The news yesterday that the French and German economies grew a little in the second quarter whilst the UK one was still plunging has led to reappraisal of the UK strategy. The UK kept interest rates too high for too long in 2007-8, as I pointed out at the time. Modest recovery will come in the UK, but lower interest rates always takes sometime to filter through. We should see some benefit from late 2008 cuts in rates before the end of this year.
The UK’s curent policy is for the government to pre-empt most of the cash for its own borrowing needs, and then to lecture the banks on how they ought to be lending it to someone else! Let’s just remind ourselves what quantitative easing entails.
The Bank of England buys let’s say £5 billion of government bonds from investors. Shortly afterwards the UK government issues another £5 billion of bonds to meet its immediate cash needs by borrowing.Very often the bonds the Bank buys are similar in interest and length of time to repayment as the new bonds the government is issuing.
Who benefits from these transactions? Dealers in bonds do, as there is more turnover and more commission. Investors in bonds may do, as often the terms offered on the new bonds they buy may be slightly better than the terms surrendered on the ones they sell back to the authorities. Foreigners benefit, as some of them just sell their government bonds for cash, and move out of sterling if they are nervous of the UK future. The biggest winner is the government, which finances its large deficit relatively easily.
Some of the UK sellers of bonds do not immediately buy new ones. They deposit the proceeds of their sales in banks. Banks money holdings go up. The Regulator tells the banks that they must keep more money liquid and must not lend this out to the private sector. So the banks use the new cash deposited to buy government bonds themselves, as these are regarded by the Regulator as safe and liquid assets.
Current policy is to push more cash into the system, but to demand more caution by the commercial banks. This policy will help the government borrow the money it needs without too much competition for funds. We should not expect it to release large sums for private ventures or to help companies. It is a policy to make financing the deficit easier before the election. It is interesting to note that the net deficit is forecast at £175 billion this year, and by coincidence the approved quantitative easing programme is now also £175 billion.