Until fairly recently, the UK Monetary Policy Committee (MPC) influenced spending in the economy by changing interest rates. When there was too much demand, which could push inflation higher, interest rates were raised. When there was too little demand, interest rates were reduced to encourage borrowing and spending and to make saving less attractive. Interest rates are the price of money, an increase in rates raises the price of borrowing money and also makes saving more attractive. However, recent experience shows that other factors can be more significant than interest rates. The UK saving ratio rose in 2009 despite the very low interest rates that were prevalent.
The banking and credit market seized up in the summer of 2007, causing major difficulties in the ’real’ economy, leading to sharp falls in demand and eventually to recession. The Bank of England (BOE) was initially considered slow to react, but cut its Bank Rate from 5% in October 2007 and then made repeated cuts to reach a record low of 0.5% in March 2009.
The economy was in such a poor state that it needed a bigger stimulus than 4.5% (450 base points) off Bank Rate could supply. As an alternative strategy, the BOE shifted its focus to stimulating demand by increasing the money supply. This was done by buying government securities (gilts) on the open market – payments for these securities were deposited in bank accounts. These deposits resulted in banks having more reserves and so being able to increase their lending to customers. That, in turn, should lead to increased availability of credit and money in the economy.
A Bank of England research note saw three ways in which this process could influence the economy. Firstly, the impact on expectations should be that businesses and consumers anticipate more lending and spending. The BOE intention with inflation expectations is to anchor them at around the 2% CPI growth inflation target. Secondly, creating credits in the liquid balances of banks makes it easier for them to lend to customers. Consequent extra spending should feed back into new bank deposits, creating an upward cycle. Thirdly, buying up government securities increases demand for financial assets. Some investors, having sold gilts to the BOE, might switch to corporate bonds or shares. This should result in an increase in asset prices and so a reduction in yields and market interest rates. The BOE Chief Economist said that “a critical issue will be the extent to which movements in asset prices and market spreads are translated into lower borrowing rates faced by businesses and households”.
Figure one below summarises these three aspects of the transmission mechanism.
Source: Bank of England
As economists don’t work in a laboratory, we cannot conduct controlled experiments to measure the difference when circumstances change. In this case, we cannot be certain how the UK economy would have performed without quantitative easing. Our best guess on this is known in jargon terms as the “counterfactual”. Even the most sophisticated economic models that are available are of little assistance. We are in one of the situations where three different economists might offer five distinct opinions. There are no grounds for believing that the situation would have improved faster without quantitative easing, but little evidence on how much benefit the gilt purchases have brought.
An alternative approach is to compare UK developments with what has happened in countries without quantitative easing. In early November, 2009, the BOE was holding around 20% of the outstanding stock of government securities. International comparisons suggest that yields on UK gilts showed just a small difference compared with the US or the Euro area. The FTSE 100 share index has picked up strongly since its low point last March. However, other global equity markets have had similar experience and the FTSE 100 fared no better than indices from several other markets once recovery started. This makes it difficult to credit quantitative easing with a contribution to the recovery. Brazil and Australia, for example, recovered faster without any quantitative easing.
One useful indicator of money market conditions is corporate finance raised, either by issuing shares and debentures or by borrowing. Bank lending, after all, plays a significant part in the transmission mechanism. Chart 1 suggests that in 2009 firms’ net borrowing has been negative; businesses have repaid more loans than they have taken out. It seems likely that businesses, like banks, have been improving their balance sheets rather than taking new risks. And when companies or investors have sold gilts to the BOE, they sometimes seem to have reinvested in ways that improve liquidity such as buying securities with two years or less to maturity.
Source: Bank of England
The combination of easier money and bank rate at 0.5% could be expected to result in lower interest rates across the economy. Some money market rates have fallen, but chart 2 shows that households have faced higher rather than lower interest payments on most forms of borrowing since March 2009. Quantitative easing seems to have had no impact on borrowing rates for households. Returns on saving, by contrast, have stayed at record low levels. If households see no improvement in the terms on which they can borrow, there is unlikely to be any consequent change in their spending behaviour.
Source: Bank of England. SVR = Standard variable mortgage rate
The BOE expected quantitative easing to boost spending by households and companies “leading to higher consumption and investment". The fact that private demand has not risen is no surprise when transmission from financial markets to real economy interest rates has been so weak. Chart 3 shows changes in GDP and private final demand to mid 2009. The best estimates for 2009 which are currently available show that private demand has fallen further than aggregate GDP.
