Saturday, 8 August 2009

Why We Are Not Economists

The Bank of England did two things this week. First it decided to keep interest rates at 0.5% - good news for mortgages, bad for savings. Second, it extended its practice of Quantitative Easing beyond its agreed limit of £150bn to £175bn, raising the question of will it go further?

The £175bn has been used to buy Gilts, or Government Bonds on future debt which we need to pay to off all our recent extra spending. In fact, in certain sectors of the Gilts market, the bank now owns above 70% of the available issues. On the face of it, this is econo-masterminding on a grand scale to save our economy and we feeble-minded numb skulls watching via the news articles should shut up and let the experts run the show.

You do not have to be a genius to work out this a high risk strategy. Quantitative Easing is in fact creating money out of nothing to purchase valuable things. It would be the same as you and I getting a classy money printing machine, printing off some fresh fivers, tenners, twenties and Fifties and then walking into a jewellers and buying a stack of gold. If anyone stopped us, we could say that are good for the money as we have a some savings in the bank and it is hardly likely that several jewellers would ask us to pay with real money all at the same time. Why, couldn't they just take those notes we have given them and use them to buy whatever they wanted - no one should worry as we are good for the money - and again not all vendors will come to us at the same time asking for the real money or its equivalent.

Quantitative Easing (QE) is really like that. Except of course, that we are no allowed to print our own money. But we have a way of doing so. Many of us have indeed printed new money over the years by taking some of the equity in our houses and creating new money in its place - sadly we have cannot behave like the Bank as we have to repay the loan, the Bank apparently doesn't. Another sad fact is that many of us are in a serious situation where the value of our assets have dipped below the original debt taken to buy them or we have negative equity - some 39% of all Northern Rock customers are in that mire while around 20% of Lloyds customers are.

QE is the process of conjuring cash from fresh air and buying really valuable items with it - with complete impunity. It works on the principle used by most banks which says if I have £1m in reserves in the bank then I can lend out many multiples of that as not everyone is going to ask for their money back at the same time or create a run on the bank. Meanwhile, the more 'unreal' money you put into circulation, the less the real money is worth. That means that each time you create more unreal money, prices have a tendency to rise as vendors think if there is proportionally more unreal money in circulation, then if they raise their prices they will keep the amount of real money they want for their goods.

It's a hard concept to grasp but if for every £1 in circulation, if 10p is unreal money created by QE, then each shop should raise their prices by 10p to get £1 of real money.

Very quickly, inflation can set in as it is so attractive to print more money to to apparently 'buy' your way out of economic trouble. Countries like Argentina did this and very nearly bankrupted themselves as so much unreal money bought apparently valuable things that the country nearly collapsed as inflation went into hyper-mode to try and compensate. QE, in economic terms, is the last resort of third world countries to save themselves.

Unless of course you are the experts at the Bank of England who think Britain is rich enough to do so. With our wonderful balance of trade heavily pitted against us, our manufacturing base pretty low and our rising debt after the bank bail outs set to almost double Sovereign Debt, QE makes perfect sense. Britain can afford it.

Our Sovereign Debt is based on cashflow, largely our tax receipts to pay the interest and repay the loan at some time. As with our own households, if we leverage our equity, then we have to pay for it, whether our assets rise or fall. In reality, by creating more money to buy our own Sovereign Debt, all we have done is created the need to raise more debt in the future to pay for it, as you have bought the debt with unreal money. It is the start of a very vicious cycle.

I am no genius, and better people than I will put me right, but one thing I know for sure is that you cannot buy anything for nothing. There is always a price to pay. QE is merely a postponement to pay in the future - we buy our own debt with more debt.
Pure genius.

No comments: