The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (42 page)

At the University of Chicago, Nobel prize-winner Robert Lucas sees it the same way for the USA. ‘It’s explicit in Milton Friedman’s work on the 1930s that policies like QE should have been done,’ he says. ‘Instead the Federal Reserve sat around and watched the economy sink deeper into the depression, and did nothing about it. This time round we are doing something. Most of the work is being done by monetary policy, not the stimulus package, but the line isn’t that sharp.’

But Richard Koo, the foremost expert on the post-bubble economic policy failures in Japan, told me at the beginning of the QE programme in 2009 that this is wrong: ‘There are some statements from the Bank that suggest that with QE they can solve all the problems. Well, we thought that in Japan, and when we put it in, absolutely nothing happened. Asset prices kept on falling, and the economy kept on weakening. When we removed it, still nothing happened. Even if there is a lot of liquidity injected into the system through QE, that liquidity will sit in the banking system, won’t be able to come out because these [over-indebted] people won’t borrow, and that’s basically what happened in Japan. And what is key is whether deleveraging is still happening,’ he says. By 2012 Mr Koo was being proven right on this. ‘In spite of the largest quantitative easing programme in the history of the world,’ he wrote, ‘the UK money supply did not increase and the BoE was unable to prevent the UK economy from contracting again.’

A furious debate also raged in the USA about a huge new trillion-dollar bout of QE, of the kind tried in Britain – buying US Treasury bonds. In turn that raised questions about the real motive behind such a move, with an assertive China suspecting that this was a backdoor dollar devaluation. In the primaries for the US presidential election of 2012, one Republican candidate even suggested that QE was a form of treason, and presidential nominee Mitt Romney promised to fire the Fed chief Ben Bernanke.

There is some irony in Washington looking to a London-style QE when there was so little evidence that it had been a success. And, yes, at the same time, influential voices in Britain were pushing for the adoption of a more US-style variety of QE aimed at stimulating a broader range of activity. Back in 2009, people in the Treasury wanted the magic money to be used to stir the mortgage bond market into life, or for more direct lending to companies. This is the difference between qualitative and quantitative easing about which David Cameron had mused. But the Bank at first said ‘no’.

Independent Bank of England policymakers such as Adam Posen suggested that such a policy would make a useful contribution as a Plan B. Giles Wilkes, the author of a LibDem pamphlet that advocated using magic Bank cash to direct funding to small businesses through a Treasury fund, is now an adviser to Vince Cable. Richard Werner thinks that ‘Green QE’ could be directed at boosting investment in environmentally friendly infrastructure. Danny Gabay has the most innovative of plans. He contends that the failure to cleanse Japan’s bank balance sheets of ‘zombie’ property companies was what caused its lost decade. ‘Zombie’ households with large debts and overvalued property is the British equivalent. QE could be used to buy up houses, setting a discounted floor price for property.

‘I’m a supporter of QE, but it needs to be more imaginative, says Danny Gabay. ‘The UK has been doing it in a very unimaginative way. We need a sniper rifle rather than a scatter gun. So far we are filling a big manual on what doesn’t work.’

Monetarists could not disagree more. The velocity of broad money had ticked up, and economists such as Simon Ward believed more QE risked the rise of the inflationary dragon: ‘The strength of commodity prices is related to QE2 speculation.’

George Osborne’s Treasury tried the NLGS, his own version of ‘credit easing’, in late 2011 after limp efforts to get banks lending to businesses. Insiders admit that this should have been done a year earlier. With Britain’s economy still mired in contraction, the Bank of England finally did act on lending, launching a huge funding-for-lending scheme, which subsidised banks for maintaining lending into the real economy. Except this too had adverse impacts on rates paid to savers.

Almost all economists believe that too much QE will eventually lead to raging inflation. It is only the limp economic recovery that is keeping that in check. But is there an exit strategy? Just as the Bank of England bought the debt, so it will soon have to sell it. But when should QE shift to QT – quantitative tightening? As this has not been done before, the Bank needs to think carefully about this question. Rates could go up first, with room to fall back if necessary. This would be followed by pre-announced sales of the Bank’s gilts, coordinated with the Treasury, and spread over a series of months. That seems to be the plan.