*Excludes car purchases. Source: ONS plus author’s calculations
The BOE Governor has suggested that broad money growth of between 6% and 9% has been consistent with steady growth and low inflation. Figures on broad money and credit barely budged between March and October of 2009 and then some growth was recorded in November. It is too early to know if this marks the start of a sustained improvement as subsequent data is not available yet.
Making borrowing easier and cheaper is just the first stage in the transmission process. Once households have more money, or are offered lower borrowing rates, it is not certain that they will want to spend more. Households around the world spent much of 2009 cutting back on spending to reduce debt and boost savings. The UK savings ratio rose despite the record low interest available on deposits.
This follows a pattern seen in Japan in the 1990s. In that case it was corporations which had run up massive debts. Even after they had reduced these debts by a third, companies were unwilling to borrow new money for several years despite record low interest rates. Chart 4 shows this behaviour. Similarly, even if rates fall and more credit is available, the British consumer’s propensity to consume may have changed. There has been a spending ‘splurge’ for Christmas 2009 and the January sales, but most indications are that people then expect to tighten their belts.
UK business investment is likely to be constrained by the large margin of spare capacity in the economy. Lower borrowing costs are irrelevant if the prospects of selling extra output seem poor. Thus, neither household consumption nor investment expenditure seems set for a speedy recovery, even if interest rates stay low. Most of the impact from the 450 base points cut in Bank Rate has already been felt.
Just as interest rates signal the BOEs intention to support or reduce demand in the economy, asset purchases may have suggested that the BOE stands ready to do whatever is necessary to support the economy. Like share prices, consumer confidence has improved around the world since mid 2009. In the context of confidence, UK consumer confidence has picked up more strongly than the global norm. Consumer confidence was lower in the UK than elsewhere at the start of 2009, but then recovered more strongly. There is no guarantee that this has any linkage to quantitative easing, but it is consistent with the asset purchases having supported the economy.
There are few signs that the BOE asset purchase programme has had a big impact to date. Most of the improvements which have been seen mirror similar developments in other countries. Significantly, the bank has been unable to effectively make credit cheaper and more easily available for ordinary households and businesses.
One of the uncertainties in all this is the extent to which quantitative easing will have a greater impact after a time lag similar to that seen with interest rate changes. At the start of 2010, there are also uncertainties about the continuation of money supply growth recorded in November and of spending increases recorded around Christmas. Retail spending grew by 4% in December but is expected to fall back subsequently.
In recent decades, Only Japan has experienced an equivalent to quantitative easing on a scale approaching the UK programme. There remains a concern that quantitative easing will have only a limited impact on the real economy in the UK, as it did in Japan.
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The UK Economy 1999-2009 by Ian Black
New 120 page book covering the last ten
momentous years in the life of the UK Economy.
When commentators started using the word ‘globalisation’ on a daily basis, it was often assumed that the word was synonymous with ‘Americanisation’. When the average student is asked for an example of globalisation, they will usually name an American company, such as McDonald’s or Microsoft. More recently, other commentators, such as Will Hutton of the Observer newspaper, and Evan Davis, who has been economics editor of the BBC, have focused on the growing influence of China.
What Christmas presents did you buy or receive this year? If it was a mountain bike which cost as little as, say, £70 then there is a strong chance that it was made in China. The Raleigh factory in Nottingham is no longer the centre of the world bicycle industry. If a younger member of the family received a ‘Hogwarts’ train set carrying the famous Hornby brand-name, then it was probably not made in Margate, as it once certainly would have been, but in China. On the one hand, something has been lost from UK industrial traditions by such developments; on the other hand British businesses which once seemed totally doomed have survived in some slimmed down shape or form.
Why is it that UK manufacturers find it economic to close their British factories and base their manufacturing in China? The answer is simply that Chinese factory owners can pay as little as £50 a month to workers who come to the manufacturing centres from distant villages, live in dormitory accommodation, and tolerate almost military-style discipline on the factory floor. A product such as a cigarette lighter, for example, which might sell for £12 in the UK can be made for around 50p in China, and still make a millionaire of the Chinese entrepreneur who obtains the contract. And China still has workers to spare: in fact, if all European and American manufacturing were to re-locate to China, there would still be Chinese workers to spare.
There have been reports of manufacturing companies moving their factories from places like Malaysia to China, thus impoverishing workers in one third world country by moving to a place where labour is even cheaper. And as Chinese incomes and living standards rise, we can confidently predict that factories will re-locate to ever more remote parts of the country, until they eventually abandon China altogether for the new low-wage country of the day.
