The need for a second round of quantitative easing, which now appears likely, highlights the Bank of England’s misplaced faith in the stimulative power of a falling pound.
Ben Broadbent, an external member of the Monetary Policy Committee, this morning blamed the “sclerotic” banking industry for the failure of the pound’s depreciation to deliver the impact Threadneedle Street was hoping for.
If Mr Broadbent is right, then the economy’s woes are more serious than previously thought, which makes the case for further QE all the more compelling.
This decline would, it was hoped – and reasonably so given past experience, boost the economy through Britain’s terms of trade. And not only in the short-term; a rebalancing is considered vital if the UK economy is to prosper in the years ahead.
However, the impact, as Charles Bean, the deputy governor for monetary policy, acknowledged in May, has been “largely disappointing”. The Bank has frequently blamed this on the import side of the terms of trade.
The deputy governor offered three reasons why: that increased specialisation means demand is less responsive to price than previously, heightened uncertainty, and the absence of UK suppliers for some sorts of goods and services. Nevertheless, the deputy governor said “the MPC still expects net exports to contribute substantially to the overall growth in demand over the next few years as the necessary rebalancing gradually takes place.”
However, Mr Broadbent on Monday listed another, more worrying, impediment; the banks’ poor health.
At a stroke, the financial crisis exposed the UK to the troubled assets of its large banks. More significantly, it reduced national income – above all government revenue – by more than in other countries. This meant that demand for UK (non-traded) output, and therefore its relative price, were bound to decline, that much more so in the presence of a sclerotic banking system that is finding it hard to reallocate capital.
He also argued that the banks’ condition was impacting the supply side.
Why so? A fall in sterling creates an incentive to invest in traded goods, rather than ones that appeal to domestic consumers. But that hasn’t happened to the degree expected because of the difficulties in reallocating capital:
We know that productivity growth tends to be slow in the aftermath of financial crises, and the UK economy today certainly fits that pattern: output per hour has risen at an annualised rate of only 0.7% since the end of the recession, far lower than the 3.6% average during other post-war recoveries. We also have compelling theoretical models that explain why a dysfunctional banking system, or other frictions in factor markets, can slow down the usual Schumpeterian process of “creative destruction”, i.e. the replacement of unprofitable activities by those that are newly profitable…
Mr Broadbent acknowledges that this is “mostly conjecture” and that anaemic growth in the UK’s trade partners has also contributed to the flagging pace of the rebalancing. Yet he points to the relatively low rates of both start-ups and corporate bankruptcies as signs that “the usual process of ‘creative destruction’” has yet to get into full swing (see the chart below).
Mr Broadbent’s argument makes for grim reading.
If the UK economy’s rebalancing is dependent on the banking system’s return to health, then – in a climate in which fear remains rife – the pace of recovery would be slower than others in the Bank had hoped. In turn, weaker growth for longer will hardly improve financial market sentiment.
It is not surprising, then, that Mr Broadbent has hinted at his support for more asset purchases.