Or not. Some economists are assuming that this pile of government debt will never be sold. The reversal of QE sounds like a doomsday machine designed to snuffle out any nascent recovery. Long-term interest rates would rise aggressively, and the Bank of England would be sitting on losses on its portfolios of gilts. Monetary tightening, and a requirement for fiscal injection from the Treasury. Is this really going to happen? Or will the gilts be left to expire? There are suspicions about how seriously the Bank of England is taking its 2 per cent inflation target. Inflation has been above this number in sixty out of the past sixty-five months, since 2008 averaging 3.3 per cent.

For Richard Werner, it is time for the Bank to quietly park that target and instead publicly embrace its quest for moderate inflation in a manner that Japan was very shy about. ‘The Bank needs to set a nominal GDP growth target,’ he says. A nominal GDP target incorporates a bit of inflation and a bit of growth in one target. In September 2012 the US Federal Reserve considered such a target, alongside a ‘price level’ target, that would basically allow for higher inflation in current circumstances. Vince Cable’s adviser Giles Wilkes suggested, before joining government, that for five years the Bank of England replaces its totemic 2 per cent inflation target with a ‘nominal GDP’ growth target of 6 per cent. The new governor of the Bank of England, Mark Carney, dabbled in versions of policies such as this in his previous job in Canada. ‘Open-mouth operations’ involve using communications to guide down expectations of future interest rises. ‘Forward guidance’ is the innovation of the moment, involving the managing-down of expectation using speeches and press statements. The hope would be that a company would be more likely to take out a loan for more equipment, or a homebuyer a mortgage, if there exists confidence on low rates over a period of years. Both Mr Carney and the ECB president Draghi deployed forms of ‘forward guidance’ in July 2013. The end result is lower interest rates for longer. The guidance can be supplemented with a conditional threshold too. For example, unemployment would have to dip below 6 per cent before interest rates were to rise. These monetary policy innovations had been rejected by the Bank of England under Mervyn King. Mark Carney imposed his plans in Britain immediately. It did raise a question: given Chancellor Osborne had gone to great lengths to tempt Mr Carney into the job, was this a high-level form of political interference at the Bank of England, meant to keep interest rates as low as possible?

In Canada, Mr Carney had been a rare sight: a G7 central banker who had raised interest rates. He had acted independently of Canadian government wishes. At the same time, however, it was clear that his approach fitted with the UK government’s desire for ’monetary activism’. As the chancellor told me: ‘I’ve always thought that the macroeconomic debate about austerity was secondary to the monetary policy debate.’ Would a Bank of England insider have pursued Carney-style innovations in monetary policy? Doubtful.

In Canada, Carney’s many fans say that it is far too simplistic to suggest his policy is just ‘lower for longer’. If the confidence coursing through the economy at the thought of low interest rates actually increases investment, jobs and house purchases, then rate rises could come sooner rather than later. In any event, the power of words and communications alone is limited. What about even more radical monetary policy options? A decade of near-zero rates is entirely feasible.

Why, it might be asked, did the Treasury or the Bank of England not just give £18,000 to each British household in a ‘helicopter drop’, rather than let that £375 billion stagnate in the murky, blocked intestines of British finance? The answer, officially, is that it would have created too much inflation, and would not have been reversible. The Bank needs its unconventional policies to at least appear as if they might be reversed at some point in the future, even if it turns out that this never happens.

And therein lies the rub. QE has been an invisible balm, but unwinding QE has displaced some pain of higher long-term interest rates, and higher deficits, to some point in the future. Is QE really consistent with Britain’s 1997 anti-inflation macroeconomic settlement, by which the government gave the Bank of England independent control over interest rates? Is Britain’s economic predicament credibly consistent with a target inflation exceeded for most of the past half-decade. Can the target be altered without igniting inflationary expectations? And does Bank of England independence really mean anything now it’s the largest purchaser and holder of UK government debt? Fiscal dominance is in fact more the norm than full central bank independence. The independent central bank doggedly pursuing an inflation target may turn out to be a two-or-three decade fad.