As Chinese living standards grow, we can expect positive returns in the UK: our steel exports, for example, were for a time revitalised by the demand from Chinese manufacturers, and this will last until China can develop its own steel making capacity. If European motor manufacturers can sell cars to just a small fraction of the Chinese population, then they will have a market of equal size to the saturated markets of Europe. Cheap clothes and similar items from China have been a major contributor to low inflation rates in the UK.
‘Globalisation’ is not only about goods, but also about services. For example, as Chinese incomes and aspirations rise, the higher education sector in the UK is busy recruiting to first degrees and postgraduate courses such as MBAs among lucrative fee-paying students from China where home universities do not yet have the capacity to satisfy demand. The British Council and Universities UK have estimated that the British economy earns more than £11bn. annually from ‘exports’ of tuition for foreign students, training, examinations, publishing and educational programming. This places education and training in the same league as exports of oil and financial services. At the present time, there is a shortage of university places within China, and many Chinese students are very keen to spend some time in Europe. British universities have organised ‘outreach’ programmes located in China, many of which lead to young people from China spending some time studying in the UK.
One problem faced by British businesses when dealing with China is the very different business culture that exists there. For example, Chinese manufacturers often have difficulty in recognising the importance of ‘intellectual property’ and routinely ignore international treaties on such matters as copyright and patent law. Worse than this casual approach to intellectual property, the Chinese government has in the past been slow to stamp out deliberate counterfeiting, which is a much more sinister and dangerous activity. The passing off as the genuine article of substandard ‘pirate’ vital components, such as brand name brake linings for motor cars not only undermines the profits of legitimate companies but puts lives at risk.
At the moment Britain is the biggest single source of investment into mainland China. Industrial development and economic growth can cause massive pollution problems, and some of China’s waterways are among the most polluted in the world. One of the privatised UK water utility companies gained the contract to build a massive purification plant near Shanghai, and the project appeared to offer guaranteed profits; however like many arrangements with Chinese authorities and enterprises the contract turned out in practice to be worthless, as the institutions which would be expected to regulate business transactions prove to be inadequate, non existent, or corrupt.
At the United Nations conference on climate change in Copenhagen in December 2009, developing countries were offered some funding by the richer countries to help finance a move towards methods of production that produce less greenhouse gas pollution. Although China is officially still classed as a developing country, and although its pollution problems are massive (it is the world’s major burner of coal, for example), the Chinese delegation refused this funding. China does not regard itself as a country in need of aid, rather it perceives itself as the leader of what is known as the ‘G72’ group of less developed countries (Britain belongs to the ‘G20’ group of countries with high GDPs).
China wishes to develop international relations, and is cultivating a particularly strong influence in Africa, where there are reserves of oil, uranium and the base metals that China needs for its continued industrial development. In return for access to these materials, China offers African countries development funding, and African nations appear to prefer this funding to come from China rather than agencies such as the IMF which they see as being dominated by the USA. They believe that Chinese funding comes with fewer strings attached, as China does not insist on, for example, privatisation programmes in return for aid in the same way as the IMF.
Some American politicians have begun to murmur against China in the corridors of power in Washington, and are beginning to question some of the effects of the free trade arrangements that have enabled a country operating a peculiar mixture of neo-communist centralisation and neo-conservative free market liberalisation. There is a growing global phenomenon of the ‘sovereign wealth fund’, which enables governments to invest in private sector companies around the world. Now that western nations have privatised many of their public utilities, it is ironic that the private sector of the democratic world is becomes part owned by the state sector of countries which, in some cases, are among the least democratic and most repressive nations in the world. A proportion of the proceeds of China’s export boom has been used in this way,
It can be confidently predicted that such tensions will at some time in the future cause further reactions in the rest of the world, and that China will be increasingly questioned about its economic activities, its contribution to global warming, and such matters as its undemocratic political processes and human rights record.
In December 2009, some of the national leaders observers who regarded the Copenhagen conference as a failure let it be known that they put the blame on China, for refusing to sign up to legally binding agreements to reduce emissions. Other observers regarded it as rather ironic that countries that had largely given up on their manufacturing sectors, and were now relying on cheap imports from China, should then criticise China for causing global warming while driving down the costs of those imports.
In due course, we might see calls for restrictions on trade with China, or demands for changes in Chinese behaviour as a condition for China’s participation in international institutions. One major global player, Google, has already faced massive international criticism for allegedly agreeing to Chinese government demands for censorship as the price of gaining access to the Chinese market.
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