held a reverse auction in which it effectively bought up billions of almost identical government debts. Under the terms of the Maastricht Treaty it would have been illegal for the DMO and Bank to trade with one another. So instead the City stepped in, making profits on trading both sides of this slightly bizarre monetary merry-go-round as it has played out for four years.

‘I fully admit it does look strange,’ Robert Stheeman, head of the DMO, told me. ‘On the other hand, we must make the distinction – we are raising money by selling new gilts but the Bank is buying old gilts in the secondary market.’

The end result: that the Bank bought about the same amount of government debt as was issued in a record year. Now the Bank of England owns 30 per cent of Britain’s outstanding gilt stock, worth just under £400 billion, and points to falls in the interest rate on gilts of about 1 percentage point as evidence of QE’s impact.

Some of the commercial banks saw it another way. Stephen Hester, chief executive of Royal Bank of Scotland, appearing before the Treasury Select Committee, was asked how RBS had been boosted by QE. He replied: ‘Quantitative easing so far has taken the form of the government effectively funding its deficit by printing money…’

Hester’s view is one that is commonly held in the City. Former Treasury aides say that is ‘nonsense’. To the contrary, they say they have been frustrated by how the Bank has chosen to buy government debt rather than corporate debt. Moreover, the Bank has barely used a Treasury-backed option for ‘qualitative easing’, a purchase up to £50 billion of private debts. One aide even described feeling ‘a little tricked’ by the Bank. The coalition government faced the same tension in 2011 when it attempted to coax the Bank of England to lend money to credit-starved businesses in the private sector. George Osborne came up with a Treasury-backed ‘credit easing’ scheme called the National Loan Guarantee Scheme (NLGS). This put some pressure on the Bank of England. To everyone’s relief, the Bank of England essentially launched its own version in summer 2012, called the Funding for Lending Scheme, or FLS, and the NLGS was parked in a corner.

To understand the sensitivities here, consider the 1797 Gillray cartoon – which is pointedly on display outside the room in the Bank of England where the votes on interest rates and QE are held. As Prime Minister William Pitt prints paper money to fund the war with France, the Bank of England, in the form of the Old Lady of Threadneedle Street, cries, ‘O you villain! What, have I kept my honour so long to have it broken by you at last?’ The Bank must guard itself against political meddling at all costs, and almost as important, it must be seen to do so. If not, thus begins the self-fulfilling cycle of elevated expectations of inflation and rapid growth in prices.

The Bank maintained its credibility, Sir Mervyn argues, by keeping its commitment to hit its inflation target, and promising to sell back the mountain of government debts it had amassed at some point in the future. The resale is much more than a simple financial transaction; the result would be to contract the money supply and raise longer-term interest rates for mortgages and businesses. So QE might look like monetisation of Britain’s debts, but as long as you confidently believe the debt will be resold into the market, it would not actually be ‘printing money’. But if it had been done at the behest of government, and the inflation target was being ignored, and you were more sceptical about a resale, then it is monetisation of debt – a modern version of letting the printing presses roll. For the Bank of England, what mattered was its intentions rather than its actions.

In effect, though, QE is a mild form of ‘financial repression’. The UK deficit is funded at negative real interest rates, effectively channelling funding to the government.

Once they were in government, Mr Osborne and Mr Cable quickly warmed to the very policy that they had derided in Opposition. Now they said that, theoretically, QE provided an option for boosting the economy at a time when the government’s austerity policies had weakened it. By 2011 three coalition cabinet ministers, including the prime minister and the chancellor, began to bang the drum for more QE, referring to themselves as ‘monetary activists’. And they were calling for more QE at a time when inflation was persistently more than double the Bank’s target. Indeed, the Bank had just released its own study showing that QE pushed up inflation, by up to 1.5 percentage points. The Bank pressed the button on more asset purchases, so-called ‘QE2’. As soon as this was announced, I rushed to Threadneedle Street. I asked the governor if the fact that inflation had been above target in sixty of the previous seventy-two months amounted to a backdoor abandonment of the targets he had so long cherished. ‘There’s absolutely no question of our commitment,’ he told me, referring to the inflation target. ‘We will not take risks with inflation, but if we had raised interest rates in the last two or three years significantly in order to bring inflation down closer to our target, we could have done that only by generating a really deep recession… That’s not part of our remit. And it would have been a disaster for the UK economy.’

Yet it is undoubtedly true that having an independent Bank of England gobbling up 30 per cent of the issuance of government debt has been useful for the Treasury during the crisis – and essential for George Osborne as his deficit numbers got worse rather than better during his austerity programme. Somewhat remarkably, the credit-ratings agencies repeatedly pointed out that a vital reason for Britain keeping its AAA rating until 2013 was the fact that the Bank of England was buying so much government debt. The prime minister, the chancellor and – most clearly – the business secretary, Vince Cable, had all been openly calling for more QE in the preceding weeks, so did the Bank of England succumb to political pressure?

‘Certainly not,’ said Sir Mervyn. ‘The Bank of England is independent. Not one of our nine members [of the Monetary Policy Committee] would dream of staying on that committee for a day longer if people thought they were trying to put pressure on us. And I can say this, that neither this government nor the previous one have ever since 1997 tried to influence a decision on interest rates or asset purchases by the MPC.’

That was 2011. Just a year later something rather odd happened. The Bank had been purchasing government bonds on an epic scale. And then, after a final purchase on 1 November 2012 of £3.2 billion (taking the total up to £375 billion), it paused. Even at low interest rates this loan from the Bank of England to the Treasury had earned a hefty amount of interest (known as coupon payments). About £37 billion of QE ‘profits’ were sitting in a Bank of England bank account. The Treasury had initiated talks with the Bank about what it called ‘cash management operations’. Around the time of those talks the interviews for a new governor of the Bank of England were taking place, and there had been some loose talk from some candidates about so-called ‘helicopter money’, which essentially would involve cancelling the debt owed to the Bank in order to fund a boost to Britain’s flagging economy.

On 23 October 2012, Sir Mervyn King made the following comments in a speech in Wales, thought at the time to be referring to these radical suggestions about monetary policy. ‘When the bank rate eventually starts to return to a more normal level, as one day it will, the Bank would then have no income, in the form of coupon payments on gilts, to cover the payments of interest on reserves at the Bank of England that we had created. The Bank would become insolvent unless it created even more money to finance those interest payments, and that would lead ultimately to uncontrolled inflation. That is a road down which the Bank will not go, and does not need to go.’

On 9 November the Treasury announced that the coupon payments were to be transferred to the Treasury. Except, it was not really a profit, as the funds were required as a buffer against future losses for the Bank of England from the sales of that portfolio of government debt. Sir Mervyn secured a guarantee that the cash would return by the tens of billions to cover a future shortfall. This was an up-front exchequer windfall caused not by raising taxes, nor by flogging state assets, nor by cutting spending. The Bank’s independence and credibility rest on the notion that this promise of repayment, made binding on any future UK government, is fulfilled.

In effect, the government itself had announced, opaquely, a further round of quantitative easing. The Treasury called the grab a ‘cash management operation’, to convey the idea that it was a run-of-the-mill accounting reshuffle. The manoeuvre did flatter the public finances at a time of stress. But it was likely to cost taxpayers more money in higher interest payments on the debt in future. It was basically a backdoor form of borrowing. And it did not stop there, as further QE profits would be banked by the Treasury too.

Effectively the British government was to stop paying interest on the third of the national debt owed to the Bank of England. Whilst this was not the actual monetisation of Britain’s national debt, it had come perilously close. Officials pointed to the fact that this was standard procedure for other major central banks, such as those in the USA and Japan. But the timing was unfortunate in Britain. It helped improve the state of Britain’s public finances at a time when the government’s austerity plans appeared off target. It seemed to set Britain on the path towards so-called ‘fiscal dominance’ – a situation in which the Treasury gains the upper hand over the central bank, and Gillray’s cartoon becomes reality.

At the very least it was a sign that the QE experiment was never intended to last three years. At most, it was a sign that the Bank of England’s independence was becoming far less sacrosanct. In half a decade’s time, we might discover whether it actually was the start of a monetisation.