The case for more quantitative easing is growing
Gavyn Davies
July 26, 2011
The latest figures show that Britain’s economy grew by only 0.2 per cent in the second quarter, which the Office for National Statistics says was equivalent to 0.7 per cent after taking account of the extra bank holiday for the royal wedding, and the effects of the Japanese earthquake.
One excuse after another! Taking a slightly longer view, the economy has barely grown at all, according to the official statisticians, over the past three quarters.
What should be done about this?
The answer depends on why growth has slowed down so sharply in the official statistics. One strong possibility is that the ONS is significantly underestimating the true level and growth rate of gross domestic product, as it has done for long periods during previous economic recoveries.
Alternative economic indicators continue to look more buoyant than the GDP figures. For example, business survey data indicate that the economy may have grown by about 1 per cent in the first quarter, and by 0.6 per cent in the second quarter. Furthermore, labour market data have not weakened in the manner that would be expected if the economy had stagnated.
On these alternative estimates, the slowdown in UK growth would be in line with the pattern in other major economies this year. Growth would now be roughly in line with trend, with the path headed slightly downwards. That would provide no cause for complacency, but no cause for panic either.
The next question is how much of the growth slowdown has been caused by supply side factors, which cannot be addressed by conventional demand management. The shrinkage of the financial and construction sectors has certainly affected the economy adversely, but these effects need not be permanent, since resources can be redeployed in other industries. More recently, however, the rise in oil prices has clearly acted as an adverse supply shock, simultaneously raising inflation and cutting output growth. There is nothing that fiscal or monetary policy can do about that, if the inflation target is to be respected.
However, once the commodity shock has passed, and assuming the economy stays subdued, there will be a strong case for a boost to demand through macroeconomic policy. Should this come from the fiscal or the monetary side? The government’s budgetary regime allows the fiscal stabilisers to work, and they are already doing so with the overshoot of the budget deficit relative to target in the new fiscal year. But this will only amount to around 0.5 per cent of GDP, which is fairly negligible.
Other ideas for fiscal easing include a temporary cut in VAT on the Labour side, or an early elimination of the 50 per cent income tax rate on the Conservative side.
The Chancellor George Osborne continues to argue against this kind of emergency fiscal action, which would undermine the confidence effects he hopes to see from the control of public debt.
There is no doubt that the fiscal tightening has slowed the economy. The idea that the budget deficit could be cut by 2 per cent of GDP per annum without this affecting GDP was always a pipedream. But these effects were intended to be cushioned by expansionary monetary policy and a lower exchange rate, and that still remains the best route to easier demand policy.
Inflation is still too high for the Bank of England to ease policy immediately. The headline rate of consumer price inflation in June was 4.2 per cent. But underlying inflation rates are now falling sharply, with some measures of core inflation having dropped below 1 per cent. This is consistent with the very subdued behaviour of wage increases and labour costs, which will determine inflation in the long run.
The Bank’s monetary policy committee looked set to increase interest rates earlier in the year. We now know that this would have been a serious mistake. The case for another round of quantitative easing is growing.
The writer is chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners
Response by Jonathan Portes
Calls for more QE are passing the buck to the Bank
As Gavyn Davies says, the idea that the very sharp fiscal contraction now in train in the UK would not be contractionary was always a pipe dream, and there is now a strong case for a boost to demand. Like Vince Cable and the International Monetary Fund, he argues that monetary policy – in particular, another round of quantitative easing – should pick up the slack.
But there are several reasons to believe that monetary and fiscal policy are far from being perfect substitutes in current circumstances. Monetary policy works, in Milton Friedman’s famous phrase, with “long and variable lags”, while fiscal policy, if it takes the form of changes to government spending, can work quickly. Simulations using the National Institute of Economic and Social Research’s model suggest that, in the UK, the contractionary effect of spending cuts is offset in the short term to a very limited extent by a monetary policy response.
Moreover, one main channel through which monetary policy could, in theory, boost demand is via a lower exchange rate. But we’ve already seen the trade-weighted exchange rate fall below trend, and we have been importing inflation; while this fall is welcome, and things would definitely be even worse without it, a further significant fall would be of questionable benefit.
And finally, while QE has clearly helped, it is likely to be subject to diminishing returns, with long term interest rates at historic lows. This is the result not of “confidence”, as the Chancellor has misleadingly argued, but, as in the US and Japan, economic weakness; UK long-term interest rates have fallen as expectations for future economic growth have been reduced.
Calling for more QE is understandable, but it amounts to passing the buck to the Bank of England at a time when it has limited room for manoeuvre. Instead, calls for action should be directed at the government. A more comprehensive growth strategy would include action on fiscal policy in the short-term – slowing the pace of spending cuts – and measures to boost the supply side over the medium term.
The writer is director of the National Institute of Economic and Social Research
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