To QE or not to QE? That is the question

By Alex Brummer, October 28, 2010

The hostility of liberal Nobel prize winning economists Joseph Stiglitz and Paul Krugman to George Osborne's spending review has been palpable.

Krugman describes the Coalition's embrace of austerity as a 'fad'. Nevermind that if Labour had remained in power the cuts would have been almost as painful.

But what if the naysayers are right and the British economy, even after a near 20 per cent depreciation of the pound since the start of the recession, is heading back towards slump?

It is then that governments here in Britain and on the other side of the Atlantic will be dusting off a volume by another famous Jewish Nobel prize winning economist Milton Friedman. In his A Monetary History of the United States he argued that it was a decision taken by central bankers in the 1930s, who declined to switch on the monetary printing presses, which was responsible for the depth of the Great Depression.

There is a great determination that this should not happen again. The Federal Reserve chairman Ben Bernanke, a scholar of the Great Depression, is making it clear that he will do all in his power to prevent the American double dip. Interest rates will remain zero bound - as close to zero as they can go - but more importantly Bernanke has expressed his intention to flood financial markets with a further $1,000 billion (a trillion) of cash through 'quantitative easing' (QE).

The quantative easing debate is back with a vengeance

This is the technique, first deployed in Japan in the 1990s, under which central banks buy in long term bonds, issued by governments, and exchange them for cash. The aim of the policy is to keep the monetary system well lubricated and make it easier for banks to lend and companies to raise funds.

Here in Britain 'unconventional' measures, as governor of the Bank of England Mervyn King calls them, have already been tried. In the period running up to the summer the Bank intervened in the corporate and government debt markets and put £200 billions of bonds on its books in exchange for cash.

The Bank believes that it was this injection of money which allowed much of corporate Britain to survive during the recession, rather than follow Woolworths into administration.

The weakest companies have been able to raise new funds, to improve balance sheets, through rights issues of new shares to existing investors.There would have been no resources for the insurers and pension funds to buy this stock had the government not swapped holdings of fixed interest securities for cash.

Now the debate is back with a vengeance. By pressing ahead with its £81bn of deficit cuts over the next four years the Coalition accepts that fiscal policy will only be of limited value in supporting growth.

It can, however, assist in several ways. First, it has improved confidence in the UK on global markets. The nation's 'triple A' credit rating has been reconfirmed and the yield of British government bonds - gilt-edged stocks -- has fallen dramatically. This will lower the nation's interest rate bill.

Secondly, since other interest rates in the economy are led by gilt yields it will also mean that companies and households can borrow more cheaply which should also enhance growth.

Finally, if and when the economy does recover, bloated public sector borrowing will not get in the way of private sector expansion.

While this will help, the monetary weapon will almost certainly have to be deployed. The most recent set of minutes from the interest rate setting Monetary Policy Committee (MPC) - issued on the day of the spending review October 20 - show that the Bank of England is by no means unanimous.

The MPC was split three ways. The largest group on the nine-member committee headed by governor Mervyn King left open the door to further 'quantitative easing' (QE) without committing to the policy.

One member of the committee the American economist Adam Posen voted for immediate QE. Posen, a former Brooking Institution fellow who enthusiastically has moved to London, has drawn on his experience of Japan's lost decade.

Posen believes that Britain risks the same unless there is dramatic action to keep the economy lubricated. He has voted for an immediate new round of QE to the value of £50bn.

Another member of the committee, former British Airways chief economist Andrew Sentance, fears that too much money has already been flushed through the economy and the Bank should be keeping a closer eye on inflation which is running way ahead of the government's two per cent target at just over three per cent. He thinks that it is time to start removing the stimulus - or remove the punch bowl - by raising interest rates by a quarter of a point.The reality is, of course, eight out of the nine members do remain ready to do more QE. This majority is also likely to be influenced by what is happening in the United States where they are going for the double play - continued fiscal expansion together with massive printing of money.

There is a grim determination that the mistakes of the 1930s not be repeated. The Coalition has embarked on a great experiment which bitterly divides economic opinion. In many ways the split reflects the old dispute between Keynesians and Friedmanites with Britain tipping back towards the latter as it did in Mrs Thatcher's era.

It is going to be a fascinating ride.

Alex Brummer is City Editor of the Daily Mail

Last updated: 3:37pm, October 28 2010