QE is a policy that is massive, controversial, remarkably redistributive, uncertain in its effect, and is now resulting in a myriad unintended consequences. There are diplomatic and political impacts. Few can claim to understand it fully. QE might work. It might even be working. The jury is still out on its effect in Japan a decade ago. But given these imponderables, does it really make sense to rely on QE as the primary weapon for fighting a prolonged economic sluggishness? It did not and it does not, and now under new management, Britain will not. But the UK will soon discover, with its new experiments, if we really are at the limits of the power of monetary policy.

Dramatis personae

Zinedine Zidane, French footballer

Klaus Wowereit, mayor of Berlin (2001
–)

Angela Merkel, German chancellor (2005
–)

Gerhard Schröder, German chancellor (1998
–2005)

Peter Hartz, former personnel director of Volkswagen

Otmar Issing, chief economist, European Central Bank (1998
–2006)

Tobias and Christoph,
Lederhosen
-sporting Bavarians at Munich’s Oktoberfest

Jens Zerkler, 17-year-old apprentice at a forklift truck factory in Aschaffenburg, Bavaria

Thomas Mayer, chief economist, Deutsche Bank

Richard Walker, anchor, Deutsche Welle TV station

Hans-Werner Sinn, economist, Ifo Institute for Economic Research, Munich

Horst Seehofer, leader of the Christian Social Union (CSU), Bavarian sister party of the Christian Democratic Union (CDU)

Peter Altmaier, CDU chief whip

Martin Murtfeld, 76-year-old retired German banker

Frank Schäffler, backbench MP in the Free Democratic Party (FDP)

Peer Steinbrück, former German finance minister, and Social Democratic Party (SPD) candidate for chancellor

Berlin in the first decade of the Eurozone was like no other city in Europe. From the abandoned East German power station re-purposed as a gay techno club and the graffitied Tacheles squat populated by Bohemians and Faux-hemians, to the World Cup Final graced by Zidane’s head-butt and the refounding of modern German footballing patriotism amid thousands of Schwarz-Rot-Gold tricolours in the Tiergarten. It was a city with space, pregnant with creative opportunity, but lacking any real industry, bar the re-emergence of national politics. Rents were cheap, jobs were scarce, and young creatives flocked to Mitte and Friedrichshain. ‘Poor but sexy,’ was the description by Berlin’s mayor Klaus Wowereit of the new undivided city. Across Berlin, in the old West, something rather different was emerging.

The Bundeskanzleramt or Chancellery in Berlin, opened in 2001, is eight times the size of its American equivalent. By design, the new home of Germany’s chancellor manages to evoke a calm, passive authority, in contrast to the executive potency of the White House. The no-nonsense Berliners have nicknamed the giant white cube with its massive round window the
Bundeswaschmaschine
(‘federal washing machine’), or, even less respectfully, the
Elefantenklo
(elephant loo).

Inside the white cube, backing onto the River Spree, there are wide spaces, open walkways, glass and sculpture. The post-modern design was supposedly a conscious effort to avoid the pompous and the grandiose. Berlin’s re-emergence as the seat of the German government for the first time since the war demanded a confident architectural statement. But it was a tightrope. German reunification was only tolerated by President Mitterrand of France because of the constraints imposed on German power by its membership of the European Union. As the German joke goes: ‘France and Germany are in an authentic marriage. A mutual insurance pact, with occasionally some love. We love them, and the French love our money.’

The euro was the ultimate embodiment of that marriage, yet the euro crisis was to push Germany into an unchallengeable economic ascendancy. Berlin’s post-reunification role in directing over a trillion euros into the impoverished former East Germany had created a certain reluctance to bail out any other countries in crisis. Not far from the city’s gleaming political quarter could be found run-down districts full of the unemployed, the underemployed and the new poor. These were the results of new policies that had given Germany its great economic success, a success that was combined with social failure. This combination became Berlin’s answer for the problems of an entire continent.