Quantitative Easing: what it is and why it’s not working

Sunday, 7 February 2010

  • Will £220bn worth of Quantitative Easing (QE) stimulate growth in the UK economy?

The Bank of England would like to stimulate the economy, but I don’t believe that is QE’s real purpose. What it was meant to do was to cover a UK debt hole that most people don’t understand but could push the economy into depression.

The Bank of England has ended QE, at least for the time being. The total amount it ‘pumped into the economy’ represents around 15% of the value of UK production or GDP. It has done this with interest rates at 0.5% and a recently announced UK production (GDP) increase of 0.1%.

Yet, 0.1% doesn’t sound much and there is a good reason that it differs from the theory.

What you’re told

The theory is that the Bank of England flicks a switch and creates money. The Bank uses this money to buy bonds from investment and high street banks as well as large companies and therefore deposit money into their coffers. Bonds are contracts to pay back a certain amount of borrowed money plus interest.

More money in banks and low interest rates, means that bank managers can lend out more money to businesses, particularly small businesses.  But QE is risky. Too much of it leads to inflation in the medium term and it may also put off global financiers buying UK government bonds or gilts.

The UK, though, has a good name when it comes to paying debt. Credit rating agencies tell global financial markets of the risks of not getting back money loaned to nations. The UK has a Triple A rating. Its bonds are called gilts because of this. The financial markets think the idea of the UK settling its debt is unthinkable.

Furthermore, the Bank of England can say there are indications that QE’s working. They also recently announced that provisional November 2009 figures show that net lending by all UK-resident banks and building societies to businesses was £0.1 billion. Meanwhile, there has been a more than expected jump in manufacturing output from December 2009 to January 2010 and QE has, as planned, helped firms buy more shares.

Yet, the lending numbers is a net figure and incorporates money businesses paid back to banks and building societies. Indeed, the Bank says that some business borrowed money from capital markets in order to pay off their bank debt. Meanwhile, the Bank admits that lending over the year remains subdued. As for the manufacturing increase, it has been small.

This should not be a surprise. Most of the QE money has not been spent on banks but rather government gilts. By the end of September 2009, out of £154bn spend on QE, £152bn was spent on gilts. Therefore, QE as of yet has not been the success it should have been. So, what is really going on?

What you’re not told

QE is part of the mysterious process of money creation and the purpose that I suspect it fulfilled is connected to this and to the value of UK sterling.

Money creation is about the money people and organisations spend, have in bank accounts, invest and save. Most of a nation’s money is created by its central bank. The government gives certain commercial or investment banks bonds and gilts. These banks then hands over money to the central bank. The central bank can then buy more bonds from other banks. The money supply is then swelled. This is why pound notes are certified by the Bank of England rather than the UK Treasury.

But most central banks are owned by commercial institutions or by private individuals. The same ones to which the government gives its bonds and gilts. The Bank of England is semi-private in that its shares are held by the Treasury Solicitor and their board of directors is appointed by the government.

This process helps to create the UK National Debt. From figures published November 2009, UK public sector net debt was £870 billion or 61.7% of National GDP (http://www.statistics.gov.uk/cci/nugget.asp?id=206). Roughly, National Debt is usually represented as the difference between money the government has spent and will spend that it has financed through tax and the extra spending that it raised through borrowing that it hasn’t yet paid back. In reality, a substantial proportion of that is money owed to the Bank of England when it created money.

In March 2009, the government found that global financial institutions avoided buying its gilts.  Gilts are regarded as a very safe bet so this was virtually unprecedented. The Bank of England was forced to step in and buy the gilts. I believe this to be the origin of QE.

But government must also pay back with interest the money borrowed from global financiers in the past. Again, this is where QE steps in. I suspect that the main function of QE is to create money to pay back foreign lenders. Instead to going into UK banks, much of the money went abroad. It was not intended to substantially stimulate the economy.

What you should be told

So, what does the Bank of England fear? There has been talk that the UK and US might not pay back its debts. This would mean financial Armageddon.  But this what Iceland and Greece are going through. So, if the UK did not pay back foreign lenders then it would lose its high credit rating. The consequence is that foreigners would not buy Sterling (through gilts and bonds), its value would fall and interest rates would go up. The UK would have to go to the IMF and they would run the UK Treasury.

Some analysts suspect that UK national debt is higher than £870bn. The Centre for Policy Studies argue that the real national debt is actually £1,340 billion – 103.5% of GDP. This figure includes all the public sector pension liabilities such as pensions, and Private Finance Initiative contracts Northern Rock liabilities, etc.

The government would say that this debt doesn’t really count because we have a long time to pay it back. And anyway, the UK is a resilient economy. It will overcome these problems and in the meantime why panic people?

Although, financial analysts have said a UK debt default is unthinkable, the mood is becoming less optimistic. Consultants McKinsey Global Institute presented a study of the UK debt situation at the global elite bash, the Davos World Economic Forum. It said that the UK problems is the worst of the major economies and would take up to seven years to get rid of. Add Morgan Stanley, and financier George Soros to those agreeing with this bleak picture of the UK and you’ve got something to worry about.

QE has bought some time. We all expect is that coming next is the slashing of public spending, an increase in taxation and perhaps an increase in interest rates. But should we also be expecting the IMF to take over the running of the UK Treasury?

More information

Bank of England explains Quantitative Easing, http://www.bankofengland.co.uk/monetarypolicy/pdf/qe-pamphlet.pdf

Bank of England halts quantitative easing, http://www.guardian.co.uk/business/2010/feb/04/quantitative-easing-bank-of-england

Asset Purchase Facility, 2009, Q4, http://http//www.bankofengland.co.uk/publications/other/markets/apf/apfquarterlyreport1001.pdf

Bank of England launches quantitative easing, March 2009, http://www.marketwatch.com/story/bank-england-buys-uk-gilts-begins

Bank of England’s lending figures:

Trends in Lending, January 2010, http://www.bankofengland.co.uk/publications/other/monetary/TrendsJanuary10.pdf

What are ‘gilts’, http://www.dmo.gov.uk/index.aspx?page=gilts/about_gilts

UK National Debt, http://www.economicshelp.org/blog/uk-economy/uk-national-debt/

Manufacturing grows more than expected, http://www.guardian.co.uk/business/2010/feb/01/manufacturing-sector-growth- soars

Record fall in bank lending to business triggers new concern over UK recovery, http://business.timesonline.co.uk/tol/business/economics/article7032968.ece

Davos World Economic Forum:
Experts paint bleak picture of UK debt crisis, http://www.moneymarketing.co.uk/regulation/news/experts-paint-bleak-picture-of-uk-debt-crisis/1006057.article

Morgan Stanley fears UK sovereign debt crisis in 2010, http://www.telegraph.co.uk/finance/economics/6693162/Morgan-Stanley-fears-UK-sovereign-debt-crisis-in-2010.html

Soros: ‘bleak outlook for UK’, http://www.bbc.co.uk/blogs/thereporters/robertpeston/2010/01/soros_bleak_outlook_for_uk.html

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