ANOTHER WEEK, another downgrade in the Bank of England’s forecasts for the British economy.
Last year, the Bank forecast that the UK economy would grow by 2% in 2012. This was subsequently revised downwards to 0.8%. Last week, the Governor of the Bank of England, Sir Mervyn King, announced that the Bank’s forecast was now just…..0%. Zero. Complete stagnation.
In an excellent imitation of Macavity the Mystery Cat, the Governor dismissed any suggestion that the UK’s poor performance might have anything to do with the Bank of England’s own policies. No, indeed. Sir Mervyn was keen to disabuse us of such a notion. Sir Mervyn made it clear that it was all the fault of volatile global conditions, the Eurozone crisis, and the ongoing problems of the international banking system. All of which, we may readily concede, are matters over which the Bank of England has no control whatsoever.
Well, yes, one accepts that the travails of the euro – and the continuing denial of Eurozone leaders from Mario Draghi downwards that there is any structural problem at all in the single currency, in the face of overwhelming evidence to the contrary – have not helped. And it is certainly not my intention to engage in ad hominem attacks on Sir Mervyn. Goodness knows, he has a difficult enough job to do as it is, and in certain respects is doing it well – as in his eminently sensible advice to the New York regulatory authorities that it might be wise to refrain from comment on their ongoing investigation of Standard Chartered’s dealings with Iran until all the facts are known, rather than leaping to premature conclusions and then shouting them from the rooftops to generate lurid headlines across the world’s press.
But can the Old Lady of Threadneedle Street really be absolved of all blame for the UK’s current predicament?
Let us not forget that this is the same Bank of England that has given consistently rosy forecasts for the economic outlook over recent years.
When the Bank first introduced Quantitative Easing in March 2009, it predicted that QE would kick-start economic recovery, forecasting that the UK economy would grow by 1.7% in 2010, 3.4% in 2011, and 3.5% in 2012. At the same time, the Bank forecast that inflation would fall.
The results were exactly the opposite. The growth predicted by the Bank simply hasn’t happened. Inflation rose to well above the Bank’s target of 2% per annum, and only started to fall back after its Quantitative Easing programme ended. Even Sir Mervyn himself admitted that QE had not performed as hoped during a visit to his native Wolverhampton last month.
Yet, despite this, the Bank has now embarked on a further £75 billion QE programme, and remains cheerily optimistic about its positive impact, forecasting in May that the UK economy will grow by 2.6% in 2014, and 3.4% in 2015.
Let's look at the theory. The notion that printing more money can stimulate economic recovery is based on a particular interpretation of the Quantity Theory of Money. In its simplest form, the Quantity Theory is an equation,
MV = PQ
This equation states that the quantity of money (M) multiplied by its velocity of circulation, or the rate at which it circulates around the economy (V) must be equal to the price level of all goods and services sold (P) multiplied by their quantity (Q).
In this form, the Quantity Theory is an accounting identity which states that the monetary value of all expenditure – on the left-hand side of the equation – must be equal to the monetary value of all output, on the right-hand side.
The statement that the money value of all purchases must be equal to the money value of all sales is hardly a startling insight. Where the equation becomes interesting as a predictive theory is the hypothesis of the Monetarist School that the left-hand side of the equation drives the right-hand side. The monetarist case is that the rate at which money circulates around the economy is fairly stable, so an increase in the supply of money (M) will drive an increase in either the price level (P) or the output level (Q), or some combination of the two.
If an economy is operating at full capacity, Q cannot increase. In these circumstances, monetarists predict that any increase in the money supply will feed through to an increase in prices – “Inflation is always and everywhere a monetary phenomenon”, as Milton Friedman famously observed.
However, when, as in 2008/09, the economy is in recession, an increase in the quantity of money can stimulate an increase in output (Q) – and this is precisely what the advocates of Quantitative Easing hoped.
As we now know, things haven’t turned out as planned. What has gone wrong? Why hasn’t quantitative easing worked?
In terms of the Quantity Theory, the increase in money supply (M) has not fed though to an increase in output (Q) because it has been offset by a sharp decline in the velocity of circulation (V).
This decline in the rate at which money is circulating around the British economy has been largely overlooked by economic commentators, and undermines the central premise of monetarist theory.
Consider the following: at the beginning of 2007, the quantity of money as measured by one common indicator, Sterling M4, stood at approximately £1.55 trillion according to Bank of England statistics. UK GDP was approximately £1.4 trillion in that year. So the stock of Sterling M4 circulated around the economy 0.9 times in that year.
By the beginning of 2011, Sterling M4 had increased to approximately £2.15 trillion, or by around 40% over its 2007 level – thanks in large part to the Bank of England’s Quantitative Easing programme. Yet nominal GDP increased by only 8% over its 2007 level, to £1.52 trillion. The velocity of circulation therefore fell from 0.9 in 2007 to 0.7 in 2011 (=1.52 / 2.15).
There are other measures of the quantity of money in the UK. But whatever measure is used, the result is the same. The rate at which money is circulating around the British economy has fallen dramatically since the introduction of Quantitative Easing.
So has the Bank of England been the victim of an unfortunate coincidence? Was it just a fluke that the rate at which money was spent fell just as the Bank of England increased its quantity? Is the failure of QE down to sheer bad luck?
I don’t think so.
Why is the velocity of circulation is falling? Let’s get behind the mathematics and statistics. In simple English, the velocity of circulation is falling because the cash that the Bank of England is pumping into the economy is not being spent. It is being hoarded. It is being hoarded by the banks, as they strive to improve their liquidity and solvency. It is being hoarded by companies, and it is being hoarded by households and individuals.
But it is no mere coincidence that this is happening. Companies and individuals are being forced to hold more cash by the Bank of England’s own Quantitative Easing policy.
Quantitative Easing works by the Bank of England printing money to buy government bonds. This artificially boosts the demand for gilts, thereby driving their prices up and their yields down. This in turn has the effect of driving down annuities, which are used to calculate pension fund liabilities and entitlements.
According to the Financial Times, “A 65-year old man with a £100,000 pension pot could have secured an annuity income of £6,930 in March 2009 when QE was started. Three years later, the same man would have been offered £5,850.” This 15% reduction in annuities has forced pensioners to cut back their expenditure, and increased the unfunded liabilities of corporate pension schemes. Last week, Dawson International was driven into insolvency by its unfunded pension liabilities, and other companies may well follow if the Bank of England continues its QE programme. And even solvent companies are being forced to allocate more of their revenues to funding their pension schemes, leaving less cash for new investment.
And it is not just pensioners who have been hurt by QE. All those dependent on their savings for income have seen their earnings slashed by QE, forcing them to rein back their expenditure.
The perverse consequence of Quantitative Easing has been to reduce the amount of free cash that the corporate sector has to invest, and that pensioners and savers have to spend. So they have been forced to cut back, and that is why the velocity of circulation of money has fallen so dramatically.
So far from kick starting economic recovery, Quantitative Easing has strangled it at birth. The Bank of England needs to be extremely careful before extending a policy which has utterly failed to achieve its objectives, and is having such a damaging and destabilising impact on Britain’s pensions and savings.
Michael Nevin is author of The Golden Guinea: The International Financial Crisis, 2007 – 2014: Causes, Consequences and Cures. Commentary on the evolving international financial crisis such as this article can be found on the book's website www.goldenguinea.com