The UK is in a liquidity trap - say no to more QE on planet ZIRP

Last week, the Governor of the Bank of England said This is the most serious financial crisis we have seen since the 1930s, if not ever. Well is it? Just like the 1930s the UK is in what we call a liquidity trap, a situation where monetary policy is unable to stimulate the economy either through lowering of interest rates or increasing money supply.   

Liquidity traps occur when rates are reduced to the zero bound or thereabouts and cannot be reduced further. In real terms UK rates (base rate minus inflation) are negative 4% plus.

The liquidity trap is compounded when expectations of adverse events, either deflation or in the current situation, a lack of aggregate demand, are manifest. Firms are loathe to invest, households are constrained to spend, government spending is limited by a desire to resolve a fiscal debt crisis.

In the UK, the first round of Quantatitive Easing or asset purchases was essential to improve liquidity in the banking system at a time of crisis. 

Inter bank lending was dessicated, LIBOR spreads were extending. The central bank was becoming not just the last lendor of resort but the only lender of resort. Action had to be taken to inject cash into the economy by undertaking a series of asset purchases predominantly gilts. The programme of some £200 billion was equal to 14% of GDP it had to be done.

This is not an argument for more asset purchases, for the exercise came at a price. QE forces up bond prices, pushes yields lower, punishes savers, places more pressure on sterling, increases import prices, leads to higher inflation, greater pressure on real incomes, a reduction in household spending, actually reduces demand and leads to lower growth.

Ten year gilt yields have fallen to 2.4% and thirty year gilt yields have fallen to 3.4%. But what does that mean? Gilts are mis priced, the real risk return on ten year gilts is negative. Effectively investors are paying the government to hold bonds.

Policy makers assume that lower interest rates at the longer end of the curve will lead to a higher level of investment. This is not the case. Any return on investment or payback calculation is a function of cash flows from a determined demand horizon. 

Cost of capital does not feature in the basic investment model. Until the uncertainty about the forward level of demand and growth is cleared, investment plans will remain on the shelf. 

The Bank of England suggests that QE increased GDP by between 1.5% - 2.0% but also led to an increase in inflation of between 0.75% and 1.5%. [Joyce M et al in the September Bank of England Quarterly Bulletin.] This is a highly speculative analysis.

If it were right, this would mean, that at best, the QE2 round of £75 billion would kick growth by just over 0.5% but increase inflation by over 1% on a pro rata basis according to the banks own figures.

One cannot be entirely confident in the bank’s hypothesis. QE led to a fall in gilt yields as a first round effect but thereafter the relationship between QE and the effect on growth and inflation is tenuous. The argument for further QE is intellectually weak and at best the potential economic impact minimal. The risks outweigh the return.

In fact I would argue that a further round of asset purchases merely oils the liquidity trap, digging a deeper hole, increasing the inflationary impact and reducing growth as investment plans are reigned back and household incomes are placed under greater strain. Sometimes the correct action is to do nothing, especially when it is more of the same toxic solution.

In 2008, writing about a zero interest rate policy, I wrote “Welcome to planet ZIRP. Unfortunately, we do not have a handbook, or fully understand the terrain. Our process of quantatitive easing, the plan to helicopter money may work but as a fire fighting option, it may be like dropping water into a desert, such are the fissures in the financial system." We just don’t really know what is achieved. So in the meantime we should say no to more QE and or asset purchases.

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Comments

[Ralph Musgrave]

A saw an excerpt from an interview of Mervyn King (possibly by Stephanie Flanders) in which she put it to him that he knew perfectly well that the latest round of QE would have no effect. He was doing it, so she suggested, just to make it look as though he was doing something. Perhaps George Osborne offered him a gong for his cooperation in this matter.

[It doesn't add up...]

THe

The first round of QE was predicated on the threat of deflation. We've ended up nearly 2 years later (when the effects of the policy are mostly evident) with inflation of around 5%. If the bank was right, then QE added at least 5% to inflation. If the study was right, then the bank was wrong in the first place: there was no threat of deflation.

We're already starting from 5% inflation. What to believe this time? Same as last time... inflation is being stirred up in a vain attempt to depreciate debts of imprudent government, imprudent bankers and imprudent house purchasers, and in beggar-my-neighbour devaluation that will only kick the balance of payments deficit further in the red. It's of the policy of those who hope they can keep kicking the can down the road until they're not around, caring nothing for the fact that it makes the eventual reckoning progressively worse.

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He was doing it, so she suggested, just to make it look as though he was doing something. Perhaps George Osborne offered him a gong for his cooperation in this matter.

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so what happend after that ??

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The first round of QE was predicated on the threat of deflation. We've ended up nearly 2 years later (when the effects of the policy are mostly evident) with inflation of around 5%. If the bank was right, then QE added at least 5% to inflation. If the study was right, then the bank was wrong in the first place: there was no threat of deflation.

We're already starting from 5% inflation. What to believe this time? Same as last time... inflation is being stirred up in a vain attempt to depreciate debts of imprudent government, imprudent bankers and imprudent house purchasers, and in beggar-my-neighbour devaluation that will only kick the balance of payments deficit further in the red.

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Great news, tells all the reality and true story behind.

[Visit England]

Government must comeout counter measures to avoid this deflation. Individuals also must do their part so that when it happens you can tackle it easily.

[Visit Britain]

I agree with you. We must fully prepare and aware for the possibility.

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Absolutely true.

[GED Online]

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