In Apocalypse Now, Wagner’s “Ride of the Valkyries” provides the soundtrack to the dirty deeds of American helicopter crews. I don’t know whether Sir Mervyn King, Governor of the Bank of England and avid classical music buff, has been listening to Wagner recently but he clearly shares Francis Ford Coppola’s horror of helicopters. In Sir Mervyn’s case, however, the source of his angst is monetary, not military, helicopters.
In a speech on Tuesday night, Mr King outlined the limits to monetary policy. Following all the talk from the International Monetary Fund about magical multipliers, Mr King offered a much-needed dose of economic reality. Taking a leaf out of Japan’s “lost decade” experience, he warned of the dangers of rising non-performing loans, implying that the banking sector would take many years to recover. He was dismissive of the idea that the Bank of England should cancel gilts – UK government debt – that it has purchased as part of its programme of quantitative easing. And he sneered at the idea of dropping money from the aforementioned helicopters. Mr King, is not a believer in “get rich quick” schemes.
It’s not so much that monetary policy is ineffective. Rather, people expect too much from it. Those who hope for a return to the good old days choose to ignore the rather obvious fact that, back then, economic activity was heavily distorted: economic growth in the years preceding Lehman was driven by a housing boom, a sub-prime lending boom, financial market shenanigans, ever-higher levels of public spending and, frankly, not much else.
Early doses of quantitative easing were consistent with the desire to rebalance the UK economy. In anticipation of the first round of unconventional policies, sterling fell, offering the opportunity for an export-led recovery. In reality, however, the UK ended up with little in the way of extra growth and rather too much in the way of inflation. Sterling’s decline amplified the impact on the UK of higher global commodity prices. That wasn’t really part of the plan: the resulting squeeze on real incomes made deleveraging that much more difficult. Meanwhile, the much-heralded export recovery failed to materialise. Relative to the BoE’s own economic forecasts made towards the end of 2010 – and conditioned on the positive effects of QE – the UK economy’s performance has been very disappointing.
It may well be that unconventional monetary policy can prevent the worst outcome – the avoidance of another Great Depression, let’s say – but it is not obvious that it can take us back to the sunny uplands of the pre-crisis years.
Indeed, I would argue that unconventional policies create distortions that make an early return to economic health rather unlikely.
I have three concerns. First, QE delivers a flat yield curve – that is interest rates for long-term loans are not much higher than for short-term loans. That should certainly help boost the demand for credit. But a flat yield curve makes it difficult for banks to make money by borrowing cheaply at short-term interest rates and lending profitably at higher long-term rates. Lower bank profitability will restrict the supply of credit. During the early-1990s credit crunch, the Federal Reserve deliberately engineered a positively-sloped yield curve to “fix” the banks, the polar opposite of today’s policies.
Second, as the BoE now well knows, QE increases pension fund shortfalls. Admittedly, fully-funded pensions shouldn’t have many problems but, today, these are few and far between. Underfunded schemes have seen the net present value of their liabilities rise more quickly than their assets, creating uncertainty over future pension entitlements and contributions, dampening household confidence in the process.
Third, despite Mr King’s insistence that monetary and fiscal policy are entirely separate, this is no longer the case. In the upcoming pre-Budget Report, George Osborne will be able to delay fiscal consolidation thanks in part to the behaviour of the Bank of England, whose gilt buying has kept yields low allowing the government to borrow cheaply to fund deficits. QE has become the Chancellor’s lifeline, sparing him from a 21st century Greek tragedy.
This, however, is another example of avoiding the worst, rather than providing a path towards recovery. QE has allowed the government to live with high – and rising – levels of debt. It has not, however, delivered the kind of recovery that would, eventually, allow those debt levels to decline. In this way, the UK is emulating Japan’s experience: low rates, high government debt and disappointing growth.
Perhaps, then, the helicopters should, after all, take flight. Might a stirring rendition of some choice Wagner do the trick? Should we demand fiscal stimulus funded by the printing press – through the cancellation of government debt held by the BOE or some other form of “money drop”?
Roosevelt pursued such policies in the 1930s. They seemed to work. From the depths of Depression, the US staged a solid recovery accompanied by a dose of inflation. Yet Roosevelt’s inflation was only acceptable because of the earlier deflation.
As Roosevelt said in one of his fireside chats, “The Administration has the definite objective of raising…prices to such an extent that those who have borrowed money will, on the average, be able to repay that money in the kind of dollar which they borrowed. We do not seek to let them get such a cheap dollar that they will be able to pay back a great deal less than they borrowed”. In other words, in the absence of deflation, it’s difficult to justify the pursuit of inflation.
Helicopters are all very well, but they should be used sparingly. Mr King may protest too much about the independence of monetary from fiscal policy. He is surely right, however, to warn of monetary policy’s limitations.
The writer is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research. He is a member of the Financial Times Economists’ Forum.