How much more proof do we need before we recognise that QE is not working?
QE is damaging growth, not helping it, but impact on older generations is being ignored
Government must organise direct support for industry and savers to get economy going

by Dr. Ros Altmann

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Today's announcement that the UK economy has indeed endured a 'double dip' recession is further evidence of the failure of Bank of England policy. QE was designed to boost growth, yet despite the Bank of England's £325billion gilt-buying spree, the economy is not recovering, bank lending is not rising and banks are raising their overdraft and credit card lending rates. How much more evidence is needed that this is the wrong policy?

Why has QE failed? QE has not boosted the economy because buying gilts does not create growth and because the damaging side-effects of artificially lowering gilt yields have been ignored or dismissed as irrelevant.

Buying gilts does not create growth: The Bank of England is relying on buying gilts as a mechanism for lowering interest rates further than is possible via conventional monetary policy actions on short-term rates. It expects that the money received by gilt-sellers will somehow transmit its way to the economy and boost growth. This is not working in real life. Academic theory would suggest that adding to bank balances by boosting institutional investor funds will ensure increased lending in the economy, lower interest rates all round and general stimulus being provided. The effect could be direct - via higher lending - or indirect - via higher asset prices. But this mechanism is not working in practice. Firstly, many gilt-sellers are foreign investors who use the money received to buy overseas assets, which does not boost the UK economy at all, although it may weaken sterling and increase UK inflation! Secondly, the banks are desperate to rebuild their balance sheets and are tightening lending conditions, while increasing their profit margins as well, so the money is getting stuck in the banking system. The theoretical argument that the money is indeed boosting the economy because it has to go 'somewhere' is a long-run phenomenon that boosts inflation further down the line, but does not help near-term - as we can see from today's figures.

Side-effects of QE damage growth: Buying gilts has undermined UK pensions. The Bank seems to be in complete denial of these negative impacts. It has artificially lowered gilt yields which leads to a sharp rise in pension fund liabilities and sharp fall in annuity incomes. The Bank has tried to argue that falling gilt yields do not actually affect pensions because the rise in gilt prices (and other assets that are supposed to be priced relative to gilts) will offset the impact. But this academic argument is again not working in practice.

QE has caused a 50% rise in pension fund liabilities, weakening corporate UK. Every fall of 1% in long-term gilt yields means a rise of 20% in pension fund liabilities. Since the start of QE, 15 year gilt yields have fallen by 2.5%, which means that pension liabilities have risen by 50%! Since pension funds are not and cannot be invested solely in gilts (there are not enough of them and, in any case, with a fund in deficit it is essential for trustees to take some investment risk in order to earn returns above those available on gilts) it is clear that asset values have not increased by 50%. Indeed, deficits have ballooned, forcing companies to divert resources to their pension funds rather than their businesses, which has harmed growth.

QE has caused a sharp fall in annuity incomes for those retiring now, damaging consumption. Since 2008, annuity values have plummeted, because annuities are priced against 15 year gilt yields. Anyone recently or soon-to-be retired is facing a permanent income reduction as a result of QE. This, in itself, is bound to have negatively affected consumption, and weakened growth relative to what it would otherwise have been. Nearly half a million annuities are sold each year - this is not a tiny issue.

QE has caused inflation, which has damaged consumer confidence. QE was originally designed to fight deflation and, clearly then, it aims to create inflation. The UK has suffered from far higher inflation than we would have experienced in the absence of QE gilt-buying. This impact on inflation comes indirectly perhaps, via the boost that QE has given to overseas assets, economies and asset prices coupled with the weakening of sterling relative to other currencies, which have boosted commodity and import prices in sterling terms and fed through to UK inflation. High inflation, coupled with low interest rates, have sapped consumer confidence and hit older generations particularly hard. It is the over 50s who have the money to spend, but they have been cutting back because of economic fears. Savers' income has fallen, so their spending has fallen. We have transferred money from savers to borrowers, but surely we actually want to encourage those with money to spend it, rather than relying on those already in big debt to keep spending more. With our aging population, the damage done to the over 50s is more than offsetting any benefits felt by the borrowers who are managing to support their debts due to artificially low interest rates.

What should we do to boost the economy then? Firstly, we must recognise that QE gilt-buying has not worked. It was an experiment - and it has failed. Relying on the argument that things would have been much worse without it, is no longer sufficient justification. Secondly, of course, the markets are 'hooked' at the moment on the fix of continued Bank of England buying so the ending of QE must be handled carefully. A sudden announcement that no more gilts will be bought would lead to a sharp rise in gilt yields. It is clear that current gilt yields do not reflect the fundamentals of the UK economy! Our inflation and fiscal deficit levels would imply far higher yields.

Temporary fiscal boost for corporate investment. Announcing a one year or two year special tax allowance for companies that undertake major capital investment would help kick-start growth. Large companies have huge cash reserves, but are fearful of investing at the moment. If they have a reason to invest now, rather than putting things off for the future, then we can help boost jobs and growth.

Harness the power of pension fund assets to boost growth directly. This requires an alternative approach to policy. Conventional fiscal and monetary policy are not enough, and we do need to spend more on infrastructure and long-term projects. Government cannot fund this, but it could underwrite the returns. Such guarantees would be worthwhile because of the short-term boost to jobs, that would save money on benefit payments. Both public (local authority) and private sector pension funds have billions of pounds worth of assets, which are currently considering buying gilts. This would not solve our pension fund problems and would not boost the economy! Instead of this, Government needs to act much more quickly to ensure these pension assets are committed to long-term investment projects to boost the economy, underpinned by some Government guarantee if necessary.

Consider using one of the partly owned banks to lend directly in the social interest - current lending targets are inappropriate: Taxpayers own most of RBS and Lloyds, yet those banks are being run to make profits for shareholders as soon as possible, which is not in the social interest. We need the big banks to lend to small firms directly, because conventional banking is not working. Small firms need access to loans on decent terms - that means reasonable charges and interest rates, without hidden fees and draconian conditions. Banks are refusing to do this in too many cases. Either the banks should be directed to do this, in order to achieve the social goals of growth and job creation, or the state must organise a lending institution to do this directly. That is a far better use of money than buying gilts. Currently, banks are being asked to fulfil gross lending targets. This is not an appropriate goal - and even then they are not meeting their targets! The small loan scheme only subsidises the interest rates charged, without looking at what those rates are, nor the other conditions imposed by banks on lenders.

Encourage lenders to take equity stakes in homes of those who have over-borrowed instead of repossessing: A big fear for policymakers is that if interest rates rise, people with mortgages and negative equity may have their homes repossessed. This would damage economic and social prospects. However, we must not hold the rest of the economy to ransom to artificially support one group. It would be better to recognise that some people have borrowed far too much, that they cannot repay their mortgage and that it is worth more than their house. Therefore, we need to find ways to restructure these debts. A sensible way forward would be for the lender to take an equity stake in the property, rather than forcing the borrower out and trying to sell. This means that families could stay in their homes but would only own, say, 60% of it rather than 100%, but could carry on living there and their mortgage payments would constitute part 'rent'. House prices are too high, if they do fall that can correct some of the other imbalances in our economy.

Overall, these latest figures should be a wake-up call to policymakers, to highlight that the current stance of policy is not working well enough and we need to find more creative ways to stimulate growth. There are routes available, especially if we can harness the power of pension assets rather than relying on the banking system. We also need to understand the importance of the spending power of older generations - rather than taking money away from them, either via low interest rates or high inflation, we should be ensuring they remain confident enough to spend.

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