The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (40 page)

So, apart from reducing the government interest bill, what else has QE achieved so far? There had been a flurry of activity by big companies bypassing the banks and raising money direct from capital markets, typically in the form of issuing corporate bonds to pension funds and insurance companies. But the big companies use this borrowing to pay back bank debt, then it acts as a drag on bank lending and impedes the desired growth in the broad money supply. Despite the injection of £375 billion, annual growth in the wider measure of the money supply, including notes, coins and bank deposits, has been a paltry 1 to 2 per cent for most of the first two phases of QE, creeping up to 4 per cent at the time of QE3, still under half its decade-long pre-crisis average. So where are the missing pounds?

‘QE didn’t go into broad money,’ says Simon Ward, chief economist at Henderson, ‘because a lot of it was used to repay lending from the banks. That negated the boost to M4.’ (M4 is a measure of the broad money supply.) A wounded banking system also meant that money was not circulating through the economy as it should. But the velocity of circulation of those pounds that
are
washing through the economy did creep up.

Proponents of QE say that it prevented deflation and a global depression by providing a bandage for the US and UK economies after the bursting of their credit bubbles. Other economists are unconvinced. ‘The bank has chopped and changed its metrics of what QE is meant to do,’ says a former Bank of England economist, Danny Gabay, of Fathom Consulting. ‘Even though M4 growth is close to zero, they now say look at how much worse it would have been, the counterfactual.’ Such speculative counterfactuals are, of course, unprovable. Gabay even questions the claim that QE has lowered the interest rates paid on government debts. He points out that these gilt yields have fallen even more, during some of the periods when QE was put on hold.

One thing is certain about QE. The policy has had political and diplomatic impacts. There have been two types of response. The emerging countries saw QE as a backdoor devaluation of currency, which would damage their exports. The Eurozone, for its part, was trying to avoid the Anglo-Saxon injunctions to forget twentieth-century German history and print money.

The ‘foreign-exchange channel’ is an important additional way for QE to boost an economy. As the New York Federal Reserve puts it in its guide to QE: ‘As normally happens when the Fed lowers interest rates, [QE] may lead to a moderate change in the foreign exchange value of the dollar that supports demand for US-produced goods.’ The USA has come a long way since the ‘strong dollar policy’ that existed until 2002, and was still officially articulated under Treasury secretary Hank Paulson as late as 2008 as the dollar tumbled.

In Britain too, anticipation of QE partly coincided with and partly helped cause a sharp fall in sterling. Over four years it was the sharpest fall in sterling since Britain exited the gold standard in 1931. ‘The best thing the Labour government did [to boost the economy] was to engineer a sterling devaluation without anyone really noticing,’ said one UK bank chief executive. The Bank of England’s economists calculated that the first £200 billion of QE alone saw a depreciation in sterling against other major currencies of 4 per cent.

China and Brazil were concerned about the impact of this money creation on their economies, through competitive depreciations, rising commodity prices and unsustainable flows of hot money. The Brazilian finance minister talked about a new era of ‘currency wars’. At the central bankers’ central bank, the Bank for International Settlements in Basel, Switzerland, arguments raged between the emerging and the developed world.

‘QE is like doping in the Tour de France,’ one well-connected Eurozone financier told me. ‘And America is like Lance Armstrong.’ The concerns expressed in Europe were different from those of China and Brazil. Europe felt the need to push back against strong pressure from the USA and the UK to stop dragging its feet on QE, and to ‘fire the bazooka’ – basically by copying London and Washington by buying the bonds of its member governments. European central bankers began openly to criticise QE in the UK and USA as a form of cheating market discipline.

The governor of the Banque de France, Christian Noyer, who sits on the governing council of the European Central Bank (ECB), pulled no punches. ‘We are paying the price for our virtue and our refusal to liquify our debt through massive monetisation of our fiscal deficits,’ he said, in a clear reference to Britain, and to a lesser extent the USA.

It was a rather telling quote. Viewed from Paris, Berlin or Frankfurt, Anglo-American quantitative easing lacked ‘virtue’. The ‘massive monetisation’ Noyer was talking about in 2011 specifically referred to the Bank of England’s then £275 billion purchase of UK government bonds – which contributed to the UK’s record lows for funding costs, and would help Britain keep its AAA rating for a time. He compared Britain’s record unfavourably with that of the ECB. ‘Those purchases amount to 51 per cent of the total debt issued since 2009 in the UK, 21 per cent in the USA and 7.6 per cent in the euro area,’ he said.

Again, the Bank of England denies this is a ‘massive monetisation’ of Britain’s debt pile, specifically because it has promised to resell this debt back into the market at some point in the future. But many in the markets share Governor Noyer’s doubts that this will actually ever happen. When I mentioned to Mr Noyer that it was great to interview a central bank governor, because in the UK we only seem to get an interview when the Bank of England is printing money, he warily burst out laughing. Nothing beats a good joke about quantitative easing.

Other senior European monetary officials, speaking privately, struggled to hide their irritation with Britain. The balance sheets of both the Bank of England and the Federal Reserve had more than doubled during the crisis. The ECB’s purchase of sovereign debt amounted to 1.6 per cent of its GDP. For Britain it is 16 per cent. The general view of these officials was that, when the financial markets had come to their senses, Europe’s ‘virtue’ would count.

Markus Kerber, the German economist who has led the constitutional charge against the ECB’s existing Italian and Spanish bond purchases, put it clearly. ‘German sovereignty is not compatible with any piece of advice by the US president or the British PM, who have already printed a lot of money,’ he told me. ‘They should know that Germany will resist this piece of advice, [because] mega-inflation is the nightmare consequence, the unavoidable consequence of printing money.’

British inflation has been by far the highest of the major European economies, and the Bank of England acknowledges that its quantitative easing policy has contributed. Europe had begun to notice Britain’s quantitative easing – but as an example to avoid, rather than to follow.

With no consensus among British economists about QE, who better to consult than the person who coined the term in the first place? Richard Werner, an expert on Japan, now of Southampton University, came up with the name in 1994. He has an unexpected perspective. He believes the whole QE exercise in Britain, as it was in Japan, is a ‘sham’, and isn’t really QE at all. ‘The Bank has dug a PR hole for itself with quantitative easing. I don’t know why they are using my expression,’ he tells me.

His ‘expression’ arises from a translation of a specific Japanese term,
ryoteki kanwa
,
which
he devised a couple of decades ago to shine a light on the inadequacies of the sluggish policies of the Bank of Japan. He says his idea involved efforts to increase credit, because the money transmission system, the banking system, was broken. He derides monetarists and their obsession with obscure measures of money, and suggests, instead, a laser-like focus on creating credit. When the Bank of Japan belatedly adopted QE in 2001, he argues it was not QE at all, but rather completely bog-standard monetary policy that the Bank of Japan wanted to dress up as something new, for reasons of political spin. It was a type of economic placebo. Now he argues something similar was happening in Britain.

‘It’s not to say that what the Bank is doing is useless,’ he says. ‘It has helped the banks but it doesn’t inject new money. That is only injected when the money leaves the banking sector and goes into the economy. So far the money has just been passed from central banks to commercial banks.’ And while healthier bank and corporate balance sheets are clearly positive, until the money flows across the economy, Britain’s recovery, like Japan’s a decade ago, is fated to be choppy.

Werner is particularly withering about a new generation of economic computer models that are being widely used in the world’s central banks to model economic behaviour. They are known as Dynamic Stochastic General Equilibrium models. ‘These DSGE models are nonsense,’ he says. ‘Until the crisis these models didn’t even include the banking sector. They are abstract mathematical dream worlds, and they are wholly irrelevant for the situation we find ourselves in.’

The Bank of England had a suite of such econometric models, called BEQM (pronounced Beckham), described as ‘state-of-the-art’ upon their introduction. The Bank used BEQM to calculate the impact of their decisions on interest rates and QE. Except QE does not work in conventional ‘New Keynesian’ models, such as this. The Bank’s forecast is compiled by about eighty of Britain’s and the world’s finest economics brains, in six divisions – covering monetary analysis, financial markets, medium-term demand, the economic model, the world economy, and writing the Bank’s inflation report.

The forecast is a continuous process that layers all new economic data onto the previous forecast. Vitally though, the forecast is not a product of pure dispassionate economics, but rather represents the ‘best collective view’ of the nine members of the Bank’s Monetary Policy Committee. How do all these economists agree on a forecast at times when there can be a four-way split on the decision on monetary policy? Only once, in spring 2002, was there sufficiently different views on the economic outlook for a ‘minority report’ with an alternative forecast. That beggars belief, given the five years of economic torpor in Britain. Part of the answer lies in the fact that the forecast has a dual purpose: prognosis and propaganda. The forecast is tweaked and changed to make sense of the decisions of the Monetary Policy Committee, and is a crucial form of communication to markets and the public. It is not the work of pure independent economics such as the ‘staff projection’ that is presented at the US Federal Reserve.

So how did it do? For the five years before the crisis, the forecasters rarely got economic growth wrong. Alas, since the crisis, they have rarely got it right. Forecast performance was noticeably worse than pre-crisis, and also worse than outside forecasters predicted. As an independent review of its forecasts concluded: ‘The forecast errors of the MPC have been characterised by persistent over-prediction of output growth and persistent under-prediction of CPI [consumer price index] inflation.’ All central banks struggled to predict the ‘Great Recession’ of 2007–09, but the Bank of England’s errors were larger than the ECB’s or the Fed’s. And, unlike the others, since the crisis the Bank of England’s errors have always been biased in the direction of over-predicting UK growth.

The Bank’s defence rested on the notion that it did not factor in the rise in energy prices, and its subsequent impact on British consumers. The forecast simply assumed that oil prices would move in line with prices in futures markets. But they stayed much higher for much longer.

Perhaps alarmed by the irrelevance of their ‘state-of-the-art’ suite of models, the Bank of England introduced a new model in 2012 called Compass (Central Organising Model for Projections and Stochastic Simulations, if you were wondering), holding out the hope that they at least vaguely knew which direction to head in.

Compass had a simpler core than BEQM – sixteen economic variables, from GDP to prices and the jobs market, supported by a range of other models. Staggeringly, as an independent review calmly concluded, the ‘Bank’s current forecast model – Compass – has very limited financial detail’. So, after a financial crisis had devastated the world economy, bankrupted half of the British banking sector and seen the nation’s annual finances descend to their peacetime nadir,
after that
, the Bank’s principal method of divining the future had ‘very limited financial detail’. It gets worse. Compass was still, at core, a New Keynesian DSGE model. As some of the Bank’s own economists admitted, ‘QE is irrelevant [in these models] unless it signals something about future policy that gets incorporated into expectations of future interest rates or inflation.’

So in the Bank of England’s current model, there is little or no financial sector, and little relevance for QE, currently the principal lever of UK macroeconomic policy. I’m surprised they have not yet reverted to the weather vane on the roof of the Bank, which long ago gave its clerks at least some sense of when ships might be arriving in the London docks, and with them a demand for credit. The Bank of England is and has been flying as blind as it has ever done.

Why does this econometric dream world matter? We are all being invited to view QE decisions as if they are analogous to a decision to shift interest rates by 0.25 or 0.5 per cent, the subject of an involved science. Yet it seems apparent that it is more of an art. One technique employed is to pretend that £200 billion of QE is in fact a negative interest rate, of say −2 per cent.

A negative interest rate is an intriguing concept. In the case of King Mervyn and his scurvy, it would mean not just flooding the market with oranges, but effectively paying people to eat them. In credit terms it would mean paying borrowers and charging savers. It is a vivid illustration that QE has had a significant – and, for some, an unfair – distributional impact. Nowhere is that more clearly seen than in the paltry incomes of recently retired pensioners, unlucky enough to have swapped their pension pots for annuities since QE